WHAT IS DIVERSIFICATION?
Diversification implies distributing one's investment among
a variety of assets to reduce risks. Since different investments
will rise and fall independent of each other, the combinations
of these assets more often than not will nullify each other's
fluctuation, thereby reducing risk.
Ways to achieve diversification
Individuals can diversify across one type of asset classification,
such as stocks. Thus, one might purchase shares in leading
companies across different (and unrelated) industries. Also,
one can diversify their portfolio across various assets
(stocks, bonds, and real estate for example) or by regional
decisions (such as state, region, or country).
An effective diversification strategy will help improve
performance as well. . Two basic types of risks associated
with investments are unsystematic risk and systematic risk.
Unsystematic and systematic risk
Unsystematic risk (also called diversifiable risk) is specific
to a company. It could include sudden unforeseen events
like strikes, fire or something as simple as slumping sales.
Two common sources of unsystematic risk are business risk
and financial risk. Diversification can help eliminate unsystematic
risk from a portfolio. It is unlikely that events such as
the ones listed above would occur in every firm at the same
time. Therefore, by diversifying, one can reduce their risk.
There is no reward for taking on unnecessary diversifiable
risk.
On the other hand, some events can affect
all firms at the same time. This is known as systematic
risk (non diversifiable risk). Events such as inflation,
war and fluctuating interest rates influence the entire
economy, not just a specific firm or industry. Diversification
cannot eliminate the risk of such events and hence considered
non-diversifiable. This type of risk accounts for most of
the risk in a well-diversified portfolio. However, the expected
returns on their investments can reward investors for enduring
systematic risks.
Diversification in stocks
It is also possible to have a diversified portfolio of:
only stocks; only bonds; stocks and bonds; or stocks, bonds,
and cash, etc.
When creating an effective diversified portfolio
of stocks, considering how to reduce unsystematic risk is
important. For example consider that a person has invested
in a book publishing industry. A strike in the book binding
unit could result in price drop, thus effecting his holdings
drastically. However, if he also has holdings in other industries
such as oil, consumer durables and electronics, they are
least likely to be effected. Unsystematic risks can be avoided
by diversifying among different industries rather that just
investing in the same one. Another way to mitigate unsystematic
risks is by diversifying across different asset classes
such as stocks, bonds, mutual funds, real estate holdings,
etc.
Diversification across asset classes
Diversification across asset classes provides a cushion
against market tremors because each asset class has different
risks, rewards and tolerance to economic events. By selecting
investments from different asset classes, one can minimise
risk. Investments whose price movements are opposite each
other are negatively correlated. When negatively correlated
assets are combined within a portfolio, the portfolio volatility
is reduced.
More pros than cons
Diversification can reduce the return of your portfolio
as well. By selecting several assets, the overall return
on the portfolio will be the weighted average of the returns
of those assets. For example, let us look at a portfolio
made up 50/50 of single stock and a single bond. In one
year, the stock has a total return 30%, the bond 6%. The
portfolio return will only be 18% (36 divided by 2). Whereas,
if the entire portfolio was invested in the stock, the return
would have been 30%.
Diversification – the best way to reduce risk
Diversification helps to reduce portfolio risk by eliminating
un-systematic risk for which investors are not rewarded.
Investors are rewarded for taking market risk. Because diversification
averages the returns of the assets within the portfolio,
it attenuates the potential highs (and lows). Diversification
among companies, industries and asset classes affords the
investor the greatest protection against business risk,
financial risk and volatility.
