If you’ve taken a peak in your portfolio this January most of you probably noticed your entire portfolio glowing bright red. We are constantly preached to diversify our investments but if it fails in the “money time” when markets crash what’s the use?
The answer lies in the following two principles of investment and finance which are crucial to understanding the importance and purpose of diversification:
#1 Good diversification lowers a portfolio’s risk level to the market risk level – When it rains everyone gets wet
When we diversify we essentially spread our investments to lower the total risk of our portfolio. How do we lower the portfolio’s risk? By diversifying our investment and investing fractions of our portfolio in different geographies, industries and more.
In so doing we are reducing the specific risks each small investment carries. Specific risks are the risk of bankruptcy of a company, war in a country etc. Due to the fact investments are correlated but not perfectly related we can achieve the same return with smaller risk (for more information read my post on the importance of diversification or Wikipedia on the CAPM model).
Since we do want some return on our investment we have to take a certain risk. The smallest risk possible is the market risk without any additional specific risks. Investing in stocks yields high returns because it is dangerous. Playing it safer yields lower returns.
#2 Portfolio diversification should be examined in the long term
In the short run all markets respond negatively to fears of recession due to the lack of information and fear reciprocal dependencies (such as export, import and consumption) will affect all markets.
In the long term differentiation begins to show. This differentiation depends on market growth, economic factors, conditions and more.