What Does Diversification Mean?

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. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

Investopedia explains Diversification

Studies and mathematical models have shown that maintaining a welldiversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate. Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments would allow an investor to have a small cushion of protection against losses due to an American economic downturn. Most non-institutional investors have a limited investment budget, and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification. In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors. Diversification is one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive.

Hedging relies on negative correlation among assets, or shorting assets with positive correlation. It is important to remember that diversification only works because investment in each individual asset is reduced. If someone starts with $10,000 in one stock and then puts $10,000 in another stock, they would have more risk, not less. Diversification would require the sale of $5,000 of the first stock to be put into the second. There would then be less risk. Hedging, by contrast, reduces risk without selling any of the original position. The risk reduction from diversification does not mean anyone else has to take more risk. If person A owns $10,000 of one stock and person B owns $10,000 of another, both A and B will reduce their risk if they exchange $5,000 of the two stocks, so each now has a more diversified portfolio. Portfolio diversification is the means by which investors minimize or eliminate their exposure to company-specific risk, minimize or reduce systematic risk and moderate the short-term effects of individual asset class performance on portfolio value. In a wellconceived portfolio, this can be accomplished at a minimal cost in terms of expected return. Such a portfolio would be considered to be a well-diversified. Although the concepts relevant to portfolio diversification are customarily explained with respect to the stock markets, the same underlying principals apply to all types of investments. For example, corporate bonds have specific risk that can be diversified away in the same manner as that of stocks.

Return expectations while diversifying

If the prior expectations of the returns on all assets in the portfolio are identical, the expected return on a diversified portfolio will be identical to that on an undiversified portfolio. Ex post, some assets will do better than others; but since one does not know in advance which assets will perform better, this fact cannot be exploited in advance. The ex post return on a diversified portfolio can never exceed that of the top-performing investment, and indeed will always be lower than the highest return (unless all returns are ex post identical). Conversely, the diversified portfolio's return will always be higher than that of the worst-performing investment. So by diversifying, one loses the chance of having invested solely in the single asset that comes out best, but one also avoids having invested solely in the asset that comes out worst. That is the role of diversification: it narrows the range of possible outcomes. Diversification need not either help or hurt expected returns, unless the alternative non-diversified portfolio has a higher expected return. But risk averse investors may find it beneficial to diversify into assets with lower expected returns, thereby lowering the expected return on the portfolio, when the riskreduction benefit of doing so exceeds the cost in terms of diminished expected return.

Maximum diversification
Given the advantages of diversification, many experts recommend maximum diversification, also known as buying the market portfolio. Unfortunately, identifying that portfolio is not straightforward. The earliest definition comes from the capital asset pricing model which argues the maximum diversification comes from buying a pro rata share of all available assets. This is the idea underlying index funds. One objection to that is it means avoiding investments like futures that exist in zero net supply. Another is that the portfolio is determined by what securities come to market, rather than underlying economic value. Finally, buying pro rata shares means that the portfolio overweights any assets that are overvalued, and underweights any assets that are undervalued. This line of argument leads to portfolios that are weighted according to some definition of economic footprint, such as total underlying assets or annual cash flow. Risk parity is an alternative idea. This weights assets in inverse proportion to risk, so the portfolio has equal risk in all asset classes. This is justified both on theoretical grounds, and with the pragmatic argument that future risk is much easier to forecast than either future market value or future economic footprint.

A Well-Diversified Portfolio
I know I've left the definition of a well-diversified portfolio a bit hazy. But the definition is highly dependent upon factors that are unique to each investor. Only when those factors are defined can the term be clearly defined. Those factors include: risk tolerance, targeted terminal wealth, investment horizon (planned holding period) and the universe an individual is willing to accept as the pool from which they will select their assets. As I stated above, a well-diversified portfolio should be diversified within asset classes to the degree at which specific risk has virtually been eliminated, and diversification across asset classes should be such that the residual risk of the portfolio is consistent with the investors risk tolerance. The residual risk of a portfolio will diminish as asset classes are added to the investment universe, but there is a point of diminishing returns and there is a finite number of asset classes, which implies that there is a point beyond which no further reduction of residual risk can be achieved. A portfolio would be fully diversified at this point. Well-conceived portfolio diversification will result in the construction a well-diversified portfolio that will serve you well in achieving your long-term investment goals. And selecting an investment universe that is sufficiently broad to ensure that the highest level of diversification consistent with your risk tolerance can be achieved is the single most important step in constructing your portfolio.

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security analysis and portfolio management

Topic: DIVERSIFICATION

Submitted to Dr:Govind bhut Prof. in AJIM

Submitted by sobin chacko 2nd MBA no. 60 AJIM