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The Importance of Portfolio Diversification
Portfolio diversification is a method used by investors that aims to reduce risk by allocating investments across different asset classes. By doing so, it aims to maximize returns by investing in different financial instruments, industries, and categories that would each react differently to the same market event.
Most fund managers and investors agree that, although diversification does not guarantee against loss, it is important in achieving long-term financial goals while minimizing risk.
Understanding Diversification & Its Importance
In practical terms, diversification is holding investments that will react differently to the same market or economic event. Let's understand it with an example.
Suppose there are two investors with both $100,000 each. One investor invests the $100,000 dollars in one stock, while the other invests the $100,000 dollars in 10 different stocks. Each stock has a 2/3 chance of doubling its money but a 1/3 chance of losing everything. We would expect both investors to earn a positive return given the higher odds. However, the investor with a diversified portfolio is taking less risk since the first investor has a 1/3 chance of losing everything on one stock, which is a pretty significant risk. In contrast to the second investor, who would only lose everything if every investment happened to its 1/3 odds, an incredibly unlikely outcome. More often than not, for the second investor, the majority of its investments will earn a positive return, and while few positions may lose everything, the positive performance of the other stocks will offset those losses. So by splitting out the holdings, the second investor minimizes significant risk compared to investor one. By diversifying, you're making sure that you're not placing all your eggs in one basket.
It is important to diversify amongst different asset classes as well. This includes bonds, stocks, real estate, emerging market stocks, cash, mutual funds, etc. A combination of these different asset classes reduces a portfolio's sensitivity to market swings because they will tend to move in opposite directions. As a result, this type of diversification allows risk to be spread while losses can be handled in a better manner.
When we say by spreading your investments into different asset classes, you can minimize risk, what does it mean? And what types of risks are investors trying to mitigate?
Investors are usually faced with two types of risks when they invest- systematic and unsystematic risk. The first type is systematic risk. Systematic or market risk is due to risk factors that affect the entire market, such as investment policy changes, foreign investment policy, change in taxation clauses, a shift in socio-economic parameters, global security threats, etc.
For example, "Black Monday" on October 19th, 1987 was a systematic event in that all stocks fell in value on that single day. This type of risk is beyond the control of investors and cannot be mitigated to a large extent, even by diversification.
The second type is diversifiable or unsystematic risk. This risk is due to factors specific to an industry or a company like product category, research and development, pricing, marketing strategy, etc.
For example, if you owned one stock, and if that company went bankrupt, you will have lost 100% of your portfolio. If you owned one hundred stocks and only one company went bankrupt, you would have lost 1% of your portfolio.
The effects of this type of risk can be avoided, as the aim is to invest in various assets, so not all will be affected the same way by market events.
Problems with Diversification
Although fund managers place a great deal of importance on a diverse portfolio, there are some downsides to this strategy as well. First, a portfolio with multiple holdings and investments could be somewhat unmanageable.
Second, the cost of diversification is high. Since cost of acquisition for all asset classes varies, buying and selling will affect an investor's overall gains through transaction costs and brokerage fees, ultimately limiting their returns.
Third, portfolio diversification is complicated. For many investment products, adequate knowledge is necessary to understand the complex nature of these products. Those with limited experience, especially beginners or small investors, will be hesitant to take such risks. For such individuals, purchasing bonds is a great option to mitigate market risk.
At last, an in-depth analysis of a company and its financial statement may not always guarantee a profitable return. In this case, diversification will not prevent a loss but will minimize the impact on the portfolio.
The Bottom Line
When you diversify your investments, you try to reduce the amount of risk you are exposed to in order to maximize gains. Since certain risks are unavoidable, like systemic risks, they can be hedged against unsystematic risks like business or financial risks. It is important to remember that risk cannot be 100% mitigated. It will always be present in an investor's portfolio. The key is to diversify in such a manner that you find a balance between risk and return, which is why portfolio diversification is necessary.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
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