The age-old rule of ‘don’t put all your eggs in one basket’ holds true for all walks of life; however, none more so than for asset allocation in a portfolio. The concept is simple, but often overlooked. When you apply for a job, you don’t just apply for one, you spread your risk by sending your resume to multiple companies.
Diversification is a simple strategy to risk mitigation, by allocating capital to different types of investments, whether it be various financial instruments, different industries or different asset classes. It is based around the principle that returns will be maximised by having various areas that would react differently to the occurrence of the same event.
Diversification is not a guarantee of preventing loss, but what it does allow you to do is reach a financial goal by minimizing risk. Risk can be defined in many ways, whether that be geopolitical risk, timeline risk, currency risk or asset class specific risk. Either way, risk can be systemic or non-systemic and a diversified portfolio aims to balance risks. This is typically represented by a lower return, but also more consistent and less volatile growth.
As a very rudimentary example, let's say you have a portfolio of only Chinese manufacturing stocks. If it is announced that Chinese manufactures are going to have trade tariffs imposed and all exports will now be more expensive, share prices of Chinese manufactures will likely decline. That means your portfolio will experience a noticeable drop in value.
If, however, you counterbalanced the Chinese manufacturing stocks with a couple of US manufacturing stocks, only part of your portfolio would be affected. In fact, there is a good chance that these stocks would climb, as they become more competitive globally.
Asset class diversification is also key. Different assets such as bonds and stocks will not react in the same way to adverse events, such as global recessions. A combination of asset classes will increase your portfolio's robustness to market swings.
With global markets ever more connected, the simple rule of bonds and stocks moving in inverse directions does not necessarily hold strictly true anymore. Given this diversion, people can also choose to diversify between private and public listed markets. And while stocks climb to record highs, private markets seem more understandable and attractive to clients.
No one should hold purely public market exposure and no one should have only private asset backed placements; clients should hold a balance between the two, with weightings dependent on their view of the potential growth in each market.