Portfolio
diversification is a technique that reduces risk by allocating your capital
among various financial instruments, industries and sectors.The idea behind it
is that when there is particular news about something it will affect each of
your investments in a different way. It is important to bear in mind that
diversification does not mean that you are not going to lose, but it decreases
statistically the risk of loss. (I am going to show that in a minute).
Diversification is the most important component for reaching long-term
financial goals, or as you saw in the last seminar the time span that we are
talking about is 6-12 months.
First, I want to
show you the simple mathematics behind diversification (for all of you first
year economics students). Consider that you have two industries e.g. oil and
beverages.And at some point each of them issues shares:
Share „Oil“ is $3
and 4$ respectively for two states and are giving a probability that an asset
is going to end up with some particular value e.g. in our case let’s suppose
that we have 50% probability for both cases that the share prices will end up
either $3 or $4 at a point in time. ( Note that it may not be just two values
but instead it could be every single value of real numbers and you just give probabily
to each of it – it is very strong assumption and no living creature (yet) can
give a 100% objective price predictability , we are only using it to show you
why diversification protects you from risk). Let’s put in a diagram to show you
why :
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Bad state
|
Good state
|
|
|
Oil industry shares
|
$3
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$4
|
|
Beverages ind. Shares
|
$3
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$4
|
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Prob of end price of share=50%
|
Prob of price of share=50%
|
|
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Buy 2 shares in Oil
ind.
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(0,5x3 +0,5x4)/2= 3,5
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(0,5x3 +0,5x4)/2= 3,5
|
|
Buy 2 shares in
Beverage ind
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(0,5x3 +0,5x4)/2= 3,5
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(0,5x3 +0,5x4)/2= 3,5
|
|
Buy 1 share in oil
and 1 in Bev.
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(0,25x3 +0,25x4+0,5x3,5)/2= 3,5
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(0,25x3 +0,25x4+0,5x3,5)/2= 3,5
|
So, now imagine that you are a the most
powerful computer on Earth and you can all the probabilities how a share price
would be moving. Look at the two scenarios , where you either buy two shares of
one ind. or one in each of the two. The expected outcome is the same- it is 3,5,
however, the probability of you ending up with either $3 or $4 is smaller if
you diversify. This does not mean that you are boring investor, but it means
you are... well it could mean a lot things really. Some investors do believe in
diversification others don’t. The proponents argue that in order to get e.g. in
our table in the 25% probability that you get $4 for both industries then this
mean that you have to research twice as many things as you would if you choose
the huge 50% gain of only industry.
One additional thing to what we have covered
in the seminar would be a situation of when diversification cannot help you.
This is what is called "systematic" or "market risk," or undiversifiable
risk is associated with every company.You cannot actually take measurements
against it because you have already bought a share andpossible causes are
things like inflation rates, exchange rates, political instability,etc.. This
type of risk is not specific to a particular company or industry, and it cannot
be eliminated.
As I said, diversification is not about the
different companies. It could be every single type of asset that exots.
Different assets - such as bonds and stocks - will not react in the same way to
adverse events. A combination of asset classes will reduce your portfolio's
sensitivity to market swings. I tried to find a picture of how a portfolio
overall performance would look like versus individual stocks price movements.
The own share price is much more volatile than the overall performance.
However, dicreased volatility does not mean gain.
One good example here would the bond and
equity markets move in opposite directions, so, if your portfolio is
diversified across both areas, unpleasant movements in one will be offset by
positive results in another.
A natural question would be to ask how many
stocks should be included in order to ensure sufficient diversification. Obviously
owning five stocks is better than owning one, but there comes a point when
adding more stocks to your PORTFOLIO ceases to make a difference. There is a
debate over how many stocks are needed to reduce risk while maintaining a high
return. The most conventional view argues that an investor can achieve optimal
diversification with only 15 to 20 stocks spread across various industries. If
you have a lot of assets, on an aggregate level, your overall performance will
be moving just like the famous indexes
Diversification can help an investor manage
risk and reduce the volatility of an asset's price movements. Remember though,
that no matter how diversified your portfolio is, risk can never be eliminated
completely. You can reduce risk associated with individual stocks, but general
market risks affect nearly every stock, so it is important to diversify also
among different asset classes. The key is to find a medium between risk and
return; this ensures that you achieve your financial goals while still getting
a good night's rest.
