When looking to invest, you’ll often be advised to “diversify” your portfolio. But exactly what is diversification? In short, diversification of a portfolio (See: investment portfolio definition) is a risk-management technique. A diverse portfolio is comprised of a variety of types of investments, instead of just one or two. The thought process and rationale behind portfolio diversification is that by having many different types of investments, the risk of each one is mitigated.
Risk Diversification Strategy
Diversification is an investment strategy to reduce overall risk and volatility in the portfolio. Typically, a well diversified portfolio will have higher returns and lower risk than a non-diversified one. The good performance of one investment will serve to balance out the poor performance of another. Research shows that the best way to take advantage of the benefits of diversification is by maintaining a portfolio of 25 to 30 carefully-chosen stocks.
Risk that can be eliminated through diversification is called “unsystematic risk.” The most common sources of this are business and financial risks, and it is specific to a business, market, country, economy or industry. The purpose of diversification is to invest in a wide variety of assets, so that they are not all negatively affected at the same time or by the same circumstances.
Investment Diversification Strategies: Risk versus Volatility
As value investors, we make a distinction between risk and volatility. We believe that risk is is not the same as volatility. Risk implies the possibility of loss, whereas volatility has no meaning other than short term ups and downs in the portfolio.
Diversifying for volatility can be done by selecting uncorrelated stocks in the portfolio. When trying to diversify your portfolio, you can think of it almost as creating your own mutual fund. Don’t put all of your investments into a single industry or sector – instead, select a variety of places and companies. The more unrelated and varied your investments are, the better and more secure your finances will be. Overall, the intent of diversification is to reduce your investments’ reaction to the volatility of the market.
Diversifying for risk requires us to figure out risks inherent in each of our investments and then selecting other investments that actively hedge against these risks. For example, financial assets can be selected to hedge and diversify away the interest rate risks elsewhere in the portfolio.
What is an Example of a Diversified Investment?
Consider an broad market index fund, say, S&P 500 fund such as SPY. SPY can be considered a diversified investment as it consists of stocks from each of the S&P 500 member companies, which represent all different sectors and industries. Alternatively, a portfolio of corporate bonds of a variety of maturities and ratings can also be considered a diversified investment.
But what about a conglomerate with different lines of businesses in different sectors or geographies? While it is true that this particular stock represents a diversified company if the individual businesses are sufficiently uncorrelated, an investment in this one stock may not offer the diversification benefits desired by the investor as several risks such as management risk is still concentrated.
Diversification needs to address all sources of risk, be it company specific risk (such as inept management) and market risk. Typically a portfolio of 10-30 stocks in a variety of industries can offer most of the benefits of portfolio diversification.
Excess Portfolio Diversification can Hurt
However, there is such a thing as overdiversification. The consensus among most financial experts is that once you hold 20 well-diversified stocks, you have diversified away as much risk as you possibly can. After that, each added stock won’t do much to lower your risk. Overdiversification likely won’t cause you huge losses or significant problems, but it can inhibit the better-performing stocks from truly giving you a return (See: are you dangerously diversified?), since they are negated by those that are lower. You may not lose a lot from overdiversification, but you probably won’t make large gains, either.
All in all, diversification is a powerful tool for investments and mitigating risk. Be careful to select not only a number of stocks, but ones that are spread across different sectors and industries. Don’t expect to eliminate all risk – after all, there is some risk that is simply part of the market – but be confident that wise diversification choices will significantly help your chances and boost your returns!