The objective of diversification is to eliminate the impact of diversifiable risks on the overall return of the portfolio
All investors, big and small, do diversification even if they are not aware of doing so. Large portfolio and professional portfolio managers include diversification into their investment criteria rather than it being accidental from their investment transactions.
According to the Chartered Financial Analyst ® there are two general definitions of diversification.
First, it involves the spreading of a portfolio over many investments to avoid excessive exposure to any one source of risk.
Second, in mergers and acquisitions, it is a term that refers to buying companies or assets outside the companies’ current lines of business.
As investors, unless you are managing a portfolio which owns business such as being done by Warren Buffett, we are more concerned with the first definition. This definition mentioned risk. In wealth management, there are two types of risk – diversifiable and systematic risk.
Diversifiable risks are risks attributable to the specific asset. For example, if the asset is a share of stock of Wal-Mart (NYSE: WMT), then the risk is attributable only to Wal-Mart rather than to both Wal-Mart and Costco (NasdaqGS: COST). Systematic or market risks, on the other hand, are non-diversifiable. This means that a portion of an asset's return that is directly influenced by macroeconomic factors, hence this type of risk is uncontrollable by an investors and thus, non-diversifiable.
Simply, the objective of diversification is to eliminate the impact of diversifiable risks on the overall return of the portfolio. Or as eggs go, diversification means NOT putting ALL your EGGS in ONE basket. To carry the egg analogy further, the types of baskets you choose to use should reduce the chance that the eggs you put in those baskets will break to ZERO. Diversification should result in a portfolio with minimal risk and optimal return. Technically, diversification should result in the highest portfolio expected return at the lowest portfolio variance. Portfolio variance is a measure of a portfolio’s expected return’s deviation from its mean (average) expected return.
Now to answer the question ‘Does diversification really work?'
Yes, I believe that diversification--rational diversification--works. Now to illustrate:
Supposing that in January 1, 2005, you have $50,000 available funds to invest. If you invested the whole amount to Wal-Mart (NYSE: WMT), then that money would have been $55,047.28 at the end of August 31, 2009, which translates to a Compounded Annual Growth Rate (or CAGR) of 2.66%%. However, if you diversified some of the risks and invested half of the funds on Wal-Mart (NYSE: WMT) and the other half to Costco (NasdaqGS: COST), then the portfolio at the end of August 31, 2009, would have been $56,471.84--or a compounded annual growth rate of 3.38%.
The better performance of the two-asset (Wal-Mart and Costco) portfolio reflects the effect of diversification. Technically, in this case, the portfolio variance and standard deviation, the variability on dispersion of the possible returns, are lower that than of a purely Wal-Mart portfolio. It follows, therefore, that if you have diversified away from the wholesale and retail sector, where Wal-Mart and Costco both belong, this variance and standard deviation would have been lower which could also have increased the value of the portfolio as of August 31, 2009.
Now the caveat. Excessive diversification might undermine the portfolio’s expected return as managers try to analyze several, instead of a handful, of asset classes and several securities within each class, at once affecting the value of the analysis.
As I always say, however we decide to do with our portfolio, the objective should always be towards what you identified as your portfolio and wealth management goals. Happy investing!