Portfolio Diversification

Investment risk diversification


portfolio diversificationPortfolio diversification is a risk management technique by which investors minimize their portfolio risk by combining a variety of assets. Diversification tries to smooth out unsystematic risk events in a portfolio, and moderate the short-term effects of individual investments, so that the positive performance of some assets will neutralize the negative performance of others. The rationale behind diversification contends that a portfolio of significantly different investment classes will yield higher returns and pose lower risk than an individual investment within the portfolio. Therefore, the benefits of diversification will hold only if the assets are not perfectly correlated.

Generally, the equity and bond markets move in opposite directions, so, if a portfolio is diversified across both these asset categories, unpleasant movements in one will be offset by positive movements in another. A very basic diversified portfolio might contain the following investments:

  • Equity and equity mutual funds: They represent the most risky portion of the portfolio. Equity and equity mutual funds provide the highest potential growth over the long-term. But short-term market volatility may erode profits.
  • Bonds: Includes treasury and corporate bonds. Investors looking for regular income often allocate more of their portfolio toward Treasury or other high-quality bonds. Bonds are less volatile than stocks, but returns over the long-term, are not as high as stocks.
  • Certificates of deposit and money market funds: A certificate of deposit is a time deposit, usually, with a fixed interest rate. On maturity, the money is withdrawn together with the accrued interest. Most certificates of deposit are insured by the Federal Deposit Insurance Corporation. A money market fund is an open-ended mutual fund that invests in high quality short-term debt securities and monetary instruments. Money market funds offer stability of principal and easy access to money, but returns are usually lower than bonds. Also, money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation.
  • International stocks and bonds: Foreign stocks and bonds may move up when the U.S. equity and bond markets are falling, and vice versa. Investing in international stocks and bonds provides greater diversification, and potentially lower portfolio volatility.

A portfolio should ideally be diversified at two levels: between asset categories and within asset categories. In addition to allocating investments among equities, bonds, money market funds and other asset classes, an investor also need to spread out his investments within each asset category. The key is to identify investment opportunities within each category that may perform differently under varying market conditions. For example, in an equity portfolio comprising of only airline stocks, if the pilots decide to go on an indefinite strike, the share prices of airline stocks will drop, which can lead to a substantial decline in the portfolio value. However, if the investor counterbalances the airline stocks with a few railway stocks, only a certain portion of the portfolio would be affected. In fact, as passengers turn to trains as an alternative means of transportation, there is a good chance that the rise in railway stock prices would more than offset the losses in the airline stocks.

Unfortunately, risk can never be eliminated completely. Diversification may not be able prevent a loss, but it still provides protection against random events in the market. Nothing short of a complete financial wipe-out would kill all assets classes at the same time. In all other scenarios, while some investments vanish faster than others, some do manage to survive. Successful diversification depends upon combining assets that are not perfectly correlated, so that higher risk-adjusted returns can be achieved.

All trading carries risk. Views expressed are those of the writers only. Past performance is no guarantee of future results. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.

Based in Saudi Arabia, Siraj has a strong understanding of and passion for accounting and finance. He has worked for international clients for many years on several projects related to the stock market, equity research and other business, accounting and finance related projects. Siraj is a published financial analyst on the world's leading websites including SeekingAlpha, TheStreet, MSN, and others.

HTML Snippets Powered By : XYZScripts.com