The key risk management tool for the average investor is portfolio diversification.
It seems like an easy concept, but it is a little more complex than it first appears.
Diversification and Investment Risk
Before we start our discussion on diversification, I want to point out a difference in my personal views and what is generally accepted in readings elsewhere.
In learning the distinctions between nonsystematic and systematic risk, diversification is normally number one on the list. In fact, that is why nonsystematic risk is also known as diversifiable risk and systematic risk is also termed non-diversifiable risk.
You will usually be taught that nonsystematic risk can be minimized through diversification. However, systematic risks cannot be diversified away.
If you are writing a finance exam, I suggest that you bear this in mind.
I think this is incorrect, but I do not want to be the one helping you to fail an exam.
As we go through diversification, I will provide examples of how to reduce systematic risks in one’s portfolio. You can decide if, in the world of non-academia, I am correct or not.
What is Diversification?
Investopedia defines diversification as:
A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
This definition makes some sense if you already know what diversification is. But if you are unfamiliar with the concept, I think it makes little sense.
And it is somewhat misleading to a non-professional investor.
For those that want to understand this very important concept, we shall attempt to dig deeper into diversification.
Digging Deeper into Diversification
Diversifying a portfolio does require one to hold a “wide variety of investments”.
But it is not that simple. We shall consider the following questions:
Why must a portfolio contain a “wide variety of investments”?
What constitutes a “wide variety”? 5 assets? 50? 500?
Are any “mixes” of assets acceptable?
Will a diversified portfolio actually generate “higher returns and pose a lower risk than any individual investment found within the portfolio”?
The answers to some of these questions may be found in a look at asset correlations.
So correlations will be our initial foray into the world of diversification.