Reduction of risk through Diversification:
The process of combining securities in a portfolio is known as diversification. The aim of diversification is to reduce total risk without sacrificing portfolio return. To understand the mechanism and power of diversification, it is necessary to consider the impact of covariance or correlation on portfolio risk more closely. We shall examine three cases: (1) when security returns are perfectly positively correlated, (2) when security returns are perfectly negatively correlated and (3) when security returns are not correlated.
Diversification means, investment of funds in more than one risky asset with the basic objective of risk reduction. The lay man can make good returns on his investment by making use of technique of diversification.
Main forms of diversification:
- Simple Diversification,
- Over Diversification,
- Efficient Diversification.
(1) Simple Diversification:
It involves a random selection of portfolio construction. The common man could make better returns by making a random diversification of investments. It is the process of altering the mix ratio of different components of a portfolio. The simple diversification can reduce unsystematic risk. The research studies on portfolio found that 10 to 15 securities in a portfolio will bring sufficient amount of returns. Further, this concept reveals that the prediction should be based on a scientific method.
(2) Over Diversification:
Investors have the freedom to choose many investment alternatives to achieve the desired profit on his portfolio. However, the investor shall have a great knowledge regarding a large number of financial assets spreading different sectors, industries, companies. The investors also more careful about the liquidity of each investment, return, tax liability, the performance of the company etc. Investors find problems to handle the large number of investments. It involves more transaction cost and more money will be spent in managing over diversification. If any investor involves in over diversification, there may be a chance either to get higher return or exposure to more risk. All the problems involved in this process may result in inadequate return on the portfolio.
(3) Efficient Diversification:
Efficient diversification means a combination of low risk involved securities and high risk instruments. The combination will only be finalized after considering the expected return from an individual security and it does inter relationship with other components in a portfolio. The securities shall have to be evaluated and thus diversification to be restricted to some extent. Efficient diversification assures the better return at an accepted level of risk.
Importance of Diversification:-
If you invest in a single security, your return will depend solely on that security; if that security flops, your entire return will be severely affected. Clearly, held by itself, the single security is highly risky. If you add nine other unrelated securities to that single security portfolio, the possible outcome changes—if that security flops, your entire return won’t be as badly hurt. By diversifying your investments, you have substantially reduced the risk of the single security. However, that security’s return will be the same whether held in isolation or in a portfolio.
Diversification substantially reduces your risk with little impact on potential returns. The key involves investing in categories or securities that are dissimilar: Their returns are affected by different factors and they face different kinds of risks. Diversification should occur at all levels of investing. Diversification among the major asset categories—stocks, fixed-income and money market investments—can help reduce market risk, inflation risk and liquidity risk, since these categories are affected by different market and economic factors.
Diversification within the major asset categories—for instance, among the various kinds of stocks (international or domestic, for instance) or fixed-income products—can help further reduce market and inflation risk.