The meaning of diversification as a risk-management approach for investors.
Investors diversify their investments among a variety of companies, industries, sectors, and asset classes rather than concentrating their money in a single company, industry, sector, or asset class.
The ultimate purpose of diversification is to lower portfolio volatility by compensating for losses in one asset class with gains in another.
Diversification – Risk Management
Before getting into the concept of diversification, first look at the types of risks.
There are two broad types of risks in investments:
Systematic risk is also known as the market risk, which is associated with every company. Some common causes of such risks include inflation, war, political instability or economic instability. Since this risk is equally applicable to all markets and does not apply to one particular industry or sector, all investors have to face it and it cannot be diversified.
Unsystematic risk can be eliminated through diversification potentially.
This type of risk is specific to a particular company, industry, sector, or market. The major sources/causes of unsystematic risks are business and financial risks. This type of risk is possibly diversifiable.
Risk Reduction through Diversification
Now, diversification deals with mitigating or limiting the effect of unsystematic risks. It smooths out unsystematic risk events in the portfolio so that the good performance of some investments can neutralize the bad performance of others.
It works when the sectors in which you invest respond differently, ideally in the opposite ways to different market movements.
Diversification Example in Trading Market
Diversification Example: Let’s say you have a portfolio where you invest in railway stocks. The share prices will drop following any financial or social crisis, for example, a track malfunction. As a result, your portfolio will suffer a serious blow.
You could also balance off the losses by investing in bus service, so only a part of your portfolio will be affected. In fact, there is a chance that stock prices for bus services rise as people will look for alternate modes of transport.
You could even diversify further to avoid risks from events that will affect the transport industry as a whole. The more unrelated your investments are, the better it is for you. So, make sure you are investing in different asset classes. In each class, you could further diversify by industry and within the industry, you can diversify based on the company’s size.
Asset Classes definition
Investors and fund managers invest in different asset classes. An asset class is a group of investments with similar risks and return traits. Some broad asset classes are:
- Stocks→ shares of a publicly-traded company
- Bonds→ government-based income debt tool
- Commodities→ goods needed for the manufacturing of other goods or services
- Real Estate→ property of any sort, including land, buildings, grounds. Livestock, mineral deposits, etc.
Pros and Cons of Diversification
Diversification is a much-needed strategy to minimize investment risks potentially. The future is highly uncertain and the world of trading is extremely volatile. The market keeps changing with sometimes predictable but generally unpredictable patterns. You may diversify your assets among different classes, industries, and companies.
The reason for diversification is not to maximize gains rather minimize losses. It is quite possible that a person with centralized investment could profit more than someone with diversified investments due to a rise in that particular sector.
However, this is short-term. In the long run, a diversified investor will outperform a more specified one.
The importance of diversification in investing is to invest in classes that perform differently in the same market. For example, when COVID came to light, medical sector stocks skyrocketed while those of the transport sector plummeted.
Realistically speaking, it is not possible to maintain an investment that is perfectly negatively correlated. The overall goal is to make sure that no two investments have the same effect on any market movement.
There are many upsides to diversification but it is not void of drawbacks either. The more holdings your portfolio has, the more difficult it will be to keep track of them.
It can also be expensive at the time of investment as each type of investment will have its own transaction fee and brokerage commission.
The Bottom Line
Diversification is a mature and responsible way of investing. It could be a great method of mitigating the risks of any asset and reducing the impact of its volatility. However, no strategy including diversification can completely eliminate risks.