Question

Describe the principle of diversification in financial portfolios. Why does it work?

Answer 1

The definition of diversification is the act of, or the result of, achieving variety. In finance and investment planning, portfolio diversification is the risk management strategy of combining a variety of assets to reduce the overall risk of an investment portfolio.

Principle of diversification

That portfolios of different sorts of assets differently correlated with one another will have negligible unsystematic risk. In other words, unsystematic risks disappear in diversified portfolios, and only systematic risks persist, those related to particular assets

Purpose of Portfolio Diversification

The purpose of portfolio diversification is portfolio risk management. A risk management plan should include diversification rules that are strictly followed.

Portfolio diversification will lower the volatility of a portfolio because not all asset categories, industries, or stocks move together. Holding a variety of non-correlated assets can nearly eliminate unsystematic risk (specific risk).

In other words, by owning a large number of investments in different industries and companies, industry and company specific risk is minimized. This decreases the volatility of the portfolio because different assets should be rising and falling at different times; smoothing out the returns of the portfolio as a whole.

In addition, diversification of non-correlated assets can reduce losses in bear markets; preserving capital for investment in bull markets. Portfolio optimization can be achieved through proper diversification because the portfolio manager can invest in a greater number of risk assets (i.e. stocks) without accepting more risk than planned in the whole portfolio.

In other words, portfolio managers with a target amount of total risk are able to invest a greater percentage of their assets in risk assets with a diversified portfolio versus a non-diversified portfolio. This is because holding a variety of non-correlated assets lowers the total risk of the portfolio. This is why some say diversification is the only free ride.

There are several ways to ensure you are adequately diversified, including:

1)--Spread your portfolio among many different investment vehicles – including cash, stocks, bonds, mutual funds, ETFs and other funds. Look for assets whose returns haven’t historically moved in the same direction and to the same degree. That way, if part of your portfolio is declining, the rest may still be growing. (See also: Bond Basics.)

2)--Stay diversified within each type of investment. Include securities that vary by sector, industry, region and market capitalization. It’s also a good idea to mix styles too, such as growth, income and value. The same goes for bonds: consider varying maturities, credit qualities and durations.

3)--Include securities that vary in risk. You're not restricted to picking only blue-chip stocks. In fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains offset losses in other areas.