Diversification is a technique that deals with risk management by mixing a wide range of investments in a single portfolio in hope that the sheer number of investments can result in higher returns with low risks. In other words, if a number of investments can yield greater results, they may neutralize the loss from an individual investment in the same portfolio. So the benefits that can result from diversification will only remain sustainable if the securities are imperfectly correlated.
A Breakdown…
According to studies, a portfolio that is well maintained with over 30 securities or stocks has the ability to yield a cost effective risk reduction level. Additional benefits from diversification are obtainable if investors invest in more securities but the rate will be comparatively smaller.
More benefits are possible if foreign securities are invested which are not affected by domestic investments. For instance, if the United States suffers from an economic downturn, it may not have an effect on China’s or Japan’s economy. In other words, if you have investments in either of the last two countries, you can protect yourself to a certain degree from a huge loss.
Some investors that do not belong to an institution don’t have the funds to create a diverse portfolio which is why mutual funds are so popular. This is actually an inexpensive way to diversify a portfolio, a fact that budget conscious investors covet.
Types of Risks
There are mainly two types of risks investors can face:
Undiversifiable risks – This is also known as a market risk and it can caused by inflation, exchange rates, political unrest, war and fluctuating interest rates to name a few. It is not specific to a single corporation or a single industry and it cannot be completely eliminated either.
Diversifiable risks – Also known as unsystematic risk, this kind is specific to a corporation, industry, economy and country and their sources are usually financial as well as business risks. However, it can be reduced with diversification. The main aim of the investor facing this risk should be to invest in a number of investments so that the loss sustained remains minimal.
Why Diversify?
Diversifying a portfolio can ensure you do not suffer massive losses that you may not be able to recover from and to preserve the integrity of your portfolio. It can also save you from going bankrupt in case the economy takes a nose dive.
Further Reading
- Time diversification and estimation risk – www.tandfonline.com [PDF]
- International diversification and the multinational enterprise – www.osti.gov [PDF]
- Specialization versus diversification as a venture capital investment strategy – www.sciencedirect.com [PDF]
- Diversification when it hurts? The joint distributions of real estate and equity markets – www.tandfonline.com [PDF]
- The determinants of firm diversification in UK quoted companies – www.tandfonline.com [PDF]
- Does diversification create value in the presence of external financing constraints? Evidence from the 2007–2009 financial crisis – papers.ssrn.com [PDF]
- International portfolio diversification: a synthesis and an update – www.sciencedirect.com [PDF]
- Curvilinearity in the diversification–performance linkage: an examination of over three decades of research – onlinelibrary.wiley.com [PDF]
- The effect of international diversification on corporate financing policy – www.sciencedirect.com [PDF]
- Ownership structure, corporate diversification and capital structure – www.emerald.com [PDF]
