Diversification is the concept is widely understood with the famous proverb “Don’t put all your eggs into one basket“. That means if the basket falls you lose all of your eggs. The principle also applies in the world of finance where diversification implies invest in different asset classes to reduce the risk or volatility of single asset in the portfolio hence reduces the overall risk of the portfolio.
If you are holding a single asset class as a complete investment portfolio which is not a diversified approach and considered to be more risky attitude towards investing. For better understanding risk can further be divided into two categories, one is a “Specific or Unique risk” and the other categories as a “Market risk”.
Research study finds fully diversified investment portfolio may contain minimum 30 assets or securities i.e. more stocks/ shares or asset class (To learn more about asset class, see Five Things To Know About Asset Allocation.) lead to reduction in substantial price volatility. Many financial experts are converged 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” i.e. if 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 for example having gold or precious metal in the investment portfolio may be a good hedged against inflation or currency wars.
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 makes sense for the investor. Nevertheless, it depends on investors’ investment goals and appetite for risk.
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