Diversification: Increasing the Likelihood of Success
Sizing Considerations
We’re celebrating Chart of the Week’s first anniversary with one of the charts you all found most interesting over the past year: the distribution of portfolio returns.
The goal of successful portfolio management is mitigating downside risk while creating the best chance of achieving your target returns. Diversification plays a major factor in that success. Here we see the return distribution of portfolios of varying levels of diversification by strategy. The left-hand chart shows the distribution of returns for portfolios investing in one fund every vintage year. The chart on the right shows increasing the portfolio to invest in 10 funds each vintage. As you would expect, the dispersion of returns is wider for the more concentrated portfolio.
When the number of funds per year is increased from one to 10, the spread of returns tightens drastically. Credit and infrastructure have limited upside potential in this scenario, but they have the tightest dispersion and therefore greatest likelihood of achieving a set return. Narrowing the dispersion in any strategy increases the certainty of portfolio return, which reduces idiosyncratic risk. These figures do not imply optimal diversification but rather illustrate the impact of diversification in portfolios. Importantly, careful manager selection may also increase the likelihood of achieving target returns.
Definitions
Corporate Finance/Buyout: Any PM fund that generally takes control position by buying a company.?
Credit: This strategy focuses on providing debt capital.
Growth Equity: Any PM fund that focuses on providing growth capital through an equity investment.
Infrastructure: An investment strategy that invests in physical systems involved in the distribution of people, goods, and resources.?
VC/Growth: Includes all funds with a strategy of venture capital or growth equity.??
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6 个月A contrarian note: The charts highlight how diversification reduces the range of potential returns, lowering the risk of extreme gains or losses. While this suggests diversification can enhance predictability and mitigate risk, it doesn't guarantee it's always optimal. Concentrated portfolios might yield higher returns in specific scenarios, but with increased risk. Additionally, diversification can be complex and costly to manage. Investor goals, risk tolerance, and market conditions further influence the ideal diversification level. In conclusion, diversification aids risk management and return predictability but isn't universally ideal. Tailoring diversification levels to individual circumstances, risk appetite, and investment goals, combined with careful manager selection, likely forms the most effective strategy.