Diversification of Investment : Meaning, How it Works & Importance

What is Diversification?

Diversification is a method of risk management where risk is reduced by distributing funds over multiple financial instruments, industries, or some other categories for investments. A diversified investment portfolio can be created by combining different assets and instruments to control the risk exposure of any single individual investment asset. The prime objective of diversification is to maximize returns and minimize risk by investing in multiple sectors that would reap higher and long-term returns. Financial experts mention that diversification doesn’t guarantee protection against any financial loss, but it is considered to be the most efficient and effective technique to obtain long-term financial goals by minimizing risk.

Geeky Takeaways:

• Diversification is an approach where a wide range of investments or financial instruments are combined in a portfolio to reduce risk.
• It can be achieved by investing in different financial instruments such as bonds, stocks, options, real estate, cryptocurrency, etc.
• Diversification can be obtained by investing in different countries’ stocks and shares, different industries, multiple sizes of companies (large, medium, small, micro, etc.), or different term lengths for generating returns from investments.
• The correlation coefficient of a group of assets is analyzed to measure the quality of a diversified portfolio.

How does Diversification Work?

1. Risk Reduction: A diversified portfolio comprises various investments that can reduce the risk associated with individual investments. As per studies and mathematical models, an optimum amount (25-30 stocks) of investments can contribute to the most effective level of risk reduction. Different investments react differently to market conditions, economic events, and other external factors, reducing the overall risk of the portfolio.

2. Variety of Assets: Different investment instruments are used to diversify and minimize the risk. Different asset classes or investment instruments include stocks, bonds, real estate, financial securities, cash equivalents, etc. Each of these assets has its own risk and return features and they all have different directions to follow.

3. Performance of Portfolio: Diversification manages the unsystematic risk in a portfolio where positive and negative performances of assets result in neutrality of the portfolio performance. The diversification is beneficial only if the instruments are not perfectly correlated, i.e., they move in different directions reacting to market conditions.

4. Different Sectors: Diversification can be of multiple dimensions. Geographically diversification can take place where securities from different regions or countries can be included in the portfolio. Different time horizons also contribute to diversification. A portfolio might comprise assets having short-term and long-term maturities. This provides a balance between liquidity and potential growth.

Strategies of Diversification

Diversification can be carried out using multiple strategies. In the financial world, investors try multiple strategies to diversify their portfolios so that with minimum risk, they can earn potential profits. The strategies can be amalgamated to improve the diversification level within a single portfolio.

1. Across Asset Classes Diversification: There are different assets where the fund managers and investors put their hard-earned money, with the expectation of maximizing their profits. The combination of different assets makes the portfolio less risky compared to individual assets. Stocks (equities), bonds (fixed-income investments), real estate, exchange-traded funds (ETFs), commodities, and cash and cash equivalents are the different classes of assets that are included in the investment portfolio. These asset classes react differently to the market and economic conditions. For instance, if interest rates increase, bond prices decrease to attract investors. Further, if the interest rates are high, rent for real estate and commodities prices also increase.

2. Within Asset Class Diversification: Different diversification strategies can be implemented within the asset class. In terms of industry-based diversification, a portfolio can contain assets from the energy sector, biotech, tech, utility, retail, and other sectors. For bonds, which are fixed-income instruments, different maturities with different offerings can be considered for diversification. Further, different funds (mutual funds, index funds) having different offerings can be included in a diversified portfolio.

3. Diversification in the Corporate Lifestyle Stages: Corporate equities (stocks) are of two types: growth stock and value stock. Growth stocks are more volatile, and risky, and have the potential to earn higher profits as compared to value stocks. Growth stocks are obtained from small companies that have the potential for growth yielding greater revenue for investors. On the other hand, value stocks are from stable and large companies that have less risk and potential to yield stable income.

4. Market Capitalization Diversification: Based on the market capitalization of the asset or company, investors might be interested in diversifying their portfolio based on this factor. Each organization has a different approach to growing its company and its market capitalization can be a great factor in deciding on which companies’ stocks to invest in so that a diversified portfolio is created.

Diversification Across Platforms

Diversification across platforms in the finance sector refers to spreading investments or financial activities across different types of financial services or platforms. From traditional banking to online banking and cryptocurrency, diversification of investments can be carried out. Different investment platforms such as robo-advisors, brokerage firms (both online and offline), and investment apps can be apt in diversifying your portfolio. Some of the other platforms include peer-to-peer lending, real estate crowdfunding, insurance platforms, and fintech services that investors can use to diversify their portfolios. Different platforms have different return-risk profiles and investors are keen to explore these strategies.

Importance of Diversification

1. Reducing Risk and Preparing a Stable Portfolio: Spreading your investments into multiple assets or instruments helps in minimizing the impact of uncertainties or risks associated with individual investments. This helps in building a more stable and smoother portfolio by offsetting the losses in one sector with profits in another sector. The overall performance of the portfolio is enhanced.

2. Asset Class and Time Diversification: Including different types of assets, such as stocks, bonds, and real estate, can provide exposure to a variety of market forces, enhancing overall portfolio resilience. Further, investing over different time horizons allows for the potential gains of compounding and helps to smooth out the impact of market fluctuations.

3. Mitigation of Market Volatility and Exposure to Different Industries or Sectors: Diversifying investment across various industries and sectors decreases vulnerability to adverse events that might affect a particular sector or area. Moreover, diversification protects investors from the volatility occurring due to economic turmoil or market fluctuations.

4. Risk Management and Return Optimization: Different assets have different risk-return profiles. Investors can achieve a balance between risk and return that aligns with their financial goals, by building a diversified portfolio. Thus, due to diversification, the risk associated with individual investments and markets can be reduced and managed while optimizing the returns.

5. Liquidity Considerations: Diversification can enhance liquidity as investors have a more balanced mix of assets that can be easily converted to cash if needed.

6. Behavioral Aspects: Diversification can further help in managing emotional responses to market fluctuations, reducing the tendency to make impulsive investment decisions based on short-term market movements.

Diversification and Retail Investors

Retail investors or individual investors might find it difficult to manage a properly diversified portfolio due to time and budget constraints. This is why, mutual funds are a common form of investment among retail investors. Mutual funds are a convenient and less expensive way to diversify their funds.

Mutual funds provide access to a wide range of asset classes, while exchange-traded funds have access to narrower markets like commodities or foreign stocks. Thus, retail investors rely on diversification via this indirect mode of investments as it is cheap compared to other individual diversification strategies.

Pros of Diversification

1. Diversification reduces the risk associated with an individual asset instrument or industry by offsetting the poor performance of one sector with the good performance of another sector.

2. A diversified portfolio has stability and resilience during times of economic crisis or market fluctuations, offering stable returns.

3. It allows investors to participate in various market opportunities, potentially benefiting from growth in different industries or regions.

4. By holding a mix of assets with different risk profiles, investors can mitigate the overall volatility of their portfolio.

5. It provides flexibility to adapt to changing market conditions, helping investors navigate economic cycles.

6. Balancing high-risk, high-return investments with more stable assets can lead to an improved risk-return profile for the overall portfolio.

Cons of Diversification

1. Sometimes, over-diversification can lead to diluted returns as a higher benefit of one can be neutralized by another higher-risk asset.

2. Continuous monitoring is a complex process and diversification demands this to align with the financial goals and objectives.

3. Frequent buying and selling of assets to maintain diversification can result in higher transaction costs, impacting overall returns.

4. Investors may lack the expertise to effectively diversify their portfolios, leading to suboptimal asset allocation and potentially increased risk.

5. Overemphasizing diversification may cause investors to miss out on potentially lucrative opportunities in specific sectors or asset classes.

6. There’s a risk of falling into the diversification paradox, where adding more assets may not necessarily reduce risk significantly if those assets are highly correlated.

Difference between Diversifiable Risk and Non-Diversifiable Risk

The main purpose of diversification is to reduce or rather eliminate risk from the investment portfolio. However, the risk associated with individual assets or financial instruments can be of two types: systematic risk and unsystematic risk.

For example, during Covid-19 when the whole global economy had a downturn, few businesses benefitted due to government intervention while few had faced deep failure. This pandemic situation and its impact on the financial markets is a systematic risk or non-diversifiable risk, as every sector was slowly and steadily affected. These types of risks cannot be controlled or reduced.

On the other hand, unsystematic risk or non-systematic risk are the ones that can be controlled by diversification. Some of the diversifiable unsystematic or non-systematic risks are, Business risk, Operational risk, Financial risk, and Regulatory risk, which can be controlled through diversified investments.

Measuring Diversification

Generally, it is quite a herculean task to measure diversification. However, financial experts, financial analysts, and portfolio managers use certain measurements to calculate the diversification of portfolios.

1. Correlation Coefficient: A statistical tool that compares the relationship between two components, is known as the correlation coefficient. It tracks the movement or direction of two assets, i.e., assets moving in either the same or different directions. The range of correlation coefficient is from -1 to 1 where:

• Near to -1, represents strong diversification between the two assets. This means both the assets move in opposite directions and they have a strong negative correlation between the two components which are measured.
• Near to 0, represents moderate diversification, i.e., the assets do not correlate. The two components measured sometimes move in the same direction while other times they move in different directions.
• Near to 1, represents a lack of diversification or no diversification between the two assets. The invested assets move in the same direction. Thus, there is a positive correlation between the two assets that are measured.

2. Standard Deviation: The deviation from the mean is calculated as the standard deviation (SD). In terms of investments, SD calculated the distance between the average return of an asset with the other returns. The risk based on the return frequency is estimated using the SD by the analysts.

If the SD is higher, then that means there is more risk and also there is a chance for higher returns. In a portfolio, if the investments have high SD, then there is a potential for higher earnings. However, those investments have higher risks associated with them as well.

3. Weighing or Counting: Based on weights or counting, diversification can be measured. That is, every asset class or instrument, used in the portfolio can be counted or weights can be associated. For example, a portfolio might comprise 40% equities, 30% bonds and 30% alternatives. Further, instead of percentages, an investor might count the number of equities or bonds invested through which they calculate their diversification.

Example of Diversification

Suppose, there is an aggressive investor. He/she wants to take higher risk and build, a portfolio comprising Japanese stocks, Australian bonds, and rice futures. For the stocks and bonds, the investor invests in ETFs and future derivatives. With this ensures a mixture of funds, the investor ensures diversification in its holdings. The different assets ensure lesser risk and higher returns.

Frequently Asked Questions (FAQs)

1. What are the benefits of diversification?

Answer:

Diversification has multiple of benefits. Primarily, reduction in risk, exposure to higher returns due to diversified asset class and investors find it attractive to diversify their investments as they get involved in the process of calculating their investments.

2. What are the methods of diversification?

Answer:

Some of the primary methods of diversification is purchasing different forms of asset class, assessing different industries or sectors, geograohical locations, time horizons, etc.

3. What does diversification mean in investing?

Answer:

Diversification is an investment strategy which aims to minimize risks and maximize returns by allocating funds into multiple financial instruments, commodities, industries, sectors, and other categories.

4. What happens when one diversifies their investments?

Answer:

When you diversify your investments, your exposure to risk reduces while mazimizing your returns. However, you cannot avoid the systematic risk, so you can hedge against the unsystematic risk (such as business risk or financial risk) to reduce the overall impact of risk.