Portfolio Diversification

What is Portfolio Diversification?

Portfolio Diversification refers to choosing different classes of assets with the objective of maximizing the returns and minimize the risk profile.

  • Each investor has his own risk profile, but there is a possibility that he does not have the relevant investment security that matches his own risk profile.
  • This is when an investor chooses a bunch of assets to equalize his risk & payoffs to the portfolios’ – the set of securities the investor has chosen to invest in.
  • From a nonprofessional’s standpoint, it is not possible to buy one security to match the wants of an investor. Portfolio Diversification is the formation of a portfolio that matches the wants.
Portfolio-Diversification

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Portfolio Diversification (wallstreetmojo.com)

Why Diversity the Portfolio?

Consider a person (Mr. A) who has just a basic idea about what finance is, and he plans to invest his retirement savings. Since the investment is for his retirement, he plans to invest at very low risk, and he just wants his portfolio to grow along with inflation. This person is considered to have a very low-risk profile.

On the other hand, consider an investor (Mr. B) who plans to invest 10% of his money in extremely risky assets. Alternatively, he might want to invest such that he gets the returns the same as the markets.

If you look at any one of the above scenarios, each one has its own risk profile – Mr. A has a very low tolerance for riskTolerance For RiskRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition.read more, and Mr. B has a very high tolerance for risk. One should be aware of the fact that risk tolerance is not the same as risk aversionRisk AversionThe term "risk-averse" refers to a person's unwillingness to take risks. Investors who prefer a low-return investment with known risks to a higher-return investment with unknown risks, for example, are risk-averse.read more. Risk aversion is the character of a person to take more or less risk to the returns he is getting. If he tries to take less risk than the returns he wanted, he is supposed to be risk-averse. Since that is not in the scope of this article, let us just park that apart and see what and how investment can be diversifiedInvestment Can Be DiversifiedA diversified portfolio of investments is a low-risk investment plan that works as the best defence mechanism against financial crises. It allows an investor to earn the highest possible returns by making investments in a mixture of assets like stocks, commodities, fixed income.read more.

Asset Classes for Portfolio Diversification

To know where to put your money, one should have an idea about what different type of assets is. Because of the growth in technology and the availability of different finance products, there is an infinite number of ways I can diversify my portfolio. To keep the difficulty of the concepts low, let us just consider a few classes of assets

#1 – Stocks

As we know, stocks represent the ownership of a part of the company – which comes with some obligations and some benefits. This goes to say that the investor (owner of stocks) is not eligible for anything except for ownership in the company. If the company goes down, the value of the investment goes down and vice versa.

Therefore, the owner will not be safe from the risks the company poses. Without proper information, it is impossible to gauge the risk of the company. This makes stocks a risky asset. If a person is to invest them, they ought to be aware of the risks they are taking and should be willing to take that risks.

#2 – Bonds: Treasury and Non-Treasury

BondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more are one way to raise money by the company, where they guarantee cash flows. Unlike stocks, bonds have a guarantee on them. A pre-specified amount will be paid to the owner of the bond for each duration. In short, a bond is like a fixed-deposit except that it is tradeable. Therefore, the price of bonds go down and go up. Treasury bonds are bonds backed by the US Government, which makes them pretty much risk-free. Hence, for all practical purposes, this article will consider Treasury Bonds as the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more.

Apart from the assets that are available for portfolio diversification, one has to have an idea about systematic and unsystematic risk.

Elements of Portfolio Diversification

To diversify a portfolio, one must have measures of rates of return, how the prices change, and other statistical variables.

investment-diversification-graph

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Portfolio Diversification (wallstreetmojo.com)

Let us look at the above graph, which provides an idea about what the entire topic of portfolio diversification is about. The safest bet is to invest in an area filled with green. The bad investment is the investment in yellow.

There are thousands of companies that are traded daily, but buying any one of these does not complete the investor’s risk profile.

Assume an investor who wants to have the returns of the market (he wants to reduce his nonsystematic risk to zero). He can try to replicate the returns and risk profile, either by a set of stocks and bonds or by a set of stocks (buying all the stocks as the market).

How to Diversify your Investment Portfolio?

Advantages of Diversification

Disadvantages of Diversification

Limitations of Portfolio Diversification

  • Market risk cannot be diversified. Crashes like 2009, 2001 can always happen, and diversification will not protect the investor against them.
  • Government policies play a large role in market movement, and it cannot be diversified.
  • Diversification is generally for long-term investors. Diversification will not help in trading.

Conclusion

In words, diversification is a pretty simple concept. One looks out for his wants and tries to match them. Since the 1970’s when Vanguard started the first index fundsIndex FundsIndex Funds is a form of mutual fund constructed to replicate and match the performance of a particular country's index like S&P, NASDAQ, etc., and helps investors take broad market exposure due to the amount invested in various stocks of the different sectors of the economy.read more, indexing is one of the prime gauges of diversification. When one compares the rates of return with the market, it might be difficult to put out where the market is. As there is no market that ensures all the assets are included. But diversification is so common these days that the number of people investing in single assets is almost nill.

This has been a guide to what is Portfolio Diversification and its definition. Here we discuss how to diversify your investment portfolio along with the type of asset classes used to diversify the portfolio. You can learn more about investment from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *