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Investment Diversification Definition
Diversification is the act of, or the result of, achieving variety. Investment diversification includes a variety of asset classes, asset categories, and individual investments.
Investment Diversification Purpose
The purpose of investment diversification is to reduce unsystematic risk. You have heard the expression “don’t put all your eggs in one basket”. If you own only one asset category, or one individual stock, you will be exposing your portfolio to great harm.
Unsystematic risk can be nearly eliminated through investment diversification. Unsystematic risk is specific to an individual investment or industry and is not correlated with the market. Therefore if you don’t participate in diversification you are taking unnecessary risk that you will not be compensated for.
Under and Over Diversification
There are large benefits to diversification in small numbers. In other words, three stocks is much better that two, and six stocks is much better that three. But with each additional investment added the marginal benefits decrease.
Most studies show that diversification is optimized at between 15 and 30 individual investments. Further diversification yields a smaller and smaller benefit. At some point the costs become greater than the marginal benefits of further diversification.
Over Diversification occurs when the marginal benefit (reduced risk) of adding additional investments to a portfolio becomes less than the marginal loss (reduced returns).
Over diversification reduces quality, leads to average performance, and can increase your costs. So while under diversification can be devastating; over diversification should also be avoided too.
For instance we know that adding an 11th stock to a 10 stock portfolio would provide a large benefit. But would adding 100 stocks to a 1000 stock portfolio give you the same benefit? No, it would not. The benefits would be small but the costs might be great.
Correlation is Important
The goal is to combine assets that have a low correlation. You want to own many assets (i.e. 15 -30) that will act differently and provide the benefits of diversification. For example, let’s say your portfolio consisted of 15 airline stocks. You would have diversification within the airline industry, but would incur a large risk to your portfolio. Those 15 airline stocks would have a high correlation.
In order to get the maximum benefit of diversification you might want to own the best 2 or 3 stocks in 6-8 different industries. Stocks in different industries will most likely have a lower correlation than stocks in similar industries.
For example, if consumer discretionary stocks were being hurt by a slowing economy, consumer staples might fare much better. If industrials were being hurt by inflation, gold stocks might be offsetting the decline in the industrial stocks. If airline stocks are suffering from rising fuel costs, oil stocks might be rising.
Use investment diversification of non-correlated assets to minimize unsystematic risk. This is one of the only “free rides” available to portfolio managers.
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