**Abstract**

Diversification involves selecting low-volatility assets to create a buffering effect, reducing overall portfolio risk. Key components include the hedge effect, decorrelation effect, and volatility-buffering effect, emphasizing the importance of low volatility and correlation in portfolio management.

Time to read: 4 to 5 minutes.

Level: Fundamental.

Category: Education Note.

The Essence of Diversification

Financial diversification is a strategy used to manage risk by spreading investments across various asset classes, sectors, or geographies. The main goal is to reduce the impact of any single investment’s poor performance on the overall portfolio.

Key Issues in Financial Diversification

Risk Reduction: Diversification helps in reducing unsystematic risk, which is the risk associated with individual investments. By holding a variety of assets, the negative performance of some can be offset by the positive performance of others1.

Return Enhancement: A well-diversified portfolio can potentially enhance returns by including a mix of high-risk, high-reward investments and more stable, lower-risk investments.

Market Volatility: Diversification can help smooth out the effects of market volatility, as different asset classes often react differently to market conditions.

Limitations of Financial Diversification

Over-Diversification: Holding too many investments can lead to over-diversification, where the benefits of diversification diminish, and the portfolio becomes too complex to manage effectively4.

Correlation Risk: During market downturns, assets that are typically uncorrelated may become correlated, reducing the effectiveness of diversification5.

Cost and Complexity: Managing a diversified portfolio can be costly and complex, requiring more time and resources to monitor and rebalance.

Diminishing Returns: Beyond a certain point, adding more investments to a portfolio does not significantly reduce risk and may lead to diminishing returns

Diversification extends beyond merely examining correlations. Effective diversification involves selecting assets with lower volatility than the portfolio or asset they are diversifying against, thereby creating a "buffering effect." Any asset not perfectly correlated with a portfolio will confer a decorrelation benefit when the correlation is between 0-100%, and a hedge benefit when the correlation is less than 0%.

We decompose diversification into three main components, building on the work of Martin Leibowitz:

The Buffering Effect: Occurs when one asset has lower volatility than another. This is applicable to any asset pair or assets versus a portfolio, not just bonds versus equities.
The Decorrelation Effect: This arises when asset correlation is less than one.
The Hedge Effect: Negative correlation between assets reduces portfolio volatility.

Graph: Diversification Benefits – Volatility Buffer Effect, Decorrelation Effect, and Hedge Effect

Decomposing Diversification

1. The Hedge Effect

Negative correlation between assets in a portfolio reduces overall volatility. Recently, bonds and equities have shown positive correlation, deviating from the historically negative relationship. While the hedge effect can be significant, it is most beneficial when asset correlations are deeply negative.

2. The Decorrelation Effect

Even without negative correlation, a low but positive correlation between stocks and bonds enhances diversification. The lower the correlation, the more likely the assets will move independently, thereby reducing overall portfolio volatility.

3. The Volatility-Buffering Effect

Even if equities and bonds are perfectly correlated, lower volatility in fixed income reduces overall portfolio volatility. This is the minimum impact of diversification. The greater the difference in volatility between stocks and bonds, the larger the benefit.

Which Effect Matters Most for Diversification?

Among the hedge effect, decorrelation effect, and volatility-buffering effect, the latter typically has the greatest impact on diversification.

A hypothetical equity/bond portfolio shows that when correlation is 1, the sole diversification benefit is from the vol-buffering effect. When correlation is zero, there's an additional decorrelation benefit, further lowering portfolio volatility. Only when correlation is deeply negative does the hedge effect contribute significantly.

In summary, the most crucial factor for effective diversification is low volatility, followed by low correlation. While negative correlation is advantageous, it is not essential.

Key Takeaways

Diversification Components: Hedge effect, decorrelation effect, and volatility-buffering effect.
Volatility: Lower volatility assets provide a fundamental diversification benefit.
Correlation: Low or negative correlations enhance the diversification effect, but are not a prerequisite for achieving benefits.
Practical Implications: Investors should focus on combining low volatility assets with varying correlations to optimize portfolio performance and reduce risk.

This comprehensive understanding of diversification underscores its pivotal role in portfolio management and its potential to enhance investment outcomes through strategic asset allocation.

References:

Leibowitz, Martin L., Anthony Bova, and P. Brett Hammond. The Endowment Model of Investing: Return, Risk, and Diversification. Hoboken, NJ: John Wiley & Sons, 2010.
Graham, Benjamin. The Intelligent Investor. New York: Harper & Brothers, 1949.
Page, Sebastien. Beyond Diversification: What Every Investor Needs to Know About Asset Allocation. New York: McGraw Hill, 2020.
Montgomery, Cynthia A., and Michael E. Porter. Strategy: Seeking and Securing Competitive Advantage. Boston: Harvard Business School Press, 1991.

Diversification Decomposition: What Do We Mean?