Skip to: site menu | section menu | main content

OzRes.com

Your Informational Portal...
Currently viewing: OzRes.com » Investing » Diversification

"I took the one less traveled by,
And that has made all the difference." -Robert Frost

Navigate:

Diversification

"A risk-management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated." - Investopida.com

In short, diversifying simply means buying the most "diverse" range of investments to lower risk. The theory is, the more you add to your portfolio, the less your overall risk (and you maintain the same returns as before). The particular risk that can be diversified away is called unsystematic risk, nonsystematic risk, unique risk or specific-risk. This sort of risk is something that usually affects only a small number of the assets. Systematic risk (AKA market risk) on the other hand is something that affects a large number of assets and cannot be diversified away as it's not specific just to any particular asset.

For example, an unexpected increase in inflation would affect wages, costs & prices for the firm. This is something that would affect all firms & is thus a systematic risk. A strike, however, that's undertaken by a single firm, or a couple of firms, is unlikely to influence that industry on a bigger scale and is thus a non-systematic risk.

If you take a look at my paint drawing below: the top section in brown is the part that is diversifiable (non-systematic risk) which gets lower as you move towards the right and add more shares to the portfolio. The bottom section on the other hand is not diversifiable (systematic) and therefore stays the same.

 

Links

Diversification - Article from Wikipedia

Modern Portfolio Theory

Beta Coefficient - In the above "diagram", the Beta would be the non-diversifiable systematic risk. The beta coefficients are as follows for the selected companies:

Amcor 0.78

BHP 1.33

Boral 0.85

Caltex Australia 1.38

NAB 1.27

The beta essentially tells us how much systematic risk is present in a particular asset in comparison to an average asset. An average asset has, by definition, a beta of 1. So that means that if Amcor had a beta of 0.5, it has half as much systematic risk as an average asset.

CAPM - Capital Asset Pricing Model

Back to top