Diversification

The process of adding securities to a portfolio in order to reduce the portfolios unique risk and thereby, the portfolios total risk.

The objective of portfolio analysis is to reduce risk. By combining securities of low risks with securities of high risk, success can be achieved by an investor in making a choice of investment outlets. Combination of securities can be made in many ways.

Forms of diversification

Portfolio approaches usually assume one of the following forms of diversification.

Simple diversification: The simple diversification would be able to reduce unsystematic or diversifiable risk. Simple diversification is the random selection of securities that are to be added to a portfolio. Simple diversification reduces a portfolios total diversifiable risk to zero and only the undiversifiable risk remains. It was found in many research studies that 10-15 securities in a portfolio would bring adequate returns. So this approach assumes that an investor can expect a reasonable return for a given level of risk.

Superfluous diversification: It refers to the investors spreading himself in so many investments on his portfolio. The investors finds it impossible to manage the assets on his portfolio because the management of a large number of assets requires a knowledge of the liquidity of each investment, return, the tax liability and this will become impossible without specialized knowledge. He also finds it both difficult and expensive to look after a large number of investments. If the plans to switch over investments by often selling and buying assets expecting a high rate of return, he involves himself in high transaction costs and more money will be spent in managing superfluous diversification.

Diversification across industries: some investment counselors advocate selecting securities from different industries to achieve better diversification. It is certainly better to follow this advice than to select all the securities in a portfolio from one industry. But, empirical research has shown that diversifying across industries is not match better than simply selecting securities randomly.

Simple diversification across quality rating categories: Simple diversification reduces risk within categories of stocks that all have the same quality rating.

Markowitz diversification: Markowitz diversification is the combining of assets, which are less than perfectly positively correlated in order to reduce portfolio risk. It can sometimes reduce risk below the undiversifiable level. Markowitz diversification is more analytical than simple diversification and considers assets correlations. The lower the correlation between assets, the more that Markowitz diversification will be able to reduce the portfolios risk.