Diversification

Reduce risk by combining asset classes with low correlation

Diversification is a portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction.

The goal of diversification is to reduce the risk in a portfolio by investing in different asset classes that have a low degree of correlation with each other.  With proper diversification volatility is reduced by the fact that not all asset classes, industries or individual companies move up and down in value at the same time or at the same rate. 

Diversification reduces both the upside and downside potential of a portfolio, but allows for more consistent performance under a wide range of economic conditions.

"In constructing optimal portfolios we find that sectors offer higher potential returns and lower correlations compared to standard equity breakouts based on market capitalization or investment styles"

The findings

Results of this ground breaking study on optimal portfolio theory suggests that building a portfolio based on industry and regional sectors offers superior risk/reward tradeoffs.  Key findings of the study:

• the average correlation among sectors is only 31%

• the average correlation among traditional size and style breakouts is 90%

• portfolios that include allocations to 8 industry sectors boost performance by an average of 55 basis points

Portfolios with sectors offers superior returns for the same level of risk when compared to a portfolio using the standard equity classes.

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