Client Advisory Bulletin
Kistler-Tiffany Advisors
March 2005
The Benefits of Diversification
Economists are famous for the concept that “there’s no such thing as a free lunch.” Yet finance theory does offer a free lunch; the
reduction of risk that is obtainable through diversification. Almost everyone has heard of diversification, but what is it? How does
one benefit? What is right for me? We will try to answer those questions and more in this descriptive on the benefits of
diversification.
What is Diversification
Its theoretical foundations were introduced by Nobel Prize winner Harry Markowitz in 1952, and later confirmed by Nobel Laureate
William Sharpe in 1964. Portfolio diversification is the practice of an investor spreading their wealth among many investments to
reduce the volatility of their portfolio, provided only that the underlying investments are imperfectly correlated. There are many
types of investments, including cash, bonds, equities, real estate, commodities, and private equity. In addition, there are different
styles of investments such as growth and value. Different styles of management reward investors at different times.
Correlation is the key concept. Typically many investors think they have a diversified portfolio when they divide their portfolio into
ten different mutual funds, but that is not necessarily true.
Correlation is a measure of the degree of linear relationship between two variables. Concerning investments, this concept would first
center on asset performance and secondarily on asset standard deviation. Correlation coefficient is between –1 and 1. If the
correlation coefficient between two assets is 1.0, 100% of the return is explained by the return of the other asset (performance is
identical). If the correlation is –1, the assets are negatively correlated and would perform exactly the opposite. Optimally, a portfolio
should be constructed with all assets having a correlation coefficient of 0, but that is nearly impossible.
An example of asset classes with low correlation is real estate (publicly traded REITS), S&P 500 and bonds. Real estate’s correlation
coefficient with the S&P 500 is .23. Real Estate’s correlation coefficient with Citigroup Investment Grade Bonds Index is .02 (an even
better correlation).
A somewhat simplistic explanation of the concept can be explained with umbrellas and sunscreen. If one invested in all sunscreen
and no umbrellas, one would be ill-prepared for rain and vice versa. If an investment was allocated to both, a better result would take
place. If the investment allocation was matched to historical occurrence, the result would be best.
Benefits of Diversification
The major benefit of portfolio diversification is the potential to increase returns in the long term through minimizing risk and
reducing the negative effects of market volatility on your portfolio. Markowitz’s initial assumption was that risk-averse investors
were concerned with only two elements of their portfolios – the expected return and the risk, as quantified by the standard deviation
or variance of the mean rate of return. When risky assets are aggregated, their correlation often determines the majority of the total
risk rather than individual volatilities. Consequently, the total risk of a diversified portfolio should be less than the sum of the risks in
the portfolio’s component pieces. The total risk of an asset is the sum of its diversifiable risk (unsystematic risk) and undiversifiable
risk (systematic risk). You cannot eliminate risk entirely, but optimal diversification eliminates unsystematic risk and minimizes the
portfolio’s risk for a certain level of return. Systematic risk (market risk), such as a terrorist attack, cannot be diversified away.
Determining Your Investment Mix
To help you determine the mix of investment options that may be appropriate for your investment goals, ask yourself the following
questions:
S What are my investment goals?
S How much do my assets need to grow to reach my goals?
S How much time do I have to reach these goals?
S How much investment risk am I willing to take to reach my goals?
It’s a good idea to periodically review your investment plan. Because different investments grow at different rates, your original
allocation will change over time. In addition, whenever you make a major life change, it is time to reassess your overall financial
situation.
Asset allocation and diversification strategies cannot assure profit or protect against loss in a generally declining market.
If you have any questions regarding the above, please give us a call. As always, it is
important to consult with a financial and legal advisor before taking any specific action.
This publication is designed to present information on business, tax and estate planning matters in general
terms and is not intended to be used as a basis for specific action without obtaining professional advice.
610.722.3300
866.250.5413
Registered Representative, Cambridge Investment Research, Inc., a Broker/
Dealer, Member FINRA/SIPC. Investment Advisor Representative, KistlerTiffany Advisors, a Registered Investment Advisor. Kistler-Tiffany Advisors
and Cambridge are not affiliated.
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