Diversification- a strategy to risk reduction
Diversification, the concept is widely understood with the famous sayings “Don’t put all your eggs into one basket” meaning if the basket falls you will likely lose all.
The same principle also applies in the world of finance where diversification implies to invest in different asset classes for unsystematic risk reduction or volatility of single asset in the portfolio hence reduces the risk of the portfolio.
If you are holding single asset strategy inside your investment portfolio which is absolutely not a diversifiable approach and may be riskier attitude towards investing.
To better understand, the risk can further be divided into two categories, one is a “Specific or Unique risk” and the rest categorised as a “Market or Systematic risk”.
Unique risk can be minimised by thinning out your investments, and circumventing an over-concentration in any solo stock, industry, or nation.
Reduce unique risk through diversification
Studies reveal that practical diversification can be attained by adding from fewer stocks to 40-50 stocks that can be purged most of the unique risk of your portfolio, however strictly subject to specific portfolio mix of asset classes.
The above diagram confirms that the more assets you add into the investment portfolio higher the reduction in Specific or unique risk may potentially be reduced to zero if add certain number of assets or investments into the target portfolio leads to 100% diversification.
Research study finds fully diversified investment portfolio may contain minimum 30 to 50 assets or securities from different asset classes i.e. more stocks, shares, ETFs, Managed Funds, etc. lead to reduction in substantial unsystematic risk or portfolio volatility.
Many of financial experts are converged on the idea that most diversification can be achieved through buying the market portfolio i.e. replicating the strategy of underlying index funds.
However, Market or systematic risk persists in the same fashion and can’t be diversified further but may be managed through adopting different techniques or hedging strategies.
The capital asset pricing model (CAPM) argues that investors should only be compensated for non-diversifiable or market risk.
The sensitivity of market or systematic risk can be measured by Beta “β”. Assume an investor has the portfolio of property stocks of beta 3 against the market’s beta of sensitivity always 1, the portfolio is 3 times more sensitive towards market shocks.
To understand better, consider an example having a gold or precious metal in the investment portfolio may be a good hedged against inflation or currency wars.
Finding the negative correlation among investments will provide a better idea how diversified is the investment portfolio. An example of balanced stock & bond portfolio considered a well-diversified portfolio as both are negatively correlated asset classes.
Beta is an indicator of measuring effects on how investments can lose its potential value due to market shocks that may potentially increase the market risks like political, macro or micro-economic risks, or country risk variate due to global recession, etc.
Hence, the right type of diversification reduces real risk and make sense for the investor to avoid unsystematic or idiosyncratic risk. Nonetheless, it depends on investors’ investment goals and appetite for risk.
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