Diversification is a risk management technique in which a portfolio has a wide range of investments. In order to reduce exposure to any one asset or risk, a diversified portfolio comprises a mix of different asset types and investment vehicles. The theory behind this method is that a portfolio made up of many types of assets would, on average, produce greater long-term returns and lower the risk of any individual holding or security.
Diversification aims to smooth out unsystematic risk occurrences in a portfolio by ensuring that the good performance of certain assets balances out the negative performance of others. Only if the assets in the portfolio are not completely correlated that is, if they react to market forces differently, frequently in opposing ways does diversification pay off.
According to studies and mathematical models, the greatest cost-effective degree of risk reduction is achieved by keeping a well-diversified portfolio of 25 to 30 companies. Investing in more assets provides further diversification advantages, albeit at a much slower rate.
It’s the most basic and the most important rule in Risk Management.
For example, $1,000,000 is invested in equal proportions in 10 stocks in 10 different industry sectors.
The financial services sector takes a massive hit on the stock market and Citigroup stock plunges 50%. The market value of Citigroup stock plunges from $100,000 to $50,000 and the portfolio value falls 5% to $950,000.
The wireless communications sector takes a massive hit on the stock market and Ciena stock plunges 50%. The portfolio value now falls to $900,000.
If the original investment of $1,000,000 was invested in equal proportions in only 2 stocks and they were Citigroup and Ciena, the investment portfolio is now valued at only $500,000, since $500,000 invested in both stocks plunges 50% in value, and both stocks are now valued at $250,000 each.
It takes much more time for an investment portfolio to recover from a 50% loss in value compared to a 10% loss in value. This is the benefit of diversification. The greater the number of assets in a portfolio, the less severe the damage if or when one asset significantly underperforms.