Before we go deep into the details of diversification, let us explain what is genuinely the diversification of investment means. Diversification is the act of spreading investment dollars across a range of assets to reduce investment risk. A well-diversified investment provides balance so that your investment performance does not rely too heavily on one asset. 

We have heard advisers telling investors to diversify their investments by picking stocks from different companies. That kind of diversification is the wrong way of investment. For instance, some investors own two stocks from other companies and consider it as diversification. 

We recommend that a diversified portfolio be diversified at less at two levels: between the asset and within asset categories. So, in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, investors also need to spread out their investments within each asset category.

Portfolio Diversification

Economic reality undoubtedly confirms the existence of the interrelatedness of and correlation between return and risk as to the basic postulates of modern financial theory. Because return and risk are interdependent, any rational investor estimating a future expected return must seek to identify and assess the risk of specific investment alternatives. In this regard, achieving the expected return is the critical driver of investment activity. At the same time, its maximization at the given level of risk is the main goal pursued by the intelligent investor.

If an investor can know future returns with certainty, he will invest in only one profitable security with the highest future return. However, being sure about the future is quite an unrealistic assumption that ignores risk and oversimplifies the investment process. Intelligent investors do not concentrate their wealth on a single security or a single type of security; they must invest in different assets, thus building a diversified portfolio. 

In terms of finance, an investment portfolio is a collection of different types of investments, for instance, a mix of various financial instruments held by investors. Having a securities portfolio is a part of the investment strategy called the diversification of investments, which is carried out to reduce the total variance without changing the expected return. A more straightforward way to reduce portfolio risk is to allocate a portion of assets to risk-free assets. However, an investor should expect that this risk reduction strategy would result in lower expected portfolio returns. 

What Are The Benefits Of Diversification

Diversification’s absolute benefit reduces an investor’s overall level of volatility and potential risk. For instance, by diversification, investors avoid losses when investments in one area perform poorly, then other investments in the portfolio can offset losses. That is particularly true when investors hold assets that are negatively correlated.

To maximize returns, investors must diversify their investments to reduce the risk they are exposed to. Although there are certain risks you can’t avoid, such as systemic risks, you can hedge against idiosyncratic or non-systematic risks like business or company risks by diversification.

To build a diversified portfolio, you should look for investments such as intangible assets, stocks, bonds, cash, or other assets whose returns haven’t historically moved in the same direction and to the same degree

What is the Different between Systematic and Non-systemic Risk

Most importantly, when investing, there are two types of risk investors have to be aware of:

• Systematic risk
• Idiosyncratic risk or non-systemic risk

Systematic risk is the risk that the entire economy and stock market will experience a downturn. Systematic risk is also something anyone investing, particularly in the stock market, can anticipate. An example of systemic risk is a subprime mortgage meltdown. The United States subprime mortgage crisis was an international financial crisis between 2008 and 2010, contributing to the 2008 global financial crisis. Brokers in the United States facilitated easy mortgages by approving mortgages without down payments, stated income, and no documentation loans.

Despite mentioning the importance of such a call diversification, unfortunately, when it comes to systemic risk, diversification won’t help investors, particularly in exchange markets. The majority of investors endure losses during times of systematic trouble. Hence, it is always a matter of when. 

Idiosyncratic risk in the other hand is explicitly attached to that individual stock or sector. For example, if you invested in a technology index fund, you would be exposed to the broader stock market risk specific to the technology industry. For instance, on April 22, 2010, British Petroleum company BP suffered a significant oil spill creating idiosyncratic or non-systematic risk. During that time, the company’s stock declined by over 50 percent. This did not impact the whole financial market; therefore, no declines were seen in other stocks, bonds, funds, the real estate market, etc.

To give an example of idiosyncratic risk, when some amateur investors had all their investments in British Petroleum stock, they lost half of their wealth because it was isolated to that one company. 

Most investors are amateurs. An intelligent investor would diversify his investment across non-paper assets, such as gold or silver. 

How To Diversify A portfolio

All investors must know that investment risk, particularly systematic risk, can be reduced through portfolio diversification. This concept can be easily applied without any complex techniques via genuine diversification. Unfortunately, some investors wrongly think that diversification is holding a diversified portfolio by randomly selecting a certain number of different stocks and investing the amount of money in them.

When investing in the paper asset, the investor cannot eliminate investment risk. However, two basic investment strategies, asset allocation and diversification, can help manage both systemic risk, which affects the economy as a whole, and non-systemic risk or idiosyncratic that affect a small part of the economy or a single company.

• Asset Allocation, is by including different asset classes in your portfolio, for instance stocks, bonds, real estate and cash, you increase the probability that some of your investments will provide satisfactory returns even if others are flat or losing value. Put another way, you’re reducing the risk of major losses that can result from over-emphasizing a single asset class, however resilient you might expect that class to be.
• Diversification, is when you diversify, you divide the money you’ve allocated to a particular asset class, such as stocks, among various categories of investments that belong to that asset class. Diversification, with its emphasis on variety, allows you to spread you assets around.

Intelligent investor must use the combination of both the asset allocation and diversification to reduce investment risk.

By genuine diversification, we mean that investors must spread their investments through investing in at least two of the below different assets, such as:

• Cash
• Stocks
• Bonds
• Mutual Funds
• Exchange Trade Funds ETFs
• Bank Products
• Options
• Real estates
• Tangible assets
• Annuities
• Businesses
• Retirement plans
• Education investments

However, standard textbooks of Investment and Financial Management tell investors that the benefit of diversification is mostly exhausted with an investment consisting of stocks, bonds, real estate, business, and intangible assets, such as gold and silver. Most of the investment risk is eliminated, leaving only the portion of systematic risk.

 

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