Using Diversification to Reduce Investment Portfolio Risk

personal financeHaving looked at how diversification can be used to reduce our exposure to unsystemic risks in an investment portfolio, we can now start looking at the specifics of how it is that diversification can improve our ability to generate returns with as little risk exposure as possible.

It is generally accepted that diversification is optimized once a portfolio contains approximately 32 investments within it. From there, we need to take a look at how much risk a specific company has above and beyond the movements of the overall market itself. Since it stands to reason that all securities carry both systemic risk and unsystemic risk, but that the market itself only moves with systemic risks, it stands to reason that the correlation of a given security’s movements with the greater market is reflective of its exposure to how much total risk it is exposed to above and beyond the movements of the market itself.

This metric is known as Beta, which represents how much more a security’s price will me in response to a movement in the overall market. If the market moves by $1, it stands to reason that a security with a bet of 2 will therefore move by $2 in response.

The Beta metric can be used to build a basic portfolio by showing us how to generally offset the individual unsystemic risks of companies within our portfolio. Ideally, we want to create an overall portfolio that has an average Beta of 1, which means that the portfolio is, statistically speaking, only exposed to the systemic risks of the overall market. This is accomplished by balancing out the betas of all the positions in our portfolio until they average out to approximately 1. So if we take on a great deal of high-Beta technology stocks in a portfolio, we can theoretically balance out that risk by taking on exposure to low-beta consumer staples securities.

While the usage of the Beta metric helps investors to see the statistical benefits of portfolio creation, it is important to remember that this metric can also mask the true risks of a portfolio because it does not differentiate between similar risks. For example, a coal mining company with a great deal of unsystemic risk that is tied to the price of coal might have a high beta, while a utilities company that provides power to customers might have a very low beta.

Even though these two companies arguably offset each other’s betas, they will both share the unsystemic risks associated with variable coal prices, and therefore not improve the overall diversification of the portfolio by enough to matter. We therefore need to take our analysis to the next level by looking at how it is that different industry classes asset groupings will have different risk exposures, and how it is that we can further segment our portfolio to minimize risk.