What is good diversification
A well-diversified portfolio can mitigate the impact of tail risks and reduce the volatility of returns. In the face of uncertainty, and risks which we do not even know about, the best protection is probably to invest in a range of assets.
Such a portfolio, for example holding quality companies with strong balance sheets and pricing power, means that events at the macro and market level may not fully affect an investor’s own portfolio. Weak economic news can make us fearful about the potential effect on our portfolio performance. However, much of the news may be noise for those that follow a robust investment process which produces a well-diversified portfolio of quality assets built for the long term.
There is also an additional emotional benefit from diversification. By insulating a portfolio from volatility, an investor may insulate themselves from the emotions that volatility can induce, which may make it easier to hold an investment portfolio when things are not going exactly to plan.
Additionally, as discussed in May’s Market Perspectives, having some illiquidity in a portfolio, perhaps by trying to harvest illiquidity premia by investing in private markets, could support good long-term investment behaviours.
As humans we like familiarity, which is mirrored in many investment portfolios that may be biased towards a particular region, or asset class. Familiarity is typically equated with lower risk (“I know the region”). We remind investors that a home-biased portfolio is more concentrated, which actually increases rather than decreases risk.