Diversification – What Is It, Why You Need It

You have probably heard the phrase “don’t put all the eggs in one basket”. The reason is an obvious one- you’d lose all the eggs if you lose the basket. Now consider the same situation with regard to your investment. The trick to avoiding such a situation in investment is diversification.

Diversification is the technique of reducing risk by investing across different assets, industries, and other categories to maximize returns through investments in different areas that would each show different responses to the same event. Although it doesn’t guarantee any kind of prevention against losses, diversification is essential for reaching long-term financial objectives while minimizing risk.

Let’s assume that your portfolio only consists of stocks from airline companies. Now if there’s an indefinite strike by pilots, it will lead to the cancellation of flights and the prices of shares are bound to drop. This means a significant dip in the value of your portfolio. What you can instead do is supplement your portfolio with a few railway stocks, which will result in only a fraction of your portfolio being affected in the event of a pilot strike. In fact, there’s a high chance that the price of your railway stocks would rise since passengers would be looking for alternative sources of transportation.

While diversification has several benefits, its biggest advantage is that it can enhance your potential returns and stabilize your results. Owning different assets that perform differently ensures that the overall risk to your portfolio is significantly reduced. Thus, no single investment gone bad can hurt you more than a certain extent.

Bernt Arne Ødegaard at the University of Stavanger carried out a study in February 2018 to look at the standard deviation on 100 random simulated portfolios. The following graph shows the average of these stimulations.

The y-axis in the above graph is the standard deviation and refers to the unsystematic risk (the inherent market risk that you can’t diversify) and the x-axis is the number of shares in the portfolio. It is clear from the above graph that there is a great diversification effect up to eight shares but after eight shares, there is limited marginal benefit even though there is marginal benefit up to 40 shares.

Therefore, a diverse portfolio would lead to better returns and you reduce the risk of unforced errors. Only if you are a very good investor should you have a concentrated portfolio.