Risk Mitigation

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

Systematic risk is the volatility that affects assets on a macroeconomic scale. Unsystematic risk is the uncertainty associated with an individual company or sector.
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.

Advantages and Disadvantages of Portfolio Diversification

Portfolio diversification presents a variety of advantages, such as less risk, and disadvantages, such as reduced potential gains.

Portfolio diversification comes with various advantages and disadvantages. An advantage of a well-diversified portfolio is less total risk. An investor with a well-diversified portfolio is not exposed to the volatility of a single company's stock or the devaluation of an industry or a specific asset class. This is because the diversified portfolio has investments that are oppositely correlated. Investors compensate for the devalued assets' negative losses by finding opposing holdings that have positive gains to include in the portfolio. Another advantage of a diversified portfolio is increased exposure to prospective gains. Expanding the range of invested assets provides exposure to assets that have growth potential opportunity that an undiversified portfolio would not have.

A disadvantage of diversified portfolios is the reduced potential to realize gains. Diversification depresses, or causes a downturn in, a portfolio's beta. Mary's portfolio has technology stock, bonds, and no real estate. If real estate stock goes up, she will not benefit. If technology stock goes up, only a portion of her portfolio will increase because she has diluted her portfolio by leaning heavily on bonds rather than assets that can have higher gains. Assets with lower beta values have a decreased level of volatility, but in aggregate they have returns lower than assets with higher beta values. An investor with a diversified portfolio should expect the maximum gains to be equal to the market's performance. Additionally, diversified portfolios may be subject to additional costs. These costs are associated with the maintenance required to preserve the portfolio's neutral beta across a variety of different assets.

A well-diversified portfolio requires a sizable time commitment for researching prospective investable assets. Investors may not put the same care into researching each investment asset as they would for a single-asset investment. This could result in an investor not fully understanding the assets in which they are investing. Investors must identify their goals and concentrate or diversify the portfolio to suit their desired gains and the level of risk acceptable to them.