Overview of Diversification Methods
Diversified Risk versus Undiversified Risk
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 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.