The 7 Types of Diversification to Decrease the Risk of Uncertainty

There’s lots of talk about diversification to reduce your risks and consequently boost your risk weighted returns.

On the other hand, in conversations with people recently I’ve noticed a significant lack of understanding about what this means and how to do it well.

The primary reason for this is because of the subject of correlation.

To avoid correlation, we’re going to discuss the 6 areas to diversify to deal with any market condition.

What Does It Mean When Assets Are Correlated?

Essentially this means they behave similarly at the same time.

For example, stocks tend to go up with the market and down with the market.

Bonds tend to move together.

House prices in a given area tend to go up or down together.

Crypto currencies tend to go up or down together at least for now.

The list goes on.

When you can look at a list of assets and see they are mostly all up or down by a similar amount on the same day or week you know they are probably fairly heavily correlated.

Note, just because they move together doesn’t mean they are correlated, non-correlated assets could happen to move together by pure chance but over time this pattern won’t hold.

I recently had some people telling me they were diversifying between 10 crypto currencies to decrease their risk but this is nonsense because mostly they tend to perform very close to identical posting double digit gains or losses on the same days, etc. and if you look at the charts they show approximately the same shape.

This is a horrible example of how to diversify intelligently.

If You Want to Decrease the Risk of Uncertainty…

Diversification protects you from the effects of uncertainty by limiting your exposure to any given unit of uncertainty.

In other words, you can decrease the impact of things you might not be sure about by limiting your exposure to them and splitting between them.

Understand then there are a variety of factors, which might cause investment performance to correlate.

As we’ve mentioned, diversification is often diworsification so where you can apply logic, intelligence, good judgement, research, etc. to gain an edge concentrate. But where you don’t have this understanding diversify in those areas.

For most people they aren’t even aware of the areas where their investments are likely correlating or what to do about them.

What follows then is an overview you should consider based on your scale of wealth. When you’re very small your portfolio might not justify diversifying in all areas but the more you grow the more it might help.

This will also help inform you how to concentrate and make more money aside from simply the asset or asset class you’re choosing.

The 7 Areas of Correlation & Uncertainty

Correlation isn’t random it comes about because of common drivers, which work together and apply similarly to multiple investments.

More importantly though there are multiple areas where you might be uncertain and as a result wish to protect yourself from those uncertainties by limiting exposure.

What’s critical is understanding these are all areas where you could be blinded.

As always, concentrate when you have an edge then level out your risk by diversifying in these areas where you don’t:

  1. Assets – diversifying between assets themselves is the most basic form of diversification. It’s worth considering diversifying not only by specific asset but also by asset class for example not buying all stocks of companies exposed to similar drivers like oil prices.
  2. Asset classes – next most common is diversifying between the classes of assets, which might tend to move up and down together.
  3. Regions – because of common regional drivers (government and bank policy, immigration, economy, etc.) regions tend to correlate. This is especially important when the drivers of your particular investment performance are largely regional such as with real estate.
  4. Timing – this is one of the easiest areas to diversify, dollar cost averaging your investments by flowing money into investments and markets as you build it up and as you sell other assets. You can also achieve this by rebalancing.
  5. Currencies – although this is not a fundamental driver in the long term for all asset classes (real estate and stocks in particular stocks of international companies tend to be less correlated with currency fluctuation than say bonds) it is a very important area of uncertainty and correlation if all your assets are measured in the same currency.
  6. Strategies – are you long or are you short? Are you capitalizing on cashflow or growth? Are you relying on leverage or not? Etc. Strategies can correlate to one another and often you can gain an advantage sticking with the same asset or asset class but varying your strategies.
  7. Managers – people tend to follow similar behavioral patterns so leaving all your investments with one manager will tend to produce more correlated returns than varying across managers. As usual this can work for or against you so whether to concentrate or diversify depends on your expertise in selecting managers.

Conclusion – A Place to Look for Opportunities Not Merely Avoid Uncertainty

We’ve often spoken about how diversification is diworsification if you know what you’re doing and you’re far better off being concentrated with skill than diversified with ignorance.

As a result the above shouldn’t simply be a place to look for opportunities to diversify. It should also be a place to look to gain an edge.

You could gain an edge in the asset you choose, the asset class or mix you choose, the regions you choose, the timing you choose, the currencies your investments are denominated in, the strategies you’re employing and managers you’re picking.

Some of these will overlap with one another, which is fine. The objective isn’t to be isolated the objective is to beat the market increasing your returns while decreasing your risk.

To learn more, becoming someone who is betting on an edge rather than diversifying against ignorance explore some of our other articles below, enroll in some of our training, reach out to us for consultation and join our network of investors and investment experts.

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