How should we look to diversify our investment portfolio?

Updated: Nov 25, 2021

By Ryan Lee

Disclaimer: Please note that the opinions expressed by the author in this article do not constitute financial advice and are solely for educational purposes only. When buying shares, the value of your investment may go down as well as up and you may get back less than you invest.

As 2021 begins to come to a close, we look back at the stock market and are faced with these facts. The S&P has had more than fifty new highs in 2021 alone and the Dow Jones Index has had dozens itself. With Robinhood and other mobile apps bringing the investing game to the fingertips of everyday consumers, it’s easy to assume many readers will have some skins in the game. But investing isn’t just about reading the first company that makes the headline on CNBC or hearing it from an uncle during a dinner conversation. Investors should understand how to regulate their risk exposure as well as create a sufficient plan to construct a well-balanced portfolio. Where should we begin?

Modern Portfolio Theory

The Modern Portfolio Theory addresses just that. It puts together a framework based on minimizing investment risk exposure to themselves, whilst maximizing the profit from investments. And in a market where no one holds a crystal ball to tell whether there is a bull run or a bear case, the best way to reduce risk is to diversify the portfolio.

A bit of history on The Modern Portfolio Theory.

Developed by Nobel-prized winner Harry Markowitz in 1990, this coding genius/ex-hedge fund president discovered that investors can arrange their investment portfolio in a way in which the combined portfolio risk is lower than the individual volatile stock within it.

A simple example

Say for example a young investor decides to invest $10,000 of his money. He invests half in an ice cream truck business, to take advantage of the sunny weather in the summer and half in an umbrella manufacturing business during the heavy rain seasons. The uncertainty of the weather determines the profit of each business (much similar to how the uncertainty of the market determines how our portfolios perform). Assume chances of sunny and rainy days every day are 50/50. Below is the table of how the investment returns for both businesses will hypothetically perform:

On average this young investor would earn a fifty percent return on one business while losing twenty-five percent on another. Making this investor yield a twelve-point-five percent return in his entire portfolio ($11,250). $2500 - $1250 = $1250. This return would be the same whichever the weather is present on the day. This is the scenario of how a diversified investor can come up on top even though not all their investments are a winner on any given day.

This simple example of diversifying works due to the perfect negative relationship between the two companies. As long as two companies move inversely and not in parallel, equity diversification can mitigate a level of risk. The degree of risk reduction depends on :

A) The number of securities the risk is spread across and;

B) The statistical interdependence between returns of different investments.

To find the degree of relationship between two asset returns we can simply find the covariance of both assets using the probabilities of the independent event and the returns of both relative investments. The calculation below simulates the example used previously.

Where U = return from umbrella company Ū = average return of umbrella company

Where I = return from ice cream company Ī = average return of ice cream company

COV IU= Probability.rain (U - if rain Ū ) ( I - if rain Ī) + Probability.sunny ( U - if sunny Ū )( I - if sunny Ī )

However, individuals looking to use this simple trick to diversify their investments should note that there are many factors that can affect the profitability of an individual company, unlike the perfect scenario we were presented with.

Diversification in the real world

When we talk about diversifying our stock portfolio, it may not entail just investing in different sectors in our relative stock market. Instead, we can look to include a global economic mindset and diversify into other global indexes and stocks in foreign countries. The risk of investment into foreign economies can be beneficial to risk reduction as foreign economies do not move in parallel with the U.S. market.

However, some would argue that with globalization increasing the connectivity of countries and subsequently the correlation coefficient between the U.S. and the global economy, the effects of diversifying securities have a lesser impact on mitigating risks.

Concluding Thoughts

To conclude, even though globalization boosts the interconnectivity of people and subsequently the economies of many nations, diversifying portfolios can still offer investors major leverage on reducing risk exposure. And for many beginner investors, the companies that are on the stock markets are in the thousands. It may seem intimidating to pick a needle in the haystack. Therefore the general recommendation is to buy the haystack, which conveniently is offered as an Exchange Traded Fund (ETF) or a mutual fund that tracks the performance of many companies wrapped under one security