What is diversification?
Diversification is a portfolio management technique used to lower the risk of an investment portfolio.
2 types of risk
As defined by academic theory, there are two types of risk:
- Specific risk (also called diversifiable risk)
- Market risk (also called undiversifiable risk)
Company specific risk can be reduced by diversification. These are risks specific to a company or industry.
For example, let's say an investor holds shares in 10 gold companies. Tomorrow, the price of gold falls, so the entire portfolio will be adversely affected. If, however, the investor held 1 gold company and 9 other diverse companies, the specific risk (i.e. a falling gold price) can be reduced.
Market risk cannot be completely reduced. An example of the market risk is the general ups and downs of share prices. This is the risk of the market.
Diversification narrows the range of return outcomes. However, it doesn't necessarily reduce the expected return.
In a diversified portfolio, the overall portfolio cannot perform better than the best-performing investment. However, it cannot perform worse than the worst-performing investment.
"Don't put all your eggs in one basket"
Evans and Archer (1968) found that 10 diversified investments were enough to remove 70% of the diversifiable risk, while Statman (1987) found that 30 to 40 stocks are required to be well diversified.
How to diversify
An investor can diversify a portfolio by holding investments across different asset classes, including:
- International shares
- Property; and
- Alternative investments
For example, consider an investor who owns their family home and their only investment is another property. That would be an example of poor diversification.
An investor can also diversify within an asset class (see the gold investor above example, above).
Test Your Knowledge
Rick Grimes uses all his money to buy property. He buys two wineries, both specialising in red wine. Unfortunately, a few episodes later, red wine is proven to stunt growth and his properties are left virtually worthless. Rick Grimes failed to consider the...
By buying two of the same wineries, Rick Grimes's portfolio was highly exposed to the same type of risk: company specific risk. This risk could have been reduced if he diversified. For example, he could have bought one winery specialising in white wine.
Carl says to Glenn, "You can eliminate 100% of investment risk with diversification." Carl…
Carl is wrong. There are two types of risk: market risk (also called undiversifiable risk) and specific risk (also called diversifiable risk). Undiversifiable risk is a risk that is (yep, you guessed it) undiversifiable.
Carol is tough and independent. She learned about diversification at The Walking Zombie University. She said diversification is used to lower portfolio returns. Is Carol right or wrong?
Diversification is a risk reduction technique. While it narrows the investment opportunities, it is not used to lower investment returns.
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