Diversification of Investments Meaning, Methods, Importance and Problems

Diversification of Investments
Unit 2 SAPM Notes 
Portfolio analysis and Management

Diversification of Investments Meaning

Diversification: Risks involved in investment and portfolio management can be reduced through a technique called diversification. Diversification is a strategy of investing in a variety of securities in order to lower the risk involved with putting money into few investments. The traditional belief is that diversification means “Not putting all eggs in one basket.” Diversification helps in the reduction of unsystematic risk and promotes the optimization of returns for a given level of risks in portfolio management.

 Diversification may take any of the following forms:

a)       Different Assets e.g. gold, bullion, real estate, government securities etc.

b)      Different Instruments e.g. Shares, Debentures, Bonds, etc.

c)       Different Industries e.g. Textiles, IT, Pharmaceuticals, etc.

d)      Different Companies e.g. new companies, new product company’s etc.

Proper diversification involves two or more companies/industries whose fortunes fluctuate independent of one another or in different directions. One single company/industry is always more risky than two companies/industries. Two company’s in textile industry are more risky than one company in textile and one in IT sector two companies/industries which are similar in nature of demand a market are more risky than two in dissimilar industries.

Some accepted methods of effecting diversification are as follows:

a)       Random Diversification: Randomness is a statistical technique which involves placing of companies in any order and picking them up in random manner. The probability of choosing wrong companies will come down due to randomness and the probability of reducing risk will be more. Some experts have suggested that diversification at random does not bring the expected return results. Diversification should, therefore, be related to industries which are not related to each other.

b)      Optimum Number of Companies: The investor should try to find the optimum number of companies in which to invest the money. If the number of companies is too small, risk cannot be reduced adequately and if the number of companies is too large, there will be diseconomies of scale. More supervision and monitoring will be required and analysis will be more difficult, which will increase the risk again.

c)       Adequate Diversification: An intelligent investor has to choose not only the optimum number of securities but the right kind of securities also. Otherwise, even if there are a large number of companies, the risk may not be reduced adequately if the companies are positively correlated with each other and the market. In such a case, all of them will move in the same direction and many risks will increase instead of being reduced.

d)      Markowitz Diversification: Markowitz theory is also based on diversification. According to this theory, the effect of one security purchase over the effects of the other security purchase is taken into consideration and then the results are evaluated.

Importance of Diversification in Portfolio Management

Diversification of investments is significant due to the following reasons:

1. Reduce the risk: Every stock or financial instrument carries some amount of risk with it except the risk-free investments. With portfolio diversification, one cannot completely remove the risks but can reduce the risk to a great extent. Without proper diversification amongst the different classes of the assets, the risk of investment rises with every investment we make. One needs to include both risky asset classes such as high- return generating stocks and to hedge their risk they should invest in fixed income assets. Diversification gradually reduces the risk of the portfolio over time.

2. Helps In Hedging: If investments are entirely made in stock market, then in case of excessive volatility the return on investments will dropped significantly. However, if they investors kept a certain amount of other investment assets like commodities, bonds, metals in their portfolio, their profits would have been higher because loss or low profits of the stock market would have been wiped off by the positive returns of the commodities market. Diversification helps in achieving desired or better returns even when the market is slow as there are other markets which make up for the negative or low yields of the former market. This way investors can hedge their investments and earn potential returns through portfolio diversification.

3. Provide Higher Returns: Since the market keeps on changing, we need to diversify with asset classes which are not correlated. Correlation plays the most critical role in determining returns. If we are investing in one market which is connected to the other, when the former goes down, that will substantially affect the other. We need to choose investment vehicles which are entirely different from each other. That’s why we need a diversified portfolio.

4. Aligning Portfolio With Financial Aspirations: As per the Behavioural portfolio theory, either our investment will give us the potential for high-growth, or it will protect from negative returns. This theory states that when a portfolio is diversified, it corresponds to a pyramid structure. A properly diversified portfolio has the maximum of low-risk investments and provides value growth and steady income generation. ‘Blend’ funds comprise the top of this pyramid which is a mix of risky and low-risk investment instruments. The regular income generating investments will provide with periodic income, and the blend funds will grow in value, and together they bring stability of investment and higher wealth accumulation.

5. Investment Mix Adjustment: Portfolio diversification allows us to modify investment mix as per changing financial needs and market changes. With age, the investment mix also needs to be changed as the tenure for investments keeps on reducing. While we start off with high-risk investment instruments, with time flowing, we must reduce our risk by shifting more towards fixed income financial instruments for regular earnings. While an investor of 20’s age group can assign 90% of his investment into stocks, investor of 50’s age group must have not more than 40% allocated to equities. That’s why we need a diversified portfolio.

Problems of Diversification

Investment in too many assets may lead to the following problems:

1)      Purchase of bad stocks. While buying stocks at random, sometimes, the investor may purchase certain stocks which will not yield the expected return.

2)      Difficulty in obtaining information. When there are too many securities in a portfolio, it becomes difficult for the portfolio manager to obtain detailed information about their performance. In the absence of information he may not provide right advice as to what to buy and what not to buy.

3)      Increased research cost. Before the purchase of stocks, detailed analysis as to economic and technical performance of individual stock has to be carried out. This requires collecting and processing of information and storing the same. These procedures involve high costs in terms of salaries to be paid to the analysts who are specialized people in this field.

4)      Increased transaction cost. Some cost has to be incurred whenever a stock is to be purchased. Purchasing stocks in small quantities frequently involves higher transaction cost than the purchase of large quantity in one go.