In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents.
Online PR News – 19-February-2011 – – In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents. Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors.
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Diversification is one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive. Hedging relies on negative correlation among assets, or shorting assets with positive correlation.
Diversification can lower the volatility (risk) of a portfolio because not all asset categories, industries, or stock, move together. Holding a variety of non-correlated assets can nearly eliminate unsystematic risk. In other words, by owning a large number of investments in different industries and companies, industry and company specific risk is minimized by diversification. In addition, diversification can reduce portfolio losses in bear markets, preserving capital for investment in bull markets.
Diversification advantages include reducing portfolio risk and simultaneously increasing portfolio returns through portfolio optimization. Holding a variety of assets enables the portfolio manager to invest in more aggressive assets without increasing the risk of the overall portfolio. Optimization can be achieved because proper diversification lowers portfolio risk, allowing an investment manager to invest in higher risk, higher reward assets, and still maintain a desired target amount of total portfolio risk.
The essence of diversifying a portfolio is to diversify the profit drivers within it. Naturally, this approach relies on the corollary that earnings drive prices. The difficult part lies in identifying the profit drivers. The following method is a process based on that taken by the founder of Sony, Akio Morita in Made in Japan: Akio Morita and Sony. The investor discovers the individual profit drivers, he can then seek to diversify them within a portfolio.
What are the strategic end drivers of their business? This is usually the most important part. Industries like miners and many energy companies are strategically exposed to the prices of the commodities that they deal in. Indeed, most companies are exposed to an over- riding macro factor. For example, consumer goods companies are exposed to consumer spending cycles.
A simplistic view of this approach would be to define companies in terms of having cyclical or defensive qualities. However, in reality, economies and, individual company prospects are far more complex. Defining a strategic profit driver may appear to be a science but in fact it is more of an art.
Harris James Associates, New York Portfolio Management
Once this process is completed and the investor has defined the key drivers, he can thing bring about diversifying the portfolio. For example, a properly diversified portfolio will not be overweight in one sector or theme. So if an investor finds that he is overweight in stocks benefiting from rising oil prices, then he should look to buy companies that are positively exposed to falling oil prices. For example, plastics manufacturers or data centre operators.
This hedging process will not necessarily result in flat performance because the companies involved will have other growth kickers. In this example, the oil companies may discover significant new reserves and the data centre could see significantly increased demand for its centres. However, the exposure to rising oil price movements will be limited via diversification.
This process is particularly applicable to portfolio that has been constructed through a bottom up process because a bottom up portfolio could be manifesting an unintentional style or sector bias.