# Diversification with Portfolios

### Overview of Diversification Methods

A diversified portfolio is one way to minimize risk associated with beta movement.
Diversification is the practice of investing a portfolio's funds in multiple assets to reduce the total risk. Risk can be classified as either systematic risk or unsystematic risk. Systematic risk, also known as market risk, is the volatility that affects assets on a macroeconomic scale. These macroeconomic trends affect the entire market environment and cannot be removed through diversification. Systematic risks include changes in interest rates, gross domestic products, tax policies, and inflation. In contrast, unsystematic risk is the uncertainty associated with an individual company or sector. For example, unsystematic risk is affected by a company's finances or new regulations for a business sector. The total portfolio risk is the sum of systematic and unsystematic risks. The purpose of diversification is to remove as much unsystematic risk as possible. A well-diversified portfolio's total risk only comes from its systematic risk. Consequently, the portfolio's only exposure is to macroeconomic, systematic risk.

#### Diversified Risk versus Undiversified Risk

A diversified portfolio is one way to minimize risk associated with beta movement. Beta is the amount of systematic risk that an asset or portfolio has with respect to the market. The market has a beta value of 1 at its baseline. An asset with a beta value of 1 is expected to have systematic risk equal to the market's and therefore is expected to move directionally and proportionally with the market. An asset with a beta of 0.5 is expected to have 50 percent of the systematic risk that the market does. An asset with a beta value of 1.5 is expected to have 50 percent more volatility than the market does. Assets with beta values greater than 1 have an increased level of volatility; however, on average, returns are higher than assets with beta values of less than 1.

A portfolio may diversify by purchasing stock of multiple companies within an industry sector, owning stock of numerous companies within multiple industry sectors, and/or investing in both small and large capitalization companies. Small capitalization companies are organizations with a book value of $300 million to$2 billion, while large capitalization companies are organizations with a book value greater than \$10 billion. Different types of diversifiable assets include stocks, bonds, real estate, currencies, and futures. Another way to diversify is by owning both globally and domestically traded stock. Mary Nelson does most of her business in real estate in the United States, so she directs her financial manager to create a portfolio with no domestic real estate. She also instructs the financial manager to mix stocks and bonds, domestically and globally. She wants the stocks to focus on technology because her research shows that it is not correlated to real estate or the economy. This will help to mitigate unsystematic risk attached to the real estate industry.