Business, Legal & Accounting Glossary
In financial economics, diversification is the concept of minimizing risk by purchasing both a wide range and a large number of securities. Diversification reduces variability.
Avoiding risk is difficult no matter how you choose to invest. Most investors are aware that you must take greater risks to achieve higher returns. However, no one wants to take more risk than necessary to achieve one’s financial goals. Diversification can help reduce risk. In the following tutorial, we will explain the meaning of diversification and how it can help to reduce risk.
Diversification means dividing your investment among a variety of assets. Diversification helps to reduce risk because different investments will rise and fall independent of each other. The combinations of these assets more often than not will cancel out each other’s fluctuation, therefore reducing risk.
Diversification in investments can be achieved in many different ways. Individuals can diversify across one type of asset classification — such as stocks. To do this, one might purchase shares in the leading companies across many different (and unrelated) industries. Many other diversification strategies are also possible. You can diversify your portfolio across different types of assets (stocks, bonds, and real estate for example) or diversify by regional decisions (such as state, region, or country). Thousands of options exist.
Luckily, in almost every effective diversification strategy, the ultimate goal is clear — to improve performance while reducing risks. Two basic types of risks associated with investments are unsystematic risk and systematic risk.
Let’s see how diversification may be able to help investors reduce these risks.
Unsystematic risk (also called diversifiable risk) is risk that is specific to a company. This type of risk could include dramatic events such as a strike, a natural disaster like a 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 happen in every firm at the same time. Therefore, by diversifying, one can reduce their risk. There is no reward for taking on unneeded unsystematic risk.
On the other hand, some events can affect all firms at the same time. This is known as systematic 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 facing these events. Therefore, it is considered an un-diversifiable risk. 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 offers you a way to reduce risk. It is possible to have a diversified portfolio of: just stocks; just bonds; stocks and bonds; or stocks, bonds, and cash, etc. The portfolio design is very important to effectively minimizing risk.
When creating an effective diversified portfolio of stocks, considering how to reduce unsystematic risk is important. For example: it is possible that if you invest in the book publishing industry, that all the bookbinders in the industry make a pact to go on strike. The effects of such an event could lead to the prices of all publishing stocks in that industry to plummet. Your holdings in publishing companies would be left at a deflated level.
However, if you also had holdings in other industries such as oil, consumer durables and electronics, it is unlikely that the unsystematic risks in the publishing industry will adversely affect your other holdings. What is more, unfortunate circumstances in the book publishing business may result in a boom in other industries. The delays in the traditional print publishing business mentioned previously could cause people to publish materials in electronic form. If you held stock in an electronic publishing company, your stock might even benefit from the troubles that are slowing the growth of your holdings in the book publishing industry.
Unsystematic risks can be avoided by diversifying among different industries rather than just investing in the same one. They may also be effectively mitigated by diversifying across different asset classes such as (stocks, bonds, mutual funds, real estate holdings, etc.). Let us take a look at how this is done.
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, you can minimize 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.
As mentioned earlier there are many diversification opportunities. All provide the well-desired reduction of risk. Diversification is a great process for investors to take advantage of and we hope you are now more familiar with it.
As you have seen, diversification can help reduce risk by eliminating unsystematic risk from a portfolio. By choosing securities of different companies in different industries, you can minimize the risks associated with a particular company’s “bad luck.” By diversifying among asset classes that are negatively or weakly correlated, you further reduce the volatility of your portfolio.
However, diversification can reduce the return of your portfolio as well. By selecting several assets, the overall return on your 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 of 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%.
The table below shows that many stocks have more variation than the markets they are in. This is why the market portfolios, comprised of many stocks, does not reflect the average variability of its elements: Diversification reduces variability.
It compares standard deviations of various non-US stocks with market indexes. (January 1999-December 2003, in per cent per year.)
|Stock||Standard deviation (%)||Market||Standard deviation (%)|
|Telefonica de Argentina||83||Argentina||42.5|
It takes about 20 stocks to effectively diversify a portfolio. As seen in the cart in the top right, it is apparent that holding a more diversified portfolio can quickly minimize risk. Notice that more than 14-18 stocks have a little incremental effect.
See “Types of Risk” in risk to see how much of this is a market risk or unique risk.
Diversification can help 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.
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This glossary post was last updated: 18th April, 2020 | 12 Views.