Investing incurs risks because it is impossible to correctly predict future returns of any investment every time (if you can let me know!). However, what is certain is that not all investments perform the same way under the same market conditions; some zig while others zag. Investors may try to pick one investment asset over the other by non-diversifying, but any wrong pick would result in lower returns or losses. Portfolio diversification reduces investment risk by eliminating such possibilities through investing in assets of different expected returns. The expected return on a diversified portfolio will always lower than the asset with the highest expected return but higher than the asset with the lowest expected return. In other words – it evens out your highs and lows for a more even return.
Risk Aversion And The Degree of Diversification
For any portfolio diversification to work, the presumption is that no two assets have identical returns. Therefore, by capturing both higher-performing assets and lower-performing assets, diversification aims to earn a more level, average rate of return. However, the proportions of how many higher-performing assets and lower-performing assets that may be included in a portfolio are still dependent on choosing and predictions. If in fact more higher performing assets than lower-performing ones are picked, the diversified portfolio would have a better return. But the potential risk is that if more low-performing assets than high-performing assets have been chosen, the portfolio would have a worse return. So further diversification to include more assets into the portfolio helps reduce the risk of inadequate diversification. The most risk-averse investors would prefer a fully diversified market portfolio of some kind of index investing.
Diversification and Wealth Accumulation
Although diversification misses out on the biggest growth opportunities, in the long run, it actually helps grow wealth. Investments that are able to compound at a steady rate of return over a long period of time can grow into a much larger future value. Portfolio diversification ensures such a rate of return by keeping the influence of volatility at a minimum. Studies show that the standard deviation of annual portfolio returns can be reduced along the way as a portfolio is further diversified. Active, non-diversified investment management approach may see higher returns in some years but losses in other years make keeping the earnings impossible to keep up. As it has been said in finance, the only free lunch in investing is diversification.
Ways to Diversify a Portfolio
Diversification can be done among asset categories and within an asset category. For example, an investor can choose to include stocks, bonds, and annuities in a portfolio to have a balanced risk and return. When stocks are down, returns in bonds and annuities can make up part of the losses. But when stocks are up, average performances of bonds and annuities can also bring down the portfolio’s total return. Alternatively, an investor may opt for an all-stock portfolio but supply it with different types of stocks. Not all stocks rise and fall together under a certain market condition. When large cap stocks stagnate, small caps may surge. Or when growth stocks show temporary retreat, value stocks may realize their potentials. Always have a blend of stocks from different groups and sectors to diversify not only company-specific risk but also industry-specific or other group-specific, diversifiable risks. Index funds and ETF’s from different asset classes can also be used to diversify a portfolio.
The only non-diversifiable risk is the so-called systematic risk, that is, the market risk for all stocks as a whole. And that is why investments in other markets such as the bond and commodity markets should also be used.
So you can see, diversifying a portfolio gives up a little bit of the highs but also helps eliminate a little of the lows to make your portfolio less volatile and your overall return more even.