Diversification is one of the fundamental tools in our arsenal of reducing risk and is the arguably the most important. Diversification is used in a portfolio (group) of investments in order to reduce the unsystematic risk level that was introduced previously.
It is achieved by combining a series of investments together, such as those in the asset allocation table, and ensuring that the selected asset classes do not move (price movements) in the same direction.
For example, if you selected to buy two different industry stocks (stocks that are in separate business areas) in a portfolio – a Coles Myer and a National Australia Bank Share – you would be diversifying your investment because Coles Myer is driven by the Retail and Food markets and the National Australia Bank is driven by Banking and Finance. A large or poor change in one of these two industries would most likely have no effect on the price of the other – but it would have an effect on the overall portfolio as it is only limited to two stocks and it is possible that only one-half of your portfolio is performing.
Now imagine that this process is repeated over and over again, effectively gaining a portfolio with a large number of totally diversified or unrelated industry stocks. This would mean that even if one industry area decreased in value, your portfolio would still be performing for you because you have diversified your selected range of investments. Increases in negative volatility in one industry sector will not change the overall performance of your portfolio because not all of your asset classes or industry stocks are moving up or down in value at the same time or the same rate. It effectively removes the potential upside and downside to investments and creates a more consistent – if not safer – overall performance for your money
The amount of stocks that need to be purchased in order to reduce the level of unsystematic risk can vary, but portfolio theory (underlying theory behind the relationships between risk and return) estimates that about 10-12 diversified stocks will give a high level of diversification. Remember – this means that 10-12 totally unrelated industry stocks in different assets classes will give you the best overall return.
Remember the age old adage “Never put all your eggs in one basket!”
Just beware to not to go too far with diversification and ask yourself Are You Over-Diversified?