Diversification (finance)

In finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk.

A common path towards diversification is to reduce risk or volatility by investing in a variety of assets.

If asset prices do not change in perfect synchrony, a diversified portfolio will have less variance than the weighted average variance of its constituent assets, and often less volatility than the least volatile of its constituents.

[1] Diversification is one of two general techniques for reducing investment risk.

The simplest example of diversification is provided by the proverb "Don't put all your eggs in one basket".

If the stocks are selected from a variety of industries, company sizes and asset types it is even less likely to experience a 50% drop since it will mitigate any trends in that industry, company class, or asset type.

Since the mid-1970s, it has also been argued that geographic diversification would generate superior risk-adjusted returns for large institutional investors by reducing overall portfolio risk while capturing some of the higher rates of return offered by the emerging markets of Asia and Latin America.

Conversely, the diversified portfolio's return will always be higher than that of the worst-performing investment.

[5] Similarly, a 1985 book reported that most value from diversification comes from the first 15 or 20 different stocks in a portfolio.

[9] One simple measure of financial risk is variance of the return on the portfolio.

Note that the favorable effect of diversification on portfolio variance would be enhanced if

, portfolio variance is minimized by holding all assets in the equal proportions

Simplifying, we obtain As the number of assets grows we get the asymptotic formula: Thus, in an equally weighted portfolio, the portfolio variance tends to the average of covariances between securities as the number of securities becomes arbitrarily large.

The capital asset pricing model introduced the concepts of diversifiable and non-diversifiable risk.

The capital asset pricing model argues that investors should only be compensated for non-diversifiable risk.

[13] In 1977 Edwin Elton and Martin Gruber[14] worked out an empirical example of the gains from diversification.

Their approach was to consider a population of 3,290 securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n. Their results are summarized in the following table.

In corporate portfolio models, diversification is thought of as being vertical or horizontal.

Horizontal diversification is thought of as expanding a product line or acquiring related companies.

Vertical diversification is synonymous with integrating the supply chain or amalgamating distributions channels.

Non-incremental diversification is a strategy followed by conglomerates, where the individual business lines have little to do with one another, yet the company is attaining diversification from exogenous risk factors to stabilize and provide opportunity for active management of diverse resources.

Yet this belief has flaws, as John Norstad explains: This kind of statement makes the implicit assumption that given enough time good returns will cancel out any possible bad returns.

While the basic argument that the standard deviations of the annualized returns decrease as the time horizon increases is true, it is also misleading, and it fatally misses the point, because for an investor concerned with the value of his portfolio at the end of a period of time, it is the total return that matters, not the annualized return.

Because of the effects of compounding, the standard deviation of the total return actually increases with time horizon.

[15]Three notable contributions to the literature on the fallacy of time diversification have been from Paul Samuelson,[16] Zvi Bodie,[17] and Mark Kritzman.

[18] Diversification is mentioned in the Bible, in the book of Ecclesiastes which was written in approximately 935 B.C.

1599):[23] Modern understanding of diversification dates back to the influential work of economist Harry Markowitz in the 1950s,[24] whose work pioneered modern portfolio theory (see Markowitz model).

An earlier precedent for diversification was economist John Maynard Keynes, who managed the endowment of King's College, Cambridge from the 1920s to his 1946 death with a stock-selection strategy similar to what was later called value investing.

[25] While diversification in the modern sense was "not easily available in Keynes's day"[26] and Keynes typically held a small number of assets compared to later investment theories, he nonetheless is recognized as a pioneer of financial diversification.

Keynes came to recognize the importance, "if possible", he wrote, of holding assets with "opposed risks [...] since they are likely to move in opposite directions when there are general fluctuations"[27] Keynes was a pioneer of "international diversification" due to substantial holdings in non-U.K. stocks, up to 75%, and avoiding home bias at a time when university endowments in the U.S. and U.K. were invested almost entirely in domestic assets.