Diversification is the strategy of combining distinct asset classes in an investment portfolio in order to reduce overall portfolio risk. In other words, diversification is the process of selecting the asset mix so as to reduce the uncertainty in the return of an investment portfolio. Diversification helps to reduce investment risks because different investments may rise and fall independent of each other. The combinations of these assets will nullify the impact of fluctuation, thereby, reducing risk.
Most financial assets are not held in isolation, rather they are held as parts of portfolios. Banks, pension funds, insurance companies, mutual funds, and other financial institutions are required to hold diversified portfolios. Even individual investors – at least those whose security holdings constitute a significant part of their total wealth – generally hold stock portfolios, not the stock of a single firm. Why is it so? An important reason is the lowering of risk, which means risk of getting zero or negative return on some assets. If a person holds a single asset, he or she is highly dependent on the issuer firm, its success, and dividend policy, as well as on the overall current market situation. On the other side, holding a well-diversified portfolio protects a person from both market fluctuations and internal problems of issuer. A diversified portfolio helps to keep investment returns stable.
Diversification in a portfolio can be achieved in many different ways. Individuals can diversify across one type of asset classification – such as stocks. To do this, one might purchase shares in the leading companies across many different (and unrelated) industries. Many other diversification strategies are also possible. You can diversify your portfolio across different types of assets (stocks, bonds, and real estate for example) or diversify by regional allocation (such as state, region, or country). Thousands of options exist. Luckily, in almost every effective diversification strategy, the ultimate goal is to improve returns while reducing risks.
The following possible ways can be applied by a fund manager while considering the mode of diversification.
- Diversify within an industry: Investing in a number of different stocks within the same industry does not generate a diversified portfolio since the returns of firms within an industry tend to be highly correlated. However, this is better than investing in a single stock.
- Diversify across industry groups: Correlation between industries is likely to be lower than between the firms with an industry. However, some industries themselves can be highly correlated with other industries and hence diversification benefits can be maximized by selecting stocks from those industries that tend to move in opposite directions or have very little correlation with each other.
- Diversify across geographical regions: Companies whose operations are in the same geographical region are subject to the same risks in terms of natural disasters and state or local tax changes. Investing in companies whose operations are not in the same geographical region can diversify these risks.
- Diversify across countries: Stocks in the same country tend to be more correlated than stocks across different countries. This is because many taxation and regulatory issues apply to all stocks in a particular country. International diversification provides a means for diversifying these risks.
- Diversify across asset classes: Investing across asset classes such as stocks, bonds, and real property also produces diversification benefits. The returns of two stocks tend to be more highly correlated, on average, than the returns of a stock and a bond or a stock and an investment in real estate.
Credit: Portfolio Management-MGU KTM