Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When this is the case, a portion of an individual stock’s risk can be eliminated, i.e. diversified away. This principle is called as Diversification and it is possibly the best way to reduce the risk in a portfolio.
A good portfolio cannot be formed by investing only in one type of security or sector, but by diversifying across various avenues. Diversification largely means investing in a variety of assets instead of just one type of asset. Due to this, potential of losses gets reduced because every instrument or industry would react differently to the same event. Although it does not guarantee against loss, diversification is the most important component of achieving long-term financial goals.
Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
Consider holding two stocks that have the same expected returns, instead of one stock. Because stock returns will not be perfectly correlated with each other, it is unlikely that both stocks will experience extreme movements (positive or negative) simultaneously, effectively reducing volatility of the overall portfolio. As long as assets do not move in lock step with one another (are less than perfectly positively correlated), overall volatility can be reduced, without lowering expected returns, by spreading the same amount of money across the multiple assets.
Imperfect correlation is the key reason why diversification reduces portfolio risk as measured by the portfolio standard deviation. This concept of diversification is one of the main tenets of modern portfolio theory – volatility is reduced through the addition of more assets to a portfolio.
Diversification, by putting stocks of various sectors that reflect the economy, is used to cancel out stock noise which is essentially the individual stock fluctuations and to reduce investor’s risks. Diversification is a strategy in which investor’s money is not invested in one place rather it is invested in different securities. It is assumed that if one category fails the loss can be made good by return from other categories.
Below mentioned are the few types of diversification:
- Diversification by asset class: A group of securities that show similar characteristics and behave similarly in the marketplace is called an asset class. The three main asset classes are stocks, fixed-income (bonds) and cash equivalents (money market instruments). Real estate and commodities such as gold are also considered as asset classes. A well-diversified portfolio invested across various asset classes can be an ideal strategy to participate in the top performing assets. e.g., Gold prices are traditionally inversely correlated to stock prices. So, gold can help minimize losses in a portfolio that includes stocks.
- Diversification by sector: A sector is one of a few general segments in the economy within which, a large group of companies can be categorized. To give an example: the financial services sector includes banking, insurance, NBFC, etc. An investor can invest across these broad sectors in order to minimize sector-specific risks. e.g., a spike in crude oil prices may boost prices of exploration & refinery sector stocks but aviation sector stocks may fall in reaction.
- Diversification by market capitalization: Mid and small-capitalization stocks have the potential to deliver higher returns than the Large-cap stocks, but they tend to be volatile in nature, which means, if the market goes down, small-cap stocks would lose maximum value followed by mid-cap stocks. On the other hand, large-cap companies provide support and stability to a portfolio as they may reduce risk in a downturn. An investor can reduce the risks faced by the mid and small-cap segment by diversifying investments into large-cap cap companies.
In this way, investors should develop a diversified portfolio that helps them limit downside risks while participating in the growth of asset classes or sectors or industries that are expected to do well. The portfolio should also be rebalanced from time to time taking into consideration the economic, business and/or policy environment. The latter two aspects are especially influential for India because our’s is still a developing nation on the path of growth. The opportunity to participate in India’s growth exists for us all but a simple tool like diversification can make our journey safer.