In: Finance
Traditional finance always stresses diversification as an essential strategy to reduce the risk in your portfolio. Warren Buffet, one of the most famous investors that ever lived, famously stated that "diversification is protection against ignorance. It makes little sense if you know what you are doing.” Is there any merit in Buffet’s claim? Try to explain the benefits and drawbacks of diversification in a few paragraphs.
Let me explain how diversification helps to reduce risk in portfolio -
The basic objective of building a portfolio is to reduce the risk of loss of capital and/or income by investing in various types of securities and over a wide range of industries.Diversification reduces volatility of returns and risks. Balancing of equities against fixed interest-bearing securities is also a type of diversification. We know that risk or variance is a combination of unsyatematic and systematic risk . Unsyatematic risk can be eliminated by adding a security of another company having a negative correlation.As a means of diversification the investment is spread over a group ofsecurities with different characteristics.As unsystematic risk can be reduced or eliminated through diversification, it is not very important for an investor to consider systematic risk as it is unavoidable.
Some of the benefits of diversification -
- Reduces risks
- Increases returns
- Capital is secured
- Gives us atlest minimum return
Some of the drawbacks of diversification -
- Complicated decision making
- Returns may not be as expected
- Time-consuming
- Improved costs to decision makers( Fund managers)
Let us analyse the statement of Warren Buffet. It clearly indicates that any individual investor makes his investments only through some market analysis . His analysis regarding a particular security is very limited . Hence when we diversify we can have some protection against the same, and we need not have much analysis if we diversify
At the end we can say "Never put all the eggs in a single basket''