When investing, it’s important to manage your risk, and diversification is among the principal tools available for doing so.
You could consult a dozen financial experts and walk away with a dozen different ideas on how to best invest your money. However, constant among them will be a recognition of the importance of diversification.
Diversification is financial speak for ‘not keeping all your eggs in one basket’. It’s a tactic that involves spreading your portfolio across a range of investments so that you aren’t overly exposed to one investment should it not perform as expected.
The logic is intuitive. Suppose an unfortunate gust of wind causes you to drop your sole egg basket; your portfolio would be reduced to a puddle of yolk and eggshells. Spreading your ‘eggs’ (read: investments) into different baskets, minimizes the impact that one gust of bad luck might have on your overall portfolio.
Managing your risk
Diversification begins with holding a sufficiently ‘large number’ of investments. Generally, the first 30 positions will capture the bulk of available diversification benefit, so you should aim to hold at least 30 positions.1
However, effective diversification entails more than simply holding a mix of 30+ investments. Instead, your mix should consist of 30 differentiated investments. Differentiated investments are investments that will perform differently to each other under a given set of market conditions – i.e. investments which carry low or negative correlations.
To illustrate, picture investing in 30 copper mining companies, if the price of copper were to fall dramatically, the impact on our portfolio would likely be equally dramatic. Instead, effective diversification involves spreading our investments across industries & sectors as to not be overly exposed to any one of them.
Diving deeper into the above, we highlighted an adverse change in copper prices as a risk factor particular to copper miners. In finance risks particular to a company or subsection of companies are known as specific risks. Diversification is important precisely because it helps mitigate your exposure to specific risk. Keen bond investors can read the “Risk Factors” segment of a bond’s prospectus to learn more about risks specific to the bond issuer & its industry.
Diversification is a broad concept and it spreads beyond differentiating between industries and sectors, you can also diversify across asset classes, cyclicality, geographies and so forth. Turning to bonds, you may wish to diversify by time to maturity, floating/fixed rate notes, currency and credit quality.
However, not all risks can be diversified away.
Risks that cannot be completely diversified away are known as systematic risks. Systematic risks are often caused by macroeconomic shocks, such as natural disasters or wars. A more benign example would be the impact of a change of interest rates on bond prices.
Credit quality and specific risk
Diversification becomes increasingly important as we move down the ratings scale.
Lower rated credits tend to be driven by specific risk particular to the issuer. As such, diversification across issuers is important to mitigate these specific risks. The same impetus for diversification does not exist with high quality credits whose performance is driven by general, systematic risks such as changes in interest rates. Though, an element of diversification is always important.
Tolstoy’s observation of the ‘Anna Karenina Principle’ can help us better understand the interaction between credit quality and primary risk factors:2
“All happy families are alike; each unhappy family is unhappy in its own way.”
Investment Grade issuers are like happy families; they enjoy access to funding on favourable terms. Furthermore, the performance of Investment Grade bonds tends to be driven by general, systematic risk factors such as changes in interest rates; in this way, like happy families, all Investment Grade companies are alike.
In contrast, High Yield issuers are unhappy families, paying high-interest rates to borrow. Compared to Investment Grade bonds, the default risk on high yield bonds is more prominent; consequently, sound financial performance of the issuing company becomes increasingly important in preventing defaults as we move down the ratings scale.
Recall that financial performance is largely driven by risk factors specific to a company – e.g. our example of copper miners whose fortunes were tied to the price of copper, as these specific risk factors vary markedly from company to company, the drivers of HY bond performance by extension vary markedly from company to company. In this way, like unhappy families, each High Yield issuer is unhappy in its own way.
In short – when investing in higher yielding names diversification becomes increasingly important.
How can I diversify?
You can diversify across companies, industries, asset classes, and geographies.
As a rule of thumb, you want to avoid having more than 5-10% of your portfolio in any one bond, unless you have a particular conviction about the investment. Furthermore, you’ll want to hold at least 30 bonds in total as a starting point for diversification.
You should also be mindful of your exposure to specific geographies and industries, ensuring that you are comfortable with the spread of your investments.
Ultimately, we want to ensure that you, our investors, have a positive experience. This means not only making bonds accessible but making them understandable and empowering investors with the knowledge to build wealth.
With the above in mind, Investors should be familiar with the concept of diversification and how it can be used to manage risk. In parting, investors should moderate their exposure to concentrated positions in line with their tolerance for unwelcome surprises.
1EVANS, J. L., ARCHER, S. H., (1968) DIVERSIFICATION AND THE REDUCTION OF DISPERSION, JOURNAL OF FINANCE.
2BAGARIA, R., (2016) HIGH YIELD DEBT: AN INSIDER’S GUIDE TO THE MARKETPLACE, WILEY FINANCE, 59.
As with all investments your capital is at risk.