What is Diversification?
Diversification is a technique of allocating portfolio or capital to a mix of different investments. The ultimate goal of the diversification is to reduce the volatility of the portfolio by offsetting the losses of one asset class by the gains of another asset class. A phrase commonly associated with diversification:
“Do not put all your eggs in one basket“.
Having eggs in multiple baskets mitigates risk as if one basket breaks, not all eggs are lost.
Diversification and Unsystematic Risk
Diversification is primarily used to eliminate or smooth unsystematic risk. Unsystematic risk is a firm-specific risk that affects only one company or a small group of companies. Therefore, when the portfolio is well-diversified, the investments with a strong performance compensate the negative results from poorly performing investments.
However, diversification does not usually affect the systematic risk because the risk is a market risk affecting all companies in the market.
One way to think about the different types of risk is thinking about how a company has its own operational risks and also has an overarching market risk.
Learn more about Systematic and Unsystematic Risk on CFI’s CAPM page
Portfolio diversification concerns with the inclusion of different investment vehicles with a variety of features. However, the strategy can bring benefits to an investor only if the investment included in the portfolio include a small correlation with each other. A small correlation indicates that the prices of the investments are not likely to move in one direction.
There is no consensus regarding the perfect amount of the diversification. In theory, an investor may continue diversifying his/her portfolio if there are available investments in the market that are not perfectly correlated with other investments in the portfolio.
An investor should consider diversifying his/her portfolio based on the following specifications:
- Types of investments: Include different asset classes such as cash, stocks, bonds, ETFs, options, etc.
- Risk levels: The portfolio generally should consist of the investments with minimal levels of risk. Investments with dissimilar levels of risks allow the smoothing of the gains and losses.
- Industries: Invest in companies from distinct industries. The stocks of companies operating in different industries tend to show a lower correlation with each other.
- Foreign markets: An investor should not invest only in domestic markets. There is a high probability that the financial products traded in foreign markets are less correlated with the products traded in the domestic markets.
Nowadays, individual investors do not need to worry about portfolio diversification, because there is a wide variety of well-diversified financial instruments available on the market. Index and mutual funds, as well as ETFs, provide individual investors with a simple and inexpensive instrument for a diversified investment.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources: