The impact of portfolio diversification on long-term investment performance

Abstract

Diversification of portfolio is considered one of the cornerstones of portfolio management largely because of its risk-reducing capabilities while sustaining a steady return stream. Diversification was conceived under Modern Portfolio Theory. The strategy helps allocate assets across multiple asset classes, sectors, and securities in a managed way for reducing non-systematic risk. Notwithstanding the theoretical rationale and support for such a strategy, its effectiveness in emerging markets such as Bangladesh still lies in unproven territory. In this research, the effects of diversification on portfolios have been observed on the basis of diversified and non-diversified portfolios with respect to the capital market of Bangladesh. Based on the secondary data for the long-term period, portfolios have been made using equities, bonds, and mutual funds, and various performance measures such as return, standard deviation, Sharpe Ratio, Maximum Drawdown, correlation, and covariance have been applied on them. Empirical results show that diversified investment portfolios are much less volatile with lower drawdowns than concentrated stock portfolios, but with more stable risk-adjusted returns. The addition of negatively correlated or less correlated assets, especially bonds, was crucial in improving the stability of the investment portfolios, especially in times of turmoil like the COVID-19 crisis. Despite the occasional superior return in the non-diversified portfolio, the risk on the downside was considerably higher. In conclusion, the results of this study indicate that asset diversification is crucial to the stability of investments in emerging markets. It should allow investors to understand the value of investing in a multi-asset strategy to achieve sustainable returns on their investments.