Portfolio Diversification Definition and Purpose

by | Portfolio Management

portfolio diversification

Portfolio Diversification is a foundational concept in investing. It can be a rather basic and easy to understand concept. However, in its implementation, many investors make catastrophic mistakes with too much concentration and others settle for average performance because of over diversification.

Definition of Diversification

The definition of diversification is the act of, or the result of, achieving variety. In finance and investment planning, portfolio diversification is the risk management strategy of combining a variety of assets to reduce the overall risk of an investment portfolio.

Purpose of Portfolio Diversification

The purpose of portfolio diversification is portfolio risk management. A risk management plan should include diversification rules that are strictly followed.

Portfolio diversification will lower the volatility of a portfolio because not all asset categories, industries, or stocks move together. Holding a variety of non-correlated assets can nearly eliminate unsystematic risk (specific risk).

In other words, by owning a large number of investments in different industries and companies, industry and company specific risk is minimized. This decreases the volatility of the portfolio because different assets should be rising and falling at different times; smoothing out the returns of the portfolio as a whole.

“There is a close logical connection between the concept of a safety margin and the principle of diversification.”

Benjamin Graham

In addition, diversification of non-correlated assets can reduce losses in bear markets; preserving capital for investment in bull markets. Portfolio optimization can be achieved through proper diversification because the portfolio manager can invest in a greater number of risk assets (i.e. stocks) without accepting more risk than planned in the whole portfolio.

In other words, portfolio managers with a target amount of total risk are able to invest a greater percentage of their assets in risk assets with a diversified portfolio versus a non-diversified portfolio. This is because holding a variety of non-correlated assets lowers the total risk of the portfolio. This is why some say diversification is the only free ride.

Can Over Diversification Hurt Investment Returns?

Some lessons can be over learned. Over diversification is almost as large a problem today as under diversification. It is common for investors to believe that if a given amount of diversification is good then more is better. This concept is false.

If adding an individual investment to a portfolio does not reduce the risk of the total portfolio more than it costs in potential returns then further diversification would be over diversification. Most experts believe 12 – 25 individual investments are sufficient to reduce unsystematic risk.

Concentration vs. Diversification

There is a debate between investors who believe in concentration and those that believe in diversification. My belief is there are few stock analysts competent enough to concentrate in less than 10 stocks.

Intense concentration leaves no room for errors in your analysis. It also inflicts a large penalty when something unforeseen causes a severe reduction in price of a single stock or a particular industry.

Those who concentrate in one stock are particularly at risk. This is usually done by investors who are employees, or former employees, of a company. They have an emotional bias that causes them to take undue risk.

In extreme cases (i.e. Enron in 2000) employees lose their job, their retirement, and their life savings. This kind of extreme concentration is particularly dangerous.

At the other extreme are those who believe in diversification without limits. Owning many mutual funds and/or ETFs can result in owning hundreds or even thousands of stocks. This much diversification assures a mediocre or average return.

Some investors choose to index and thus assure themselves of an average return (passive investing). There is nothing wrong with this decision if that is what you choose. However, this is not really the right blog for you to be seeking guidance.

In my opinion diversification beyond 40 – 50 stocks is needless and counterproductive. You want to own enough investments to mitigate specific risks but still own the best investment ideas.

Many financial analysts agree that 12 – 25 individual stocks will provide significant diversification from specific risk. I like to make allowances for additional diversification for special situations, deep value bargains, etc.; but I would rarely ever go beyond 30 – 35 individual investments. Very few investors have the ability to even keep up with more than 35 different companies.

You can see I think there is a sweet spot in the debate between diversification and concentration. I’m usually going to be between 12 and 30 individual investments. I believe that is the range where you significantly reduce specific risk but are able to concentrate on the best opportunities.

Portfolio diversification is a balance between concentration and over diversification. Now, with a better understanding of what portfolio diversification is, you can build your risk management plan and establish your optimal amount of concentration.

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Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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