Concentration Risk and Diversification

Just add capital: ETPs and instant diversification.

Two of the most critical characteristics of any investment portfolio are its breadth and diversification. Importantly, diversification implies more than simply owning a large number of holdings: It means owning assets that will perform differently from each other. That can mean owning securities that have different sector, country, currency and company size correlations—to name a few of the most critical. At a portfolio level, it can also mean owning a mixture of different asset classes—stocks, bonds, even commodities or other alternative assets.

The basic objective of diversification is to reduce risk and/or to increase expected returns. An optimally diversified portfolio tailors portfolio risk specifically to those risks that the investor wants to bear while minimizing exposure to undesired risks.

The most diversified portfolios can be considered “neutral,” as they don’t make disproportionate bets on any specific company, country, sector, etc. Of course, maximum diversification is not the goal of every investor—nor should it be.

For example, an investor with a high conviction in the future of technology might desire a disproportionately large allocation to the technology sector. As such, the investor might establish positions in big technology names such as Apple, Microsoft, Google, IBM, Oracle, Intel and Hewlett-Packard.

However, since all seven companies are large US technology corporations, the investor isn’t simply making a bet on technology, she’s also implicitly conveying conviction in the future of the United States, the US dollar and large companies—bets that may be unintentional and undesired.

In contrast, a true global technology portfolio would allocate more than 30% of assets to companies domiciled outside the United States, such as Japan, South Korea, Taiwan and Germany.

At any given point in time, the risk of regulatory intrusion, natural disaster or war in the United States might be low, but over long holdings periods, the risks become relevant, as the probabilities for such binary events are largely uncertain. As such, the objective for investors is to target their risk exposure.

The positive effects are apparent: A diversified global investor isn’t heavily impacted by the developments of any single country, so even if an extremely unlikely but highly adverse event occurs in one country, her portfolio will not be devastated.

As a point of clarity, it’s worth distinguishing between portfolio diversification and the diversification within a particular ETF. Ultimately, as an investor, portfolio diversification and portfolio risk is what’s important: Taking all assets into account, how exposed to various risk factors are you?

The best way to think about ETFs and portfolio diversification is to mentally eradicate the ETF wrapper and instead look through to the holdings of the ETF, as the ETF itself is simply a conduit for its underlying holdings—to which you, as an investor, own a claim.

If your entire investment portfolio consists of a single ETF, then the diversification of that particular ETF is important as it is also the diversification of your entire portfolio.

However, if a particular ETF represents 2% of your portfolio, there is no imperative for that particular ETF to be diversified. Instead, you can think of it in the context of your overall holdings.