Strategic Diversification is an advanced approach to portfolio management. Successful portfolio construction should balance return goals with risk management. To accomplish this portfolio managers employ various diversification approaches.
The First Level of Portfolio Diversification
Investment Diversification reflects the idea that investors shouldn’t "put all of their eggs in one basket.” The concept is that including multiple assets in a portfolio will reduce risk because they will each perform differently in various market conditions. When one holding is going down another might be going up, reducing the overall risk of the portfolio. Imagine, a portfolio that holds stock of a single company. The investor is exposed to all of the risk associated with that single company. By splitting your investment between the stocks from two different companies, you can reduce the potential risk to your portfolio. Mutual funds are a good example of the first level of investment diversification. They combine groups of typically similar stocks into a single product.
The Second Level of Portfolio Diversification
Asset Class Diversification is the second level of portfolio diversification. Most mutual funds hold assets of a similar style. Investment professionals typically identify nine different styles, including Large Cap mutual funds that hold stocks of large companies and Small Cap mutual funds that hold stocks of small companies, to invest among. Additionally, there are Income mutual funds that hold different types of bonds. By building a portfolio with multiple asset classes, investors can further reduce risk in their portfolio.
The Third Level of Portfolio Diversification
The third level of Portfolio Diversification is Strategic Diversification. This approach takes portfolio management to a new level, by combining actively managed strategies designed to respond to changing markets. This approach starts with both investment and asset class diversification but adds multiple management strategies, each designed to perform well in different market conditions. At Q3, we recommend combining at least three distinct management styles to maximize risk-adjusted performance. The same way investment diversification reduces risk of a single stock and asset class diversification reduces risk of a single fund, we believe strategic diversification reduces risk of a single management approach.