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Diversification

 

A diversification is an investment technique or a part of an investment strategy, which is used to reduce the investment risk of the portfolio, including in it larger number of different securities or other investments.

 

If there are several investments and each of them contains equal risk, a combined portfolio of them will have lower risk than each of them separately, if correlation between them is less than 1. Usually even similar investments have lower than 1 correlation, so the larger number of investments portfolio includes, the better is diversification. However, if diversification is made between the same asset class and in the same local market, its significance will go down noticeably when number of securities exceeds 20 because investment portfolio risk will be close to a market risk, which is non-diversifiable.

 

But market risk can be extended diversifying between more asset classes and different regions. The wider the diversification is, the better result of the investment portfolio can be achieved. The lowering of portfolio risk is equal to return increase. Because the portfolio consisted of higher risk and return investments may have the same risk level that one separate investment of lower return has.

 

Some known investors argue that wide diversification is only for investing amateurs and better to focus on few best investments - but it will not necessary bring the best results. No one knows what risks may lay ahead, and only diversification can lower consequences of the worst outcome.

 






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