What is Portfolio Diversification?

  • Each investor has his risk profile, but there is a possibility that he does not have the relevant investment security that matches his risk profile.This is when an investor chooses a bunch of assets to equalize his risk & payoffs to the portfolios – the set of securities the investor has chosen to invest in.From a nonprofessional’s standpoint, it is not possible to buy one security to match the wants of an investor. Portfolio Diversification is the formation of a portfolio that matches the wants.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Portfolio Diversification (wallstreetmojo.com)

Why Diversity in the Portfolio?

Consider a person (Mr. A) who has just a basic idea about finance and plans to invest his retirement savings. Since the investment is for his retirement, he plans to invest at very low risk, and he wants his portfolio to grow along with inflation. This person is considered to have a very low-risk profile.

On the other hand, consider an investor (Mr. B) who plans to invest 10% of his money in extremely risky assets. Alternatively, he might want to invest such that he gets the returns the same as the markets.

If you look at any of the above scenarios, each one has its risk profile – Mr. A has a very low tolerance for riskTolerance For RiskRisk tolerance is the investors’ potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor’s age, income, investment objective, responsibilities and financial condition.read more, and Mr. B has a very high tolerance for risk. One should know that risk tolerance is not the same as risk aversionRisk AversionThe term “risk-averse” refers to a person’s unwillingness to take risks. Investors who prefer a low-return investment with known risks to a higher-return investment with unknown risks, for example, are risk-averse.read more. Risk aversion is the character of a person to take more or less risk for the returns he is getting. If he tries to take less risk than the returns he wants, he is supposed to be risk-averse. Since that is not in the scope of this article, let us park that apart and see what and how investment can be diversifiedInvestment Can Be DiversifiedA diversified portfolio of investments is a low-risk investment plan that works as the best defence mechanism against financial crises. It allows an investor to earn the highest possible returns by making investments in a mixture of assets like stocks, commodities, fixed income.read more.

Asset Classes for Portfolio Diversification

To know where to put your money, one should have an idea about what different type of assetsDifferent Type Of AssetsAssets are the resources owned by individuals, companies, or governments expected to generate future cash flows over a long period. There are broadly three types of asset distribution: 1. Based on convertibility (current and non-current assets), 2. Physical existence (tangible and intangible assets), 3. Usage (operating and non-operating assets)read more are. Because of the growth in technology and the availability of different finance products, there are an infinite number of ways I can diversify my portfolio. To keep the difficulty of the concepts low, let us consider a few classes of assets.

#1 – Stocks

As we know, stocks represent the ownership of a part of the company – which comes with some obligations and benefits. This says that the investor (owner of stocks) is not eligible for anything except for ownership in the company. If the company goes down, the value of the investment goes down, and vice versa.

Therefore, the owner will not be safe from the company’s risks. Without proper information, it is impossible to gauge the company’s risk. This makes stocks a risky asset. If a person invests in them, they ought to be aware of the risks they are taking and should be willing to take those risks.

#2 – Bonds: Treasury and Non-Treasury

BondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more are one way to raise money for the company, where they guarantee cash flows. Unlike stocks, bonds have a guarantee on them. A pre-specified amount will be paid to the bond owner for each duration. In short, a bond is like a fixed deposit except that it is tradeable. Therefore, the price of bonds goes down and goes up. Treasury bondsTreasury BondsA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company.read more are bonds backed by the US Government, which makes them pretty much risk-free. Hence, this article will consider Treasury Bonds as the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more for all practical purposes.

Apart from the assets available for portfolio diversification, one has to know about systematic and unsystematic risk.

  • Systematic risk is the risk that is existent in the market. One cannot hedge himself against the market with high returns. If he diversified enough, he would have market returns and risks. This makes systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more an unavoidable risk.Unsystematic risk is the opposite of this. If a person buys the entire market, this risk is zero. So this risk can be used to measure how risky a person’s portfolio is. This risk can be reduced with enough diversification.

Elements of Portfolio Diversification

To diversify a portfolio, one must have measures of rates of return, how the prices change, and other statistical variables.

Let us look at the above graph, which provides an idea about the entire topic of portfolio diversification. The safest bet is to invest in an area filled with green. The bad investment is the investment in yellow.

Thousands of companies are traded daily, but buying any of these does not complete the investor’s risk profile.

Assume an investor who wants to have the market returns (he wants to reduce his nonsystematic risk to zero). He can try to replicate the returns and risk profile, either by a set of stocks and bonds or by a set of stocks (buying all the stocks as the market).

How to Diversify your Investment Portfolio?

  • Spread the wealth. Do not invest in one place. Look for a portfolio where the risk matches the returns. There are a lot of details regarding what are the different sectors, how they are correlated, and how each one of them affects the portfolio.Do not invest where risk and returns do not match. There is no free lunch out there.Consider investing in index or bond funds. Mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more and bond fundsBond FundsThe bond fund, also known as a debt fund, is a mutual fund that invests in bonds and other debt securities, pays dividends periodically and does not possess any maturity date. It generates a stream of income by investing in fixed income securities like government securities, bonds, debentures.read more will do the portfolio diversification for you. You need not study the history of finance to see how to diversify stocks and buy them. Look at the details of an index fund and trust in the index. Indexes like the S&P 500 and DJIA, in most cases, reflect the entire market. In addition, some funds follow and try to match the returns of these indexes for a very small (and sometimes zero) fee. Choose such a fund and invest in it.Go away from your country and market. Investing in a variety of places will help in diversification.Buying and holdingBuying And HoldingThe term “buy and hold” refers to an investor’s investment strategy in which they hold securities for a long period of time, ignoring the ups and downs in market price during a short period of time.read more have different costs from active investing. Try to see which makes more sense. Invest in the one that has the least opportunity and real cost.Know the different types of financial assetsTypes Of Financial AssetsFinancial assets are investment assets that derive their value from a contractual claim of what they represent. Cash and cash equivalents, accounts receivable, fixed deposits, equity shares, debentures/bonds, preference shares, mutual funds, interests in subsidiaries, associates, and joint ventures, insurance contracts, rights and obligations under leases, Share-Based Payments, Derivatives, and Employee Benefit Plans are all examples of financial assets.read more that are available. There are almost enough types of investments to suit every risk profile. The point of diversification is too old. Knowing about this will help, but one need not go out and do the diversification themselves. Find out diversified funds and choose.Beware of asset bubbles – by following government and other regulations.

Advantages of Diversification

Disadvantages of Diversification

  • Only unsystematic risksUnsystematic RisksUnsystematic risk refers to risk that is generated in a specific company or industry and may not be applicable to other industries or the economy as a whole.  There are two types of unsystematic risk: business risk and financial risk.read more can be diversified. Systematic risks cannot be diversified.Over diversification is very expensive because of the number of assets available in a portfolio. The higher the number of assets, the higher the cost to manage the portfolio.The more you diversify, the less it is invested in the best companies that provide great returns (but also with great risk).The process of diversification is too complex, and many people find it difficult to gauge the effort it takes to diversify. The best way is to pay someone a small amount to do it.Customized diversification methods might be very expensive.It isn’t easy to track a portfolio when it is diversified. Only the net change is monitored; each stock cannot be tracked individually.There is a chance of below-average diversification because of high fees.

Limitations of Portfolio Diversification

  • Market risk cannot be diversified. Crashes like 2009 and 2001 can always happen, and diversification will not protect investors against them.Government policies play a large role in market movement and cannot be diversified.Diversification is generally for long-term investors. Diversification will not help in trading.

Conclusion

In words, diversification is a pretty simple concept. One looks out for his wants and tries to match them. Since the 1970s, when Vanguard started the first index fundsIndex FundsIndex Funds are passive funds that pool investments into selected securities.read more, indexing is one of the prime gauges of diversification. When one compares the rates of return with the market, it might be difficult to determine where the market is. As no market ensures all the assets are included. But diversification is so common these days that the number of people investing in single assets is almost nil.

This has been a guide to what portfolio diversification is and its definition. Here we discuss how to diversify your investment portfolio along with the type of asset classes used to diversify the portfolio. You can learn more about investment from the following articles –

  • Formula of Portfolio VarianceCareer in Portfolio ManagementPortfolio OptimizationWhat is Modern Portfolio Theory?