Professional Documents
Culture Documents
Page 1 of 4
Portfolio Diversification
Portfolio diversification is the means by which investors minimize or eliminate their exposure to company-specific risk, minimize or reduce systematic risk and moderate the short-term effects of individual asset class performance on portfolio value. In a well-conceived portfolio, this can be accomplished at a minimal cost in terms of expected return. Such a portfolio would be considered to be a well-diversified. Although the concepts relevant to portfolio diversification are customarily explained with respect to the stock markets, the same underlying principals apply to all types of investments. For example, corporate bonds have specific risk that can be diversified away in the same manner as that of stocks.
Create PDF files without this message by purchasing novaPDF printer (http://www.novapdf.com) http://www.investing-in-mutual-funds.com/portfolio-diversification.html
10/4/2011
Portfolio Diversification
Page 2 of 4
risk, and systematic risk can be reduced by investing over a broader market, i.e., a larger universe. International diversification provides a good example of the effects of diversifying across asset classes. A portfolio invested 50% in domestic large -cap stocks and 50% in international large-cap stocks would have approximately half the residual risk of a portfolio comprised solely of domestic large-cap stocks, assuming that the investments in each market were sufficiently diversified to eliminate specific risk. Some investors may choose to be exposed to specific risk with the expectation of realizing higher returns. But this is contrary to financial theory and such investors are therefore deemed to be irrational. Deliberate exposure to specific risk is unnecessary and is essentially gambling...unless you are trading on inside information, but we won't go there, as trading on inside information is a flagrant violation of the securities laws.
Create PDF files without this message by purchasing novaPDF printer (http://www.novapdf.com) http://www.investing-in-mutual-funds.com/portfolio-diversification.html
10/4/2011
Portfolio Diversification
Page 3 of 4
is where the correlation between asset classes really comes into play. Asset classes that are not highly correlated can be expected to under- and overperform at different times. Thus, holding a variety of asset classes that are not highly correlated is insurance against the probability of having a low terminal value when liquidation occurs during or shortly after a period of under-performance of a minority of the asset classes in a portfolio. In such cases, the other asset classes should moderate or fully offset the effects of the under-performing asset class or classes.
Over-Diversification
Over-diversification can occur when two or more investments overlap. For example: If you hold an index fund that tracks the Wilshire 5000, investing in any other actively traded U.S. stocks will result in overlap and overdiversification. Owning a Wilshire 5000 index fund and a U.S. technology fund wouldn't necessarily double your investment in U.S. technology stocks, as the Wilshire 5000 is capitalization weighted and most non index funds are not, but you would have a significant overlap in the technology
Create PDF files without this message by purchasing novaPDF printer (http://www.novapdf.com) http://www.investing-in-mutual-funds.com/portfolio-diversification.html
10/4/2011
Portfolio Diversification
Page 4 of 4
sector. This is more likely to happen with mutual funds but it also can occur with the securities of large diversified corporations. Overlap is a problem only if it's done inadvertently. Some investors desire additional exposure to one or more sectors and achieve this by deliberately creating overlap in their portfolios. Although this is contrary to financial theory, deliberate overlap is a matter of choice and as such is a part of some investors investment strategy.
A Well-Diversified Portfolio
I know I've left the definition of a well-diversified portfolio a bit hazy. But the definition is highly dependent upon factors that are unique to each investor. Only when those factors are defined can the term be clearly defined. Those factors include: risk tolerance, targeted terminal wealth, investment horizon (planned holding period) and the universe an individual is willing to accept as the pool from which they will select their assets. As I stated above, a well-diversified portfolio should be diversified within asset classes to the degree at which specific risk has virtually been eliminated, and diversification across asset classes should be such that the residual risk of the portfolio is consistent with the investors risk tolerance. The residual risk of a portfolio will diminish as asset classes are added to the investment universe, but there is a point of diminishing returns and there is a finite number of asset classes, which implies that there is a point beyond which no further reduction of residual risk can be achieved. A portfolio would be fully diversified at this point. Well-conceived portfolio diversification will result in the construction a welldiversified portfolio that will serve you well in achieving your long-term investment goals. And selecting an investment universe that is sufficiently broad to ensure that the highest level of diversification consistent with your risk tolerance can be achieved is the single most important step in constructing your portfolio.
Return to the top of Portfolio Diversification. Return to the Investing Basics summary page. Move on to the next subsection, Time Diversification.
SBI!
Create PDF files without this message by purchasing novaPDF printer (http://www.novapdf.com) http://www.investing-in-mutual-funds.com/portfolio-diversification.html
10/4/2011