Reduction of Portfolio Through Diversification

7/25/2019 Reduction of Portfolio Through Diversification

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REDUCTION OF PORTFOLIO RISK THROUGH

DIVERSIFICATION

DEFINITION:-

Portfolio diversification is the practice of spreading out portfolio capital into several differentareas. A portfolio of ten different stocks is more diversified than a portfolio of five differentstocks. Spreading investment capital over multiple financial markets such as stocks, bonds andfutures is another form of portfolio diversification.

INTRODUCTION:-

Diversified portfolios greatly reduce risk while smoothing investment returns by including manysecurities across a wide range of industries. This allows investors to participate in a wide varietyof investment opportunities while reducing the risk of large losses due to any one security.

Diversification is an investment strategy in which you spread your investment dollars amongdifferent sectors, industries, and securities within a number of asset classes.A well-diversifiedstock portfolio, for eample, might include small-, medium-, and large-cap domestic stocks,stocks in si or more sectors or industries, and international stocks. The goal is to protect thevalue of your overall portfolio in case a single security or market sector takes a serious downturn.

Diversification can help insulate your portfolio against market and management risks withoutsignificantly reducing the level of return you want. !ut finding the diversification mi that"s rightfor your portfolio depends on your age, your assets, your tolerance for risk, and your investment

goals. A risk management investment strategy in which a wide variety of investments are miedwithin a portfolio# the rationale is that a portfolio of different investments will, on average, yieldhigher returns and pose a lower risk than any individual investment within the portfolio.Diversification strives to smooth out unsystematic risk in a portfolio so that the positiveperformance of some investments will neutrali$e the negative performance of others. Therefore,the benefits of diversification will hold only if the securities in the portfolio are not correlated.

The main purpose of diversification is to lessen risk. %or eample, if someone has &' percent ofher portfolio invested in ()* stock, she stands to lose a significant percentage of her portfoliovalue if ()* declines. +owever, if the investor diversifies by investing in other stocks andleaves only percent of her portfolio in ()*, she will lose a much smaller percentage of

portfolio value in the event of a decline.

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DIVERSIFICATION

IMPORTANCE OF DIVERSIFICATION:-

Diversification is not a new concept. e should remember that investing is an art form, not a

knee-erk reaction, so the time to practice disciplined investing with a diversified portfolio is

before diversification becomes a necessity. !y the time an average investor /reacts/ to the

market, 0'1 of the damage is done. +ere, more than most places, a good offense is your best

defense and in general, a well-diversified portfolio combined with an investment hori$on of three

to five years can weather most storms.

1. Spread the Wealth-

23uities are wonderful, but don"t put all of your investment in one stock or one sector. 4reate

your own virtual mutual fund by investing in a handful of companies you know, trust, and

perhaps even use in your day-to-day life. People will argue that investing in what you know will

leave the average investor too heavily retail-oriented, but knowing a company or using its goods

and services can be a healthy and wholesome approach to this sector.

2. Co!"der Ide# or $od F%d!-

4onsider adding inde fundsor fied-incomefunds to the mi. 5nvesting in securities that track

various indees make a wonderful long-term diversification investment for your portfolio. !y

adding some fied-income solutions, you are further hedging your portfolio against market

volatilityand uncertainty.

&. 'eep $%"ld"(-

Add to your investments on a regular basis. 6ump-sum investing may be a sucker"s bet. 5f youhave 78',''' to invest, use dollar-cost averaging. This approach is used to smooth out the peaks

and valleys created by market volatility9 you invest money on a regular basis into a specified

portfolio of stocks or funds.

). 'o* Whe to +et O%t-

!uying and holdingand dollar-cost averaging are sound strategies, but ust because you have

your investments on autopilot does not mean you should ignore the forces at work. Stay current

with your investment and remain in tune with overall market conditions. :now what is

happening to the companies you invest in.

,. 'eep a Wath%l E/e o Co00"!!"o!-

5f you are not the trading type, understand what you are getting for the fees you are paying. Some

firms charge a monthly fee, while others charge transactional fees. !e cogni$ant of what you are

paying and what you are getting for it. ;emember, the cheapest choice is not always the best.

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DIVERSIFICATION

NEEDS OF TE DIVERSIFICATION:-

The portfolio should be spread among many different investment vehicles such as cash, stocks,

bonds, mutual funds, and perhaps even some real estate. The securities should vary in risk.

)ou"re not restricted to picking onlyblue chip stocks. 5n fact, the opposite is true. Picking

different investments with different rates of return will ensure that large gains offset losses in

other areas. :eep in mind that this doesn"t mean that you need to ump into high-risk investments

such aspenny stocks.

The securities should vary by industry, minimi$ing unsystematic risk to small groups of

companies. Another 3uestion people always ask is how many stocks they should buy to reduce

the risk of their portfolio. The portfolio theory tells us that after 8'-8& diversified stocks, you are

very close to optimal diversification. This doesn"t mean buying 8& internet or tech stocks will

give you optimal diversification. 5nstead, you need to buy stocks of different si$es and from

various industries.

5f we invest in a single security, our return will depend solely on that security# if that security

flops, our entire return will be severely affected. 4learly, held by itself, the single security is

highly risky. 5f we add nine other unrelated securities to that single security portfolio, the

possible outcome changes < if that security flops, our entire return won=t be as badly hurt. !y

diversifying our investments, we can substantially reduce the risk of the single security.

Diversification substantially reduces the risk with little impact on potential returns. The key

involves investing in categories or securities that are dissimilar.

Diversification of investment means selecting multiple asset classes or investing in the different

asset categories. 5t is a popular techni3ue employed by most investors to lower risk and increase

the chances of good returns. >nfolding your investment in different areas develops a risk-proof

portfolio, which means if one investment fails, another will balance it out.

Diversified portfolio has certain built-in risks. %or eample, stocks could be fickle in the short

term. 2ven though you have carefully diversified your portfolio, there is always a percent chance

of investors undergoing losses due to emergency conditions. Some of these factors include

commodities meltdown, global financial crises, socio-political condition and others.

TE $ENEFIT OF DIVERSIFICATION:-

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DIVERSIFICATION

Diversification can be used with many types of investments, and it allows the investor to still

earn a profit, or limit her losses, even if one investment performs badly. %or eample, a

farmer can grow corn, soybeans and wheat, so if a corn beetle eats all of the corn in the

farmer"s field, the farmer still has soybeans and wheat available to sell.

1.+eo(raph"al D"er!""at"o-

?eographical diversification protects an investor from problems in the local market. %or

eample, a restaurant owner may build restaurants in Pasadena, San Diego and San @ose. 5f many

companies in San @ose lay off their employees, reducing the number of customers at the San @ose

restaurant, the restaurant owner can still collect revenue from his Pasadena and San Diego

restaurants.

2.Cro!!-!etor D"er!""at"o-

4ross-sector diversification protects an investor if one type of company"s sales decline. A

business conglomerate can own unrelated businesses, such as a pencil factory, a potato farm and

a motorcycle dealership. 5f customers decide to purchase pens instead of pencils, the

conglomerate does not have all of its resources invested in the pencil factory.

&.Itra-!etor D"er!""at"o-

An investor can purchase multiple types of investments in the same sector. %or eample, a real

estate developer can build condominiums in one development, single-family houses in another

and apartments in a third. A real estate investment trust obtains funds from many investors, so it

can afford to purchase several types of real estate, which is difficult for a homeowner who can

only pay the mortgage on a single house.

).Ta#e!-

Diversification may provide ta benefits. 5f the pencil factory doesn"t sell enough pencils in one

year to earn a profit, the conglomerate reports a loss for the pencil factory, which reduces the

amount of income taes it has to pay that year on its successful potato farm and motorcycle

dealership.

,.Sea!oal D"er!""at"o-

Diversification can improve the cash flow of a seasonal business. any customers want to

purchase pumpkins right before +alloween, but demand will be lower during the rest of the year.

The pumpkin farmer can grow another crop that he can sell in the spring, such as apples, so he

doesn"t have to wait until +alloween to have cash available.

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DIVERSIFICATION

PRINCIP3ES OF DIVERSIFICATION:-

5t has been said that diversification is the secret sauce of asset allocation. Diversification seemsso obvious and so easyBCDont put all your eggs in one basket.C 5nvestment professionals

suggest that you invest in a portfolio of non-correlated assets, which in simple terms refers to

securities that generally do not change in price and direction at the same time. The idea here is

that owning a portfolio of non-correlated assets allows an investor to reduce volatility and

achieve better long-term risk-adusted performance.

5n the first two segments of this series on asset allocation we established that constructing the

optimum portfolio depends on measuring risk, forecasting returns and calculating correlation. e

eplained the importance of replacing normal distributions with non-normal distributions in aneffort to better understand the probability and severity of etreme events. e also discussed how

?A;4+ analysis can improve an investment forecasting model the way Doppler radar improves

weather forecasting, as it places more emphasis on recent data and takes into account the way in

which the data has been changing.

Diversity is a pretty general concept meaning simply a lack of similarity. hen we want to speak

technically with more precise language we use the statistical terms correlation and dependence,

which describe and measure similarity. 4orrelation describes how pairs of securities act in

relationship to each other over some period of time# if you can predict the change in one based

on the change in the other, you have demonstrated dependence. As investors, we know that

owning a portfolio of highly correlated assets does little to cushion the impact of down markets

and we are told by our investment advisors that that owning non-correlated or negatively

correlated assets will protect us from market crashes and dampen our losses in bear markets.

ne problem with correlation is the stubborn unwillingness of securities to remain at a fied

level of correlation over time. 5n fact, the daily noise reflects real variations in behavior. )ou will

often see negatively correlated securities become highly positively correlated, especially during

market crashes and maor market rebounds. Seasoned professionals often remark, EThe only

thing that goes up in a down market is correlation! 5n other words, the common pitfall of using

correlation to do portfolio optimi$ation is assuming that correlation is fied and can be

determined from long-term averages. @ust as we pointed out in the discussion of risk and return

forecasting, the long-term average value is 3uite often not indicative of future results.

COMPONENTS OF A DIVERSIFIED PORTFO3IO:-

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DIVERSIFICATION

A diversified portfolio is a collection of asset classes. Asset classes refer to distinctly differenttypes of securities such as stocks, bonds, commodities, international investments, cash and realestate. The purpose of the diversified portfolio should be to offer maimum return while

minimi$ing the overall risk of the portfolio.

1.A!!et Cla!!e! Ma4e a D"er!""ed Portol"o-

4ommon asset classes are stocks, bonds, commodities and currencies. Asset classes are a uni3ue

group of stocks that have common properties. Stocks and preferred stocks can be considered

different classes but they are not as diversified as a combination of stocks and foreign currencies.

2.D"er!"/ W"th" Eah A!!et Cla!!-

wning a stock portfolio is better than owning a single stock. wning a stock and bond fundadds another new asset class. Adding a third asset class, commodity echange traded funds,

further spreads risk and smoothes returns.

&.D"er!""ed Portol"o "! a Core Pr""ple o Ie!t"(-

5nvesting is not being smarter than the market. 5t is about riding the market trends as profitably

as possible under a variety of circumstances. Diversified portfolios help ride out market

uncertainty.

).Id"e! are D"er!""ed Portol"o!-

)ou can buy an inde fund of stocks, bonds, or other asset classes that is a proportionate sample

of all the securities in that inde. 2change traded funds are low cost replicas of many asset

classes. Purchased together, a cost-effective diversified portfolio of many asset classes can be

assembled.

,.The Alterat"e! to a D"er!""ed Portol"o-

wning securities that are very similar or highly correlated provides irregular returns and high

risk. 5nvestors suddenly needing to convert their asset to cash at inopportune times will have no

choice but to accept the current market price.

TOO3S OF PORTFO3IO DIVERSIFICATION:-

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DIVERSIFICATION

As an investor, you are well advised to spread your money among a number of instruments. This

way, you don"t risk putting all your eggs in one basket. 2ven if you lose money on one

investment, you could make up the loss in another. Diversifying among and within asset

classes is a way to create a healthy portfolio, as is investing in mutual funds.

1.D"er!"/"( A0o( A!!et Cla!!e!-

There are a number of asset classes for investors to choose from. )ou could invest in stocks orbonds, the two best known classes. )ou could also choose real estate or commodities. +ow aboutprecious metalsF 2ach asset class has its own risks and rewards. hen stocks do well, bondsmay not. )our diversification will prevent your portfolio from going down all at once.

2.D"er!"/"( W"th" A!!et Cla!!e!-2ven if your portfolio is made up of a number of asset classes, you may not be ade3uatelydiversified within them. 5f you have a number of stock holdings, they should be in companiesoperating in different industries. 5f you have eposure to ust one industry, you will lose money ifthat industry does not do well. Also, spread your investments among established companies,which are less likely to default, and startups, which come with a higher level of risk.

&.M%t%al F%d!-

4onsidering that it is difficult for an individual investor to buy a large number of stocks andbonds on a limited budget, a mutual fund is a good option as a portfolio diversification tool. A

fund invests the money in many individual stocks and could also give you access to investmentsyou may not be able to buy on your own. )ou could buy a stock fund that gives you eposure todifferent industries and even different countries.

!e aware, though, that you should have diversity in your mutual fund choices as well. There arealso mutual funds that invest in bonds of different companies. There are mutual funds that investin alternative investments such as commodities, precious metals and real estate. These aretypically run by managers with epertise in those sectors

ADVANTA+ES 5 DISADVANTA+ES OF PORTFO3IO

DIVERSIFICATION:-

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DIVERSIFICATION

A diversified portfolio is having a collection of financial instruments carefully spread in differentindustries, fields and ensures minimal attachment or effects against each other. Diversification ofportfolios had allowed investors to gain more profit and lessen the impact of their losses.

+owever, there are also some disadvantages to a diversified portfolio.

ADVANTA+ES-

The advantage of diversification is that it broadens your eposure to market swings. Theprinciple is that one sector Gor stockH may devalue, but not all sectors will devalue. 5n the longterm, most sectors tend to eperience growth, so the total portfolio value of a diversified accountshould gradually grow.

A diversified portfolio works by investing in different areas of industries where one industry

cannot affect another industry should it have minimal to negative market activity. ith

diversification, investors lower the risk value of their assets and portfolio. ost diversified

portfolios work well with long-term investors to outlast economic storms.

1.A!!et Cho"e!-

hen your holdings are widely diversified, you can spread them out over widely divergent formsof assets, including securities such as stocks and bonds, commodities such as oil and minerals,real estate and cash. 2ach of these assets ehibits different strengths and weaknesses in terms ofrisk and profitability. aintaining holdings in all of these areas helps to create a stable portfoliothat will increase in value over the long term.

2.3o*er Ma"teae-

5nvestments re3uire a certain amount of care and attention to keep them performing well. 5f youare playing high-stakes games with your assets and moving them around through risky ventures,you will probably be spending a fair amount of time watching the markets and dodging financialbullets. A diversified portfolio is less eciting and more stable. nce you have your investmentssettled into a wide variety of stocks and securities, they can remain there for etended periodswithout re3uiring a lot of maintenance. This frees up your time to pursue other matters andreduces the market stress that may lead to burnout.

&.R"!4-

Portfolio diversification tends to reduce your long-term risk. Anytime you hold an investment,you risk losing its value. %or eample, if you purchase a share of stock for 7' and end up selling

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DIVERSIFICATION

it for 7I, you incur a loss. Jow imagine that you own two shares of stock. )ou purchase onestock for 7' and end up selling it for 7I. The second stock costs 78' and you sell it for 7&. 5nthis eample, you eliminate your loss through diversification. ost diversified portfolios do not

achieve complete elimination of loss -- only reductions in its potential.

)."(her Ret%r!-

A diversified portfolio could result in higher returns. !etween @anuary 8, &''8 and JovemberI'th, &'88, the Standard and Poor"s '' %und 5nde returned a 8.K percent gain. 5nvestors withdiversified portfolios returned an average .K percent gain during the same time period,according to />SA Today./ A larger percentage of bonds were in the diversified portfolios.+igher returns from diversification tend to be seen with longer periods of time. Diversificationdoes not always increase returns in the short term, however. 5f the overall health of theinvestment market is poor, diversification may still result in a negative return.

,.Ad6%!t0et!-

An advantage of diversification is that you can adust your investment mi. A more risky,growth-oriented strategy makes more sense when you"re young. )ou have more time to tolerateups and downs in the market. A growth-oriented diversification strategy for &'- to I'-year-oldsmight consist of L' percent stocks and 8' percent bonds, according to >SA Today. 5f yourdiversification strategy is more advanced, you might invest heavily in the stocks of small andemerging >.S.-based companies.

7.$alae-

!ehavioral portfolio theory states that investments either protect from loss or provide high-growth potential. According to the theory, your portfolio represents a pyramid when youdiversify. A diversified portfolio has a higher percentage of low-risk, income and valueinvestments. At the top of the portfolio pyramid is a lower percentage of /blend/ and growthfunds. /!lend/ funds are a combination of high-risk and risk-averse investments. Portfoliodiversification allows you to achieve more than one financial goal. The income and valueinvestments can provide you with stability and regular payments. !lend and growth funds canhelp you increase your wealth. f course, any of these can incur risk# positive returns are neverguaranteed.

DISADVANTA+ES-

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DIVERSIFICATION

The disadvantage of diversification is that a portfolio focused on a single sector or stock can

have some super growth, naturally this comes with increased risk. Another disadvantage is that

diversification can be difficult for small investors. G5t doesn"t need to be, but it can be.

A diversified portfolio spreads assets Etoo thinlyC. hen risk is lower, this also means the gain is

lower. An investor also lessens the chance of having growth from industry booms because they

have less investment on such fields. hile diversified portfolios do not easily shake with daily

market fluctuations, they also guarantee lower returns and profit for the investor.

1. Red%e! 8%al"t/-

There are only so many 3uality companies and even less that are priced at levels that provide a

margin of safety. The more stocks you put into your portfolio the less concentrated your portfoliowill be in the best opportunities.

2. Too Co0pl"ated-

any investors include so many assets in their portfolio they don=t really understand what=s in

them. Diversification in investing is important,but keep your portfolio simple enough that you

can stay on top of your investments.

&. Ide#"(-

5f you have too many assets in your portfolio it essentially becomes an inde fund. 5f you wantan inde fund, buy an inde fund# don=t waste transaction fees on purchasing numerous assets

that morph into an inde fund.

The more stocks you own the more correlated your portfolio will be to market returns. hile

passive management or indeing might work in bull markets it does not work well in flat or bear

markets. ost indices are skewed toward stocks that have already risen and underweight stocks

that have fallen, and may be at bargain prices.

). Mar4et R"!4-

!efore you buy an inde fund be sure you understand how the mathematics ofportfolio volatilitylowers your portfolio performance. %ew investors ever achieve even close to EaverageC returns

because of volatility caused by market risk.

,. $elo* Aera(e Ret%r!-

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DIVERSIFICATION

5ndeing and over diversification are disadvantages of diversification because 3uality suffers

when you own inferior investments along with good investments. !elow average returns result

from transaction fees or mutual fund epenses. 5n addition to portfolio volatility lowering

returns, many investors let their emotions cause them to buy high and sell low.

7. $ad Ie!t0et Veh"le!-

ost investors, who over diversified use investment vehicles such as inde funds, or even worse,

actively traded mutual funds. Actively managed mutual funds trade in and out of stocks and have

a tendency to focus on short term trading instead of value. Studies show these funds

underperform market indices in the long run.

DIVERSIFIED PORTFO3IO FOR STOC':-

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DIVERSIFICATION

hile investing might seem like one of those ho-hum chores, it"s not. 5n fact, your future, at least

a financially secure one, depends largely on sound investing. A diversified mi of stockpositions serves as the cornerstone of many successful investment portfolios.

Step 1-

!uy various types of stocks. As @eremy ?laser of orningstar indicates in relation to youroverall portfolio, it"s not about 3uantity, it"s about how your investments play against one another.The same goes for the stock portion of your holdings. Select stocks from different sectors and ofdifferent si$es that might perform differently during a market downturn, for eample. %orinstance, although individual specifics vary, you might be on the road to diversification if you

hold a few technology growth stocks such as Apple, a few staples like Proctor Mamp# ?ambleand cDonalds, a couple small company stocks, a couple stocks from banking and real estate, acouple traditionally /safe/ stocks such as utility stocks and a few international plays.

Step 2-

Try to emulate the makeup of maor stock market indees, namely the SMamp#P ''. %orinstance, check out the how the Standard Mamp# Poor"s weights the SMamp#P '' by sector andby company si$e. Attempt to hold a number of stocks from each sector that correlates to howStandard Mamp# Poor"s divvies things up.

Step &-

!uy mutual funds. 5f your head spins trying to find and track tens or hundreds of stocks fromvarious sectors and of several si$es, leave it up to somebody else. And this does not necessarilymean a financial advisor. )ou can purchase mutual funds that provide diversification. %oreample, stakes in an international or emerging markets fund, a large cap stock fund, a small capstock fund, a fund focused entirely on growth stocks, a conservative value or balanced fund andan inde fund that tracks the Sample '' offer fantastic diversification minus the allocation oftime and resources you might not have.

TECNI8UES OF DIVERSIFICATION:-



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DIVERSIFICATION

Diversification is a techni3ue that reducesriskby allocating investments among various financialinstruments, industries and other categories. 5t aims to maimi$e returnby investing in differentareas that would each react differently to the same event. ost investment professionals agree

that, although it does not guarantee against loss, diversificationis the most important componentof reaching long-range financial goals while minimi$ing risk. +ere, we look at why this is true,and how to accomplish diversification in yourportfolio.

2fficient financial management combines safety of principal, alongside opportunities for growth.

Diversified investment portfolios are designed to neutrali$e economic volatility and

provide for steady returns amidst numerous economic scenarios. Still, all financial

transactions carry distinct risks.

1.Idet""at"o-

Diversification relates to asset allocation strategy that combines varying levels of stocks, bondsand cash within one investment portfolio. 4ommodities, real estate and derivatives arealternative investments that increase diversification.

2.$ee"t!-

Diversification is intended to manage the wild fluctuations in price associated with the stockmarket and individual investments. %urthermore, diversification allows for higher returns overinflation than certificates of deposit and bonds.&.Co!"derat"o!-

Proper diversification strategies are dynamic, and vary according to your personal risk toleranceand time frame towards particular goals. %or eample, savers approaching retirement will favorportfolios that feature larger proportions of bonds. 4onversely, young savers prefer to invest forgrowth---with higher weightings for stocks.

).M"!oept"o!-

Simply owning several different stocks and bonds does not e3uate to perfect diversification.5nvestments should cover multiple industries and geography, so that different portions of theportfolio are profitable at each point during the economic cycle.

,.R"!4!-

Diversification cannot counter systemic risk. Systemic risk describes the collapse of the entirefinancial system.

PORTFO3IO RIS':-

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DIVERSIFICATION

ith the markets moving up and down like a Si %lags roller coaster, is there anything you can

do to stomach the riskF +ave you carefully considered the various risks that are associated with

each investment you makeF

The fact is, many people either have no desire or no knowledge about how to protect themselves

from unneeded risk. 5n this tutorial, we"ll introduce you to risk and give you a good foundation to

understand the relationship between return and risk

1.Portol"o R"!4 ad D"er!""at"o-

hether it is investing, driving, or ust walking down the street, everyone eposes themselves torisk. )our personality and lifestyle play a big role in how much risk you are comfortably able totake on. 5f you invest in stocks and have trouble sleeping at night, you are probably taking on too

much risk.;isk is defined as the chance that an investment"s actual return will be different than epected.This includes the possibility of losing some or all of the original investment.

Those of us who work hard for every penny we earn have a harder time parting with money.Therefore, people with less disposable income tend to be, by necessity, more risk averse. n theother end of the spectrum, day tradersfeel if they aren"t making do$ens of trades a day there is aproblem. These people are risk lovers.

hen investing in stocks, bonds, or any investment instrument, there is a lot more risk thanyou"d think. 5n the net section, we"ll take a look at the different kind of risk that often threaten

investors" returns.2.T/pe! O Portol"o R"!4-

S/!te0at" R"!4- Systematic riskinfluences a large number of assets. A significant

political event, for eample, could affect several of the assets in your portfolio. 5t is

virtually impossible to protect yourself against this type of risk.

U!/!te0at" R"!4- >nsystematic riskis sometimes referred to as /specific risk/. This

kind of risk affects a very small number of assets. An eample is news that affects a

specific stock such as a sudden strike by employees. Diversificationis the only way toprotect yourself from unsystematic risk.

http://www.investopedia.com/terms/r/risk.asphttp://www.investopedia.com/terms/r/riskaverse.asphttp://www.investopedia.com/terms/d/daytrader.asphttp://www.investopedia.com/terms/r/risklover.asphttp://www.investopedia.com/terms/s/systematicrisk.asphttp://www.investopedia.com/terms/s/systematicrisk.asphttp://www.investopedia.com/terms/u/unsystematicrisk.asphttp://www.investopedia.com/terms/u/unsystematicrisk.asphttp://www.investopedia.com/terms/d/diversification.asphttp://www.investopedia.com/terms/r/risk.asphttp://www.investopedia.com/terms/r/riskaverse.asphttp://www.investopedia.com/terms/d/daytrader.asphttp://www.investopedia.com/terms/r/risklover.asphttp://www.investopedia.com/terms/s/systematicrisk.asphttp://www.investopedia.com/terms/u/unsystematicrisk.asphttp://www.investopedia.com/terms/d/diversification.asp


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DIVERSIFICATION

Jow that we"ve determined the fundamental types of risk, let"s look at more specific types

of risk, particularly when we talk about stocksandbonds.

Cred"t or Dea%lt R"!4-4redit riskis the risk that a company or individual will be

unable to pay the contractual interest or principal on its debt obligations. This type of risk

is of particular concern to investors who hold bonds in their portfolios. ?overnment

bonds, especially those issued by the federal government, have the least amount of

default risk and the lowest returns, whilecorporate bondstend to have the highest amount

of default risk but also higher interest rates.

Co%tr/ R"!4- 4ountry riskrefers to the risk that a country won"t be able to honor its

financial commitments. hen a country defaultson its obligations, this can harm theperformance of all other financial instruments in that country as well as other countries it

has relations with. 4ountry risk applies to stocks, bonds, mutual funds, options and

futures that are issued within a particular country. This type of risk is most often seen in

emerging marketsor countries that have a severe deficit.

Fore"(-E#ha(e R"!4- hen investing in foreign countries you must consider the

fact that currency echange rates can change the price of the asset as well. %oreign-

echange riskapplies to all financial instruments that are in a currency other than your

domestic currency. As an eample, if you are a resident of America and invest in some4anadian stock in 4anadian dollars, even if the share value appreciates, you may lose

money if the 4anadian dollar depreciates in relation to the American dollar.

Itere!t Rate R"!4- 5nterest rate riskis the risk that an investment"s value will change as

a result of a change in interest rates. This risk affects the value of bonds more directly

than stocks.

Pol"t"al R"!4- Political riskrepresents the financial risk that a country"s government

will suddenly change its policies. This is a maor reason why developing countries lack

foreign investment.

Mar4et R"!4- This is the most familiar of all risks. Also referred to as volatility, market

risk is the the day-to-day fluctuations in a stock"s price. arket risk applies mainly to

stocks and options. As a whole, stocks tend to perform well during a bull market and

poorly during a bear market - volatility is not so much a cause but an effect of certain

http://www.investopedia.com/terms/s/stock.asphttp://www.investopedia.com/terms/b/bond.asphttp://www.investopedia.com/terms/c/creditrisk.asphttp://www.investopedia.com/terms/c/creditrisk.asphttp://www.investopedia.com/terms/g/governmentsecurity.asphttp://www.investopedia.com/terms/g/governmentsecurity.asphttp://www.investopedia.com/terms/c/corporatebond.asphttp://www.investopedia.com/terms/c/corporatebond.asphttp://www.investopedia.com/terms/c/countryrisk.asphttp://www.investopedia.com/terms/d/default2.asphttp://www.investopedia.com/terms/e/emergingmarketeconomy.asphttp://www.investopedia.com/terms/f/foreignexchangerisk.asphttp://www.investopedia.com/terms/f/foreignexchangerisk.asphttp://www.investopedia.com/terms/f/foreignexchangerisk.asphttp://www.investopedia.com/terms/i/interestraterisk.asphttp://www.investopedia.com/terms/p/politicalrisk.asphttp://www.investopedia.com/terms/v/volatility.asphttp://www.investopedia.com/terms/s/stock.asphttp://www.investopedia.com/terms/b/bond.asphttp://www.investopedia.com/terms/c/creditrisk.asphttp://www.investopedia.com/terms/g/governmentsecurity.asphttp://www.investopedia.com/terms/g/governmentsecurity.asphttp://www.investopedia.com/terms/c/corporatebond.asphttp://www.investopedia.com/terms/c/countryrisk.asphttp://www.investopedia.com/terms/d/default2.asphttp://www.investopedia.com/terms/e/emergingmarketeconomy.asphttp://www.investopedia.com/terms/f/foreignexchangerisk.asphttp://www.investopedia.com/terms/f/foreignexchangerisk.asphttp://www.investopedia.com/terms/i/interestraterisk.asphttp://www.investopedia.com/terms/p/politicalrisk.asphttp://www.investopedia.com/terms/v/volatility.asp


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DIVERSIFICATION

market forces. Nolatility is a measure of risk because it refers to the behavior, or

/temperament/, of your investment rather than the reason for this behavior.

&. The Portol"o R"!4-Re*ard Tradeo-

The risk-return tradeoffcould easily be called the iron stomach test. Deciding what amount of

risk you can take on is one of the most important investment decision you will make.

The risk-return tradeoff is the balance an investor must decide on between the desire for the

lowest possible risk for the highest possible returns. ;emember to keep in mind that low levels

of uncertainty Glow riskH are associated with low potential returns and high levels of uncertainty

Ghigh riskH are associated with high potential returns.

The risk-free rate of returnis usually signified by the 3uoted yield of />.S. ?overnment

Securities/ because the government very rarelydefaultson loans. 6et"s suppose that the risk-free

rate is currently O1. Therefore, for virtually no risk, an investor can earn O1 per year on his or

her money.

!ut who wants O1 when inde fundsare averaging 8&-8K.1 per yearF ;emember that inde

funds don"t return 8K.1 every year, instead they return -1 one year and &1 the net and so

on. 5n other words, in order to receive this higher return, investors much also take on

considerably more risk.

The following chart shows an eample of the riskreturn tradeoff for investing. A higher standard

deviation means a higher risk9

http://www.investopedia.com/terms/r/riskreturntradeoff.asphttp://www.investopedia.com/terms/r/risk-freerate.asphttp://www.investopedia.com/terms/d/default2.asphttp://www.investopedia.com/terms/d/default2.asphttp://www.investopedia.com/terms/i/indexfund.asphttp://www.investopedia.com/terms/r/riskreturntradeoff.asphttp://www.investopedia.com/terms/r/risk-freerate.asphttp://www.investopedia.com/terms/d/default2.asphttp://www.investopedia.com/terms/i/indexfund.asp


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DIVERSIFICATION

). D"er!"/"( The Portol"o To Red%e The R"!4-

ith the stock markets bouncing up and down 1 every week, individual investors clearly need

a safety net. Diversificationcan work this way and can prevent your entire portfolio from losing

value.

Diversifying your portfolio may not be the seiest of investment topics. Still, most investment

professionals agree that while it does not guarantee against a loss, diversification is the most

important component to helping you reach your long-range financial goals while minimi$ing

your risk. :eep in mind, however that no matter how much diversification you do, it can never

reduce risk down to $ero.

,. Portol"o R"!4-

Different individuals will have different tolerances for risk. Tolerance is not static, it will change

as your life does. As you grow older tolerance will usually shrink as more and more obligations

come up, including retirement.

There are several different types of risks involved in financial transactions. 5 hope we"ve helped

shed some light on these risks. Achieving the right balance between risk and return will ensure

that you achieve your financial goals while allowing you to get a good night"s rest.

http://www.investopedia.com/terms/d/diversification.asphttp://www.investopedia.com/terms/d/diversification.asp


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DIVERSIFICATION

CORRE3ATION DIVERSIFICATION REDUCES PORTFO3IO

RIS':-

Diversifying across growth or value styles, market capitali$ations, regions or countries does notnecessarily provide risk protection against the components of your portfolio moving up or downat the same time or to the same degree. Diversifying by correlation does help prevent all yourportfolio components from marching in unison.

4orrelation is a statistical measure of how two securities move in relation to each other.4orrelation is epressed by numbers ranging from -8 to Q8. Perfect negative correlation meansthe two securities move lockstep in opposite directions. Perfect positive correlation means thetwo securities move lockstep in the same direction. *ero correlation means the two securitiesmove randomly with respect to each other.

atching the portfolio soldiers marching shoulder-to-shoulder in an up market is a lovely thing,but that sets you up for them to march together in a down market B and that=s an ugly thing.Portfolios diversified as to correlation generally don=t go up as fast or far as non-diversifiedportfolios and they generally don=t go down as fast or far either.

The chart below shows the correlation between the broad >S stock market and the growth andvalue styles for the whole market, for large-cap stock and for small-cap stocks R no hidingplaces there.



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DIVERSIFICATION

2T%s shown are9

G5NH B ;ussell I''' G5H B ;ussell I''' Nalue

G5*HB ;ussell I''' ?rowth G5!H B ;ussell 8''' G5DH B ;ussell 8''' Nalue G5%H B ;ussell 8''' ?rowth G5H B ;ussell &''' G5JH B ;ussell &''' Nalue G5H B ;ussell &''' ?rowth

The net chart shows that little in the way of correlation diversification is available by spreadingassets between domestic and foreign stocks, whether in developed or emerging markets. 5t doesshow that bonds provide diversification through negative correlation.

The chart epresses the correlation of each 2T% to the broad >S stock market as represented by

the ;ussell I''' through its proy 2T%, 5N. The other 2T%s are9

G2%AH B S45 2A%2 G2urope, Australasia, %ar 2astH G22H B S45 2merging arkets GA??H B 6ehman Aggregate !ond 5nde G52%H B 6ehman -8' )ear Treasury !onds

http://seekingalpha.com/symbol/iwvhttp://seekingalpha.com/symbol/iwwhttp://seekingalpha.com/symbol/iwzhttp://seekingalpha.com/symbol/iwbhttp://seekingalpha.com/symbol/iwdhttp://seekingalpha.com/symbol/iwfhttp://seekingalpha.com/symbol/iwmhttp://seekingalpha.com/symbol/iwnhttp://seekingalpha.com/symbol/iwohttp://seekingalpha.com/symbol/efahttp://seekingalpha.com/symbol/eemhttp://seekingalpha.com/symbol/agghttp://seekingalpha.com/symbol/iefhttp://seekingalpha.com/symbol/iwvhttp://seekingalpha.com/symbol/iwwhttp://seekingalpha.com/symbol/iwzhttp://seekingalpha.com/symbol/iwbhttp://seekingalpha.com/symbol/iwdhttp://seekingalpha.com/symbol/iwfhttp://seekingalpha.com/symbol/iwmhttp://seekingalpha.com/symbol/iwnhttp://seekingalpha.com/symbol/iwohttp://seekingalpha.com/symbol/efahttp://seekingalpha.com/symbol/eemhttp://seekingalpha.com/symbol/agghttp://seekingalpha.com/symbol/ief


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DIVERSIFICATION

SOME PRO$3EMS WIT PORTFO3IO DIVERSIFICATION:-

Simply put, diversification is not putting all your eggs in one basket# it is spreading your assetsacross multiple investment vehicles to reduce risk while trying to maimi$e return. The

term diversification is used interchangeably with asset allocation, although asset allocation

pertains to having various classes of assets in your portfolio Gstocks, bonds, commoditiesH,

while diversification refers to having several securities within the same class, such as

several stocks in a stock portfolio. Portfolio diversification is supposed to protect you on

the downside, but as the &''-&''0 bear market demonstrated, it does not, with many

diversified portfolios losing ' percent or more. There are several problems with

diversification as it is practiced in &'8'.

1.Part"al Protet"o-

Diversification provides partial protection against non-systemic risks. %or eample, any stockyou buy can go down to $ero at any time for any reason, but if you buy two stocks, you reduceyour risk by ' percent while your return may remain the same or even improve Gif the secondstock does betterH. )our risks are further reduced when you increase your portfolio to five stocks,but after about &' stocks, your risk and return approach the market, meaning your portfolio willmirror the market on both the downside and the upside.

2.Oer-d"er!""at"o-

!asic assets allocation calls for your portfolio to hold several classes of assets with limitedcorrelation, i.e., assets that do not move in the same direction--for eample, stocks, bonds andcommodities. 2ven if each of those assets is risky, the assets" non-correlated moves can makeyour portfolio more stable overall. !ut many investors go beyond that and diversify within eachclass of assets for /further protection./ %or eample, they can hold government bonds, corporatebonds, short-term bonds, intermediate term bonds and foreign bonds, which provides littleprotection, because when interest rates rise, all bonds decline.

&.$elo* Mar4et Ret%r!-

5f you spread your assets across every conceivable asset class and fund, you effectively invest inthe market as a whole, so your return is going to be the market return minus management feesand epenses.

SIES COLLEGE Page 2


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DIVERSIFICATION

).Co%!"o-

Some financial advisers use diversification as a selling point, making it sound overly

complicated and academic. 2very 3uarter or so you are supposed to /rebalance/ your portfolio bymaking sure, for eample, that you have precisely 8K percent in investment 3uality intermediateterm corporate bonds. Those /precise/ targets provide no protection or edge and only confuse.

,.Opport%"t/ Co!t-

5n any market, some assets or sectors outperform while others lag. %or eample, 4hinese stocks,commodities or unk bonds can take the lead at different times. The key to superior returns is tomove into the outperforming assets while avoiding laggards. 5f instead you spread your assetsacross the board in the epectation that one day Gor one yearH you will /capture/ those returns,you incur tremendous opportunity costs by keeping your money in assets that may go nowhere or

even decline for years while limiting your eposure to the leading sectors by maintaining some/scientific/ percentage allocation.



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DIVERSIFICATION

MEASURIN+ PORTFO3IO DIVERSIFICATION:-

5n the market place, diversification reduces risk and provides protection against etreme events

by ensuring that one is not overly eposed to individual occurrences. e argue that

diversification is best measured by characteristics of the combined portfolio of assets and

introduce a measure based on the information entropy of the probability distribution for the final

portfolio asset value. %or ?aussian assets the measure is a logarithmic function of the variance

and combining independent ?aussian assets of e3ual variance adds an amount to the

diversification. The advantages of this measure include that it naturally etends to any type of

distribution and that it takes all moments into account. %urthermore, it can be used in cases of

undefined weights G$ero-cost assetsH or moments. e present eamples which apply this measure

to derivative overlays.

8. They are not a function of the allocation to the additional investment.

&. The sum of the diversification benefit and the return benefit e3uals the overall benefit.

I. The return benefit always e3uals the difference between the epected return of the additionalinvestment and that of the eisting portfolio, which makes common sense.

K. All benefits, including the diversification benefit, are measured in return terms.Since these are epected returns, they are meaningful only when a risk reference is provided.G5ndeed, all benefits are epressed at the risk level of the eisting portfolio.H

. And lastly, when an infinitesimal amount of the additional investment is included in theeisting portfolio, the marginal benefits can be calculated per unit of allocation, making itpossible to compare the benefits across investments in a consistent fashion.

E9AMP3ES OF PORTFO3IO INVESTMENT:-



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DIVERSIFICATION

%a; 2


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DIVERSIFICATION

Jever married, with no children, iriam wants to retire from her ob as a freelance computer

consultant while still young enough to fulfill her dreams of world travel. +er investments of

7,''' are growing at a good clip, as she is currently socking away a full &' percent of herafter-ta earnings U about 7&',''' a year. !ut she knows that she has a long way to go.

iriam is right# she has a long way to go. To fulfill her dreams of world travel, iriam needs

considerably more than a nest egg of 7,'''. 5n this case, the bond allocation 3uestion is a

tough one. iriam needs substantial growth, but she isn=t in a position to risk what she has,

either. 4ases like iriam=s re3uire delicate balance.

She should most likely opt for a starting portfolio of mostly stocks and about & to I' percent

bonds Gsee %igure 8&-OH, but as iriam gets closer to her financial goal in coming years, she

could up that percentage of bonds and take a more defensive, conservative position.

CONC3USION:-

%or asset investments, diversification is an effective tool in reducing the risk of investments instocks, bonds, and other securities. >tili$ing the correlation structure among the assets,



25/28


DIVERSIFICATION

idiosyncratic risk can be reduced or even eliminated. %or businesses, diversification is a strategicdecision. 5t is vital for a firm=s long-term value creation to identify and manage growthopportunities. Diversification is an important way to manage these opportunities well, reducing

risk and ensuring success.

To be more specific, while international investments make systematic risk to lower, other kindsof risk, such as transaction costs, ta rates, greater resources, foreign echange risk and possibleinformation disadvantages, are created. 5nvestors are unable to allocate, fully understand and atthe same time handle these risks and many times are driven to the choice of a regional Gnon-internationalH diversified portfolio.

Portfolio diversification in the stock market consists of not only investing in multiple stocks, butinvesting in stocks representing different sectors of the market. A portfolio that focuses only onone sector, such as technology, is not diversified even if capital is spread over several stocks.

This is because the stocks are subect to the same factors and will likely be highly correlated.5nstead, someone holding technology stocks could diversify by investing in other sectors, such aspharmaceuticals, real estate and retail.

The truest form of diversification is investment in multiple markets such as stocks, bonds,

commodities and real estate. The percentage of portfolio value dedicated to each market is

entirely up to the investor and varies widely. %or eample, one investor may have a portfolio

consisting of 0' percent stocks and &' percent bonds, while another investor may have '

percent in stocks, K' percent in commodities and 8' percent in bonds.

$I$3IO+RAP=:-



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DIVERSIFICATION

.P;T%65?T.4

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.?T.4

xecutive Summary Diversification is a way to reduce risk by investing in a variety of assets or business ventures.

Systematic riskis not diversifiable, while idiosyncratic risk can be reduced or even eliminated.

Portfolio diversification depends onrisk-aversion and time horizon, and the portfolio mix must be rebalanced

periodically.

verdiversification!"diworsification# can occur under certain conditions. $usiness diversification relies on

endogenous opportunities, whose value depends on how flexibilities such as timing and expansion options are managed.

Introduction%o diversify is to do things with variety in order to improve well-being. Diversification is thus a common and fundamental

concept in both daily life and business. &owever, the practice is primarily known as a way of reducing risk by investing in a

variety of assets or business ventures. $uying one utility stock in the 'ast coast and one in the (est will minimize local

shocks, while maintaining roughly the same return as buying either of the two alone. ) shop at a resort selling both

umbrellas and sunglasses clearly will have a less variable income whether a sunny or a rainy day comes up.

%o obtain the optimal strategy of diversification, the risk must be defined and the associated investment opportunities

modeled. *n addition, the utility or investor+s risk tolerance and investment horizon must be specified. *n terms of asset

allocation and portfolio choice, the risk is usually defined as the standard deviation of the portfolio return. %his measures the

variability of the return relative to the expected value of the return. iven a fixed level of expected return, the strategy that

generates the minimum variance is preferred. %o achieve this, the optimal diversification among the assets will usually be

reuired. %he risk tolerance of an investor determines the trade-off between return and risk, as well as the level of risk to

take.

(ithout a formal framework, naive diversificationcalls for an allocation of an eual amount of money across Nassets, and

thus it is also known as the !Nrule. %his rule goes back to as early as the fourth century, when /abbi *ssac bar )ha

suggested0 "ne should always divide his wealth into three parts0 a third in land, a third in merchandise, and a third ready to

hand.# 1aive diversification is clearly not optimal in general. 2or example, when investing in a money market and a stock

index, few investors will allocate 345 to the money market.

http://www.portfoliomgt.com/http://www.investmentmgtorg.com/http://www.investopedia.com/http://www.scribd.com/http://www.financepractitioner.com/dictionary/systematic-riskhttp://www.financepractitioner.com/dictionary/risk-aversionhttp://www.portfoliomgt.com/http://www.investmentmgtorg.com/http://www.investopedia.com/http://www.scribd.com/http://www.financepractitioner.com/dictionary/systematic-riskhttp://www.financepractitioner.com/dictionary/risk-aversion


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DIVERSIFICATION

*n 63 7arkowitz published his famous portfolio theory, which provides the optimal portfolio weights on a given Nrisky

assets 8stocks9 once the expected returns, covariances, and variances of the assets are given, along with the investor+s risk

tolerance, in a uadratic utility function. %he resulting optimal portfolio is a full diversification with money invested in all of the

risky assets. %he benefits of diversification depend more on how the assets perform relative to one another than on thenumber of assets you want to invest. %he more the assets do not behave alike:that is, the lower the correlations among

them:the more the risk can be minimized by holding the right mix of them.

%he optimal portfolio is not risk-free. *t is simply the one that has the minimum risk among all possible portfolios of the assets

for a given a level of expected return. 2or any asset, one can decompose its total risk into two components,

systematic!market-wide risk and idiosyncratic risk. %he optimal portfolio has only market risk, because idiosyncratic risk is

diversified away. )s a result, there is no point in taking any idiosyncratic risk. $ut market risk is unavoidable. *ntuitively, the

return on a suitable portfolio of all stocks in the market has only the market risk, and will not be affected by bad news from

some companies, which is likely be offset by good news from others. &owever, a war, a national disaster, or a global crisis

will likely affect the entire portfolio in one direction.

(ith leverage, the optimal portfolio can theoretically be designed to obtain any desired level of expected return by taking

certain necessary risk. %he greater the desired expected return on the optimal portfolio, the higher is the risk. (ithout

borrowing and short selling, the diversified portfolio must have an expected return between the highest and the lowest of the

asset expected returns. &owever, the risk is often much smaller than the lowest risk of all the assets.

)n efficient portfolio is one that offers either the highest expected return for a given level of risk or the lowest level of risk for

a given expected return. %he efficient frontier represents that set of portfolios that has the maximum expected return for

every given level of risk. 1o portfolio on the efficient frontier is any better than another. Depending on the investor+s risk

tolerance, the investor chooses theoretically one, and only one, efficient portfolio on the frontier.

%he investment opportunity set is static in the mean;variance framework underlying the 7arkowitz portfolio theory. )s

investment opportunities change over time, many argue for time diversification:that the risk of stocks diminishes with the

length of the investment horizon. (hile this is debatable, the benefit of diversification across assets, and much of the mean;

variance theory, carry through into dynamic portfolio choice models with changing investment opportunities. &owever, due to

incomplete information 8such as parameter and model uncertainties9, trading costs 8such as learning and transaction costs9,

labor income, and solvency conditions, it can be optimal theoretically to underdiversify:to not invest in all assets.

Diversification purely for the sake of diversification can cause unnecessary diversification or overdiversification, to end

up diworsificationi.e. worsening off from bad diversification.

Aleander, ?ordon, @., Sharpe, illiam, %. and !ailey, @effery, N., E%undamentals of 5nvestment,Ird 2dition, Pearson 2ducation. !odie, *., :ane, A, arcus,A.@., and ohanty, P. E

5nvestmentsC, Oth 2dition,Tata c?raw-+ill. !hole, 6.., and ahakud, @. G&''LH, %inancial

institutions and markets.th2dition, Tata c?raw +ill G5ndiaH. %isher D.2. and @ordan ;.@.,

ESecurity Analysis and Portfolio anagementC, Kth2dition., Prentice-+all. @ones, 4harles, P.,



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DIVERSIFICATION

E5nvestment Analysis and anagementC, Lth 2dition, @ohniley and Sons. Prasanna, 4.,

E5nvestment Analysis and Portfolio anagementC, Ird 2dition, Tatac?raw-+ill. ;eilly,

%rank. and !rown, :eith, E5nvestment Analysis

M Portfolio anagementC, th 2dition,Thomson Soth-estern.


Documents

Reduction of Portfolio Through Diversification