The Pros and Cons of a Diversified Portfolio
Portfolio diversification is a key financial planning concept in Singapore which is pivotal in mitigating risk. Spreading out investments across more than a single investment channel nullifies the “all eggs in one basket” syndrome, which deluges avid risk-takers in debt when a market venture turns sour. Portfolios can be generally diversified via investing in different asset classes or within the same asset class by using mutual funds, bonds, real estate, insurance, precious metals and other notable assets.
Although portfolio diversification seems like a good fall back strategy in achieving stable financial goals, it does carry its own series of advantages and disadvantages.
1) Pros of Portfolio Diversification.
i) Reduces Risk.
A properly diversified portfolio can help level out market volatility and reduce risk. This financial strategy can be observed when you spread out your investments across multiple asset classes, and if one stock falls, the other stocks will not be affected. Theoretically, unsystematic risk is eliminated with a truly diversified portfolio. Realistically speaking, it is hard to totally eliminate unsystematic risk, thus a truly diversified portfolio is virtually impossible to create. In the case of systematic risk however, the risk can be reduced with time; for example, over time, markets in general will rise, thus any risk of being caught in a falling market will be eliminated if a portfolio is held long enough.
Thus, it is important to take heed that diversifying one’s portfolio and holding on to it for the long-term will reduce overall risk significantly, but will not eradicate it completely.
ii) Higher Profits.
Higher profit returns are observed with a more diversified portfolio. With diversification steering the helm, extra returns may be gained from other asset classes even if a particular asset class is underperforming and in red. For example, a Singaporean investor has decided to invest in two assets classes – stock and gold. Should the stock underperform and become negative, the investor may gain returns from the gold instead. The easiest way to see a positive profit growth would be to invest in markets or stocks/bonds that have value and are not overpriced. Statistically, it has been shown that future returns are greatly enhanced if one purchases so-called ‘cheaply valued stocks or markets’.
Also, the negative or even zero correlation between asset classes in a portfolio is actually deemed positive. It has been academically proven via models such as the Capital Asset Pricing Model and the Efficient Frontier that well diversified portfolios with negatively correlated components can help maximise returns while minimising risks.
2) Cons of Portfolio Diversification.
i) Average Profit Returns.
Most individuals in Singapore who diversify their portfolios believe this offshoot of financial planning is sound and fool-proof. Unfortunately, too much diversification, also known as overdiversification, can lead to average or marginal profit returns. Generally, there is an optimal number of holdings that will maximise profits or minimise risks after which the marginal increments make it less worthwhile to increase diversification. In some cases, this might even subtract from returns and increase volatility.
Basically, the more a portfolio is diversified, the less the earning potential will become. In theory, overdiversification may even lead to higher brokerage fees, transaction costs or bank charges, but this depends on the instruments used and the benefits achieved from the diversification, either in terms of additional returns or lower volatility.
ii) Higher Risk as a Result of Overdiversification.
Mitigating risk is a crucial aspect of financial planning in Singapore. However, some investors may blindly diversify their portfolios for the sake of diversification, without considering the nature of the stocks they invest in. Such a move actually increases risk instead of nullifying it. This is because you lose the benefit of diversification after an optimal point is crossed; for example, the addition of more stocks/bonds will increase the correlation between asset classes instead of reducing it, thus increasing overall risk.
Hence, there needs to be four core principles to boost the odds in the favour of an investor such as:
a. Investing for the long-term and buying value
b. Holding a well-diversified portfolio
c. Better risk management
d. Rebalancing one’s portfolio periodically
Thus, portfolio diversification carries its own share of advantages and disadvantages. A well-diversified portfolio may lead to higher returns and mitigate risk, but an overly-diversified portfolio may also elicit the opposite effect by increasing risk and lowering a portfolio’s returns. Therefore, it is important to note that the ideal portfolio does not exist, since the success of a portfolio really depends on a few key factors, such as the investment time horizon, allocation into the various asset classes and the individual attitude and goals of each investor.
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Important: The information and opinions in this article are for general information purposes only. They should not be relied on as professional financial advice. Readers should seek independent financial advice that is customised to their specific financial objectives, situations & needs. This advertisement or publication has not been reviewed by the Monetary Authority of Singapore.