How diversification reduces risk of an investor

What exactly is diversification when it comes to your investments? It is all about not putting all your eggs in one basket. It is about spreading your risks. In other words, diversification is the antithesis of concentration. When you put all your money in one or two investment products then you run the risk of concentration. That is not a wise decision especially when you are relying on these investments to meet your long term goals. A better idea would be to spread your risk by diversifying.

There is an eminent logic to diversification

Diversification is all about reducing your risk and not about enhancing your returns. By diversifying you reduce your directional risk in the stock markets or in any other asset market. For example, if all your assets are going to move in the same direction then it means all your assets will give negative returns when the cycle turns down. You can argue that they will give positive returns when the cycle turns up by your investment strategy cannot be predicated on the likelihood. It must have an underlying plan and logic to it. That logic comes from diversification. How does diversification work? If you are heavily invested in cement industry and if the cement industry goes into a down cycle due to oversupply then your investments will underperform. So you diversify the investments with different industries to reduce the risk of cycles. Portfolio diversification is a risk-return trade-off. What does that mean? A diversified portfolio may underperform in specific cycles but over a longer period of time your portfolio will be much better off. Breaking down types of risk and how diversification fits in?

In financial parlance, you need to understand that there are two specific kinds of risk. Understanding these risks is fundamental to your understanding of diversification. In stock markets we divide risk into systematic risk and unsystematic risk. Unsystematic risk is unique to assets or sectors or themes. When we talk of risk reduction through diversification, we talk of unsystematic risk, which is why it is also called diversifiable risk.. Systematic risk is the risk that impacts all asset classes systematically. Examples of systematic risk are political uncertainty, shift in inflation, changes in interest rates, fall in GDP growth, global geopolitical risk etc. When we talk of diversifying risk, we talk of only reducing our unsystematic risk and that reduces the overall risk in the process.

The chart above is fairly illustrative and explains the unique features of unsystematic risk and systematic risk. You can see that the systematic risk is constant irrespective of the number of stocks that you add to the portfolio. Here are some key observations. Firstly, systematic risk remains constant through the stock additions even when you diversify across asset classes. Secondly, even unsystematic risk cannot really be reduced to zero because some element of unsystematic risk will remain in your portfolio despite diversification.

Different ways of diversifying your portfolio

Quite often we use the word diversification quite generically. In reality, there are a lot of sub-plots to diversification. Diversification happens across different levels and you need to address all these aspects to get a truly diversified portfolio.

  • You can diversify across asset classes. How does that work? This can be done by combining asset classes like equities, debt, hybrid asset classes, ETFs, index funds, gold, property, foreign assets etc. This will spread your risk your overall portfolio risk is reduced. Gold and equities typically move against each other and help in diversification.
  • How to diversify within debt? You diversify across quality; meaning across AA rated debt and AAA rated debt. You can also diversify across maturities. Longer maturities are more sensitive to shifts in interest rates compared to shorter maturities.
  • How to diversify across equities? The guiding principle is to diversify across sectors, themes and also across market capitalizations. Themes typically cover a number of sectors or sub-sectors and we can have themes like rate sensitivity, rural demand, consumption etc.

Diversification is one of the core principles of portfolio structuring.