Think about betting 10,000$ on one coin toss with the possibility of winning 25,000$ and loosing everything. Now think about betting 1$ on each of 10,000 coin tosses with the possibility of wining 2.5$ and loosing 1$ each time. That is diversification in a nutshell. While participating in both bets yield, on average, the same gain (7,500$) the second bet seems much more inviting. The appeal of the second bet is due to the fact each one of the 10,000 bets is a small version of the large one thus reducing risk of losing everything in one big bet.
Same principal goes for investing in financial assets. Each financial asset has a risk factor that should be taken into account. If simplified each financial asset yields a certain return with certain odds. Think of biotech company which has a chance of 1/100 of succeeding and yielding 100,000% return on investment and 99/100 chance of loosing the initial investment. This is a risky investment although profitable on average. The problem is getting to that average.
As demonstrated above a financial asset’s risk is influenced by the variability attributed to the various return on investment scenarios this financial asset is thought to have. Ranking financial assets by risk is usually done as follows: Derivatives will be ranked highest, growth and small company stocks next (high possible return and a considerable chance of failure), blue-chip company stocks, company bonds, government bonds and last a bank deposit where the outcome of the investment is almost 100% certain.
Simply put, a diversified portfolio is a portfolio which has many “bets”, each with a relatively low investment when compared to the sum of the portfolio. The risk level of the entire portfolio can still be high (all stock for example) but a diversified risky portfolio is, of course, better then having just a risky portfolio.
Diversification can be and should be achieved across various variables as each variable has its own specific risks. Specific risk, in finance, is the variability in the return on a security due to exposure to risks relating to that security in isolation (bankruptcy of a certain company for example). Good diversification eliminates specific risks. Each variable of investment carries its own specific risk and should be diversified. By variables I’m referring to:
1) Industry It is important to diversify across various industries as each industry has specific risks (Sub-prime crisis for example might affect one sector to under perform while another to over perform).
2) Geography As industries, a certain region can be affected by a war or crisis. 3) Various other variables such as financial asset types, investment terms and more.
How do we achieve a diversified portfolio then? We participate in many bets with changing variables with relatively low sums of investment:
1) Buy a large number of promising’ stocks For diversification purposes one could buy a large number of stocks (over 10) in a portfolio. This method of diversification is not recommended. Many researches have shown beating market performance by choosing specific stocks is not easy. There is another disadvantage in buying many specific stocks as buy/sell commissions can be quite high.
2) Invest in mutual funds Mutual funds are run by professional who do exactly what we are trying to achieve. Diversify. Mutual funds purchase many, thought to be promising, stocks and use them to diversify our investment in them. There are many types of mutual funds. Some specialize in certain markets while some are more general. Even though mutual funds diversify our investment we should still minimize specific risks and diversify our investment in mutual funds as well. Buying various mutual funds, with various specializations in industry and geography is a good way of diversifying.
3) Invest in ETF’s mimicking market indices As aforementioned even professional brokers have a hard time beating market performance by choosing specific stocks as mutual funds do. Why not invest in market indices then? An ETF is a good way to do that and with lower commissions. There are many ETF’s which mimic market indices (such as QQQQ for NASDAQ). Buying ETF’s is easy and relatively cheap. As before further diversification is still required. 4) Invest in bonds and deposits investing in bonds and deposits is a good way of diversifying as the source of return in these financial assets is debt and not ownership. When a market under performs corporations still have to pay interest on bonds.
To conclude, diversification is one of the most basic tools of investors. Diversification will enable your portfolio to minimize specific risk (Not to be confused with market risk of the portfolio), lower the portfolio’s variability and change over time and help generate better return on investment.