Friday, June 28, 2013

What is Diversification?

Diversification is the process of reducing risk by investing in a wide variety of assets such as stocks, bonds and real estate. Diversification strives to reduce unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. So, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

If the asset classes do not move up and down in perfect synchrony, a well diversified portfolio will have lesser risk than the weighted average risk of its total assets, and often less risk than the least risky of its constituent. Hence, any risk-averse investor will diversify at least to some extent, with more risk-averse investors diversifying more completely than less risk-averse investors. 

Studies and many mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will result in the most cost-effective level of risk reduction. Investing in more securities will still yield further diversification benefits, although at a drastically smaller rate.

In a diversified portfolio, no matter how a particular economy performs, some asset classes will perform and provides benefits, which reduces your chances of losing a lot at a given time. Over a longer period of time, a diversified portfolio will provide better returns with lower risk.

Further diversification benefits can be gained by investing in securities of foreign countries because they tend be less closely correlated with domestic investments. For example, an economic slowdown in the U.S. economy may not affect China's economy in the same way; therefore, having Chinese investments would allow an investor to have a small cushion of protection against losses due to an American economic slowdown.