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different areas. A portfolio of ten different stocks is more diversified than a portfolio of five different stocks. Spreading investment capital over multiple financial markets such as stocks, bonds and futures is another form of portfolio diversification.
INTRODUCTION:Diversified portfolios greatly reduce risk while smoothing investment returns by including many securities across a wide range of industries. This allows investors to participate in a wide variety of investment opportunities while reducing the risk of large losses due to any one security. Diversification is an investment strategy in which you spread your investment dollars among different sectors, industries, and securities within a number of asset classes.A well-diversified stock portfolio, for e ample, might include small-, medium-, and large-cap domestic stocks, stocks in si or more sectors or industries, and international stocks. The goal is to protect the value of your overall portfolio in case a single security or market sector takes a serious down turn. Diversification can help insulate your portfolio against market and management risks without significantly reducing the level of return you want. !ut finding the diversification mi that"s right for your portfolio depends on your age, your assets, your tolerance for risk, and your investment goals. A risk management investment strategy in which a wide variety of investments are mi ed within a portfolio# the rationale is that a portfolio of different investments will, on average, yield higher returns and pose a lower risk than any individual investment within the portfolio. Diversification strives to smooth out unsystematic risk in a portfolio so that the positive performance of some investments will neutrali$e the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not correlated. The main purpose of diversification is to lessen risk. %or e ample, if someone has &' percent of her portfolio invested in ()* stock, she stands to lose a significant percentage of her portfolio value if ()* declines. +owever, if the investor diversifies by investing in other stocks and leaves only , percent of her portfolio in ()*, she will lose a much smaller percentage of portfolio value in the event of a decline.
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REDUCTION OF PORTFOLIO RISK THROUGH DIVERSIFICATION IMPORTANCE OF DIVERSIFICATION:Diversification is not a new concept. -e should remember that investing is an art form, not a knee-.erk reaction, so the time to practice disciplined investing with a diversified portfolio is before diversification becomes a necessity. !y the time an average investor /reacts/ to the market, 0'1 of the damage is done. +ere, more than most places, a good offense is your best defense and in general, a well-diversified portfolio combined with an investment hori$on of three to five years can weather most storms. 1. Spread the Wealth23uities are wonderful, but don"t put all of your investment in one stock or one sector. 4reate your own virtual mutual fund by investing in a handful of companies you know, trust, and perhaps even use in your day-to-day life. People will argue that investing in what you know will leave the average investor too heavily retail-oriented, but knowing a company or using its goods and services can be a healthy and wholesome approach to this sector. 2. Co !"der I de# or $o d F% d!4onsider adding inde funds or fi ed-income funds to the mi . 5nvesting in securities that track various inde es make a wonderful long-term diversification investment for your portfolio. !y adding some fi ed-income solutions, you are further hedging your portfolio against market volatility and uncertainty. &. 'eep $%"ld" (Add to your investments on a regular basis. 6ump-sum investing may be a sucker"s bet. 5f you have 78',''' to invest, use dollar-cost averaging. This approach is used to smooth out the peaks and valleys created by market volatility9 you invest money on a regular basis into a specified portfolio of stocks or funds. ). ' o* Whe to +et O%t!uying and holding and dollar-cost averaging are sound strategies, but .ust because you have your investments on autopilot does not mean you should ignore the forces at work. Stay current with your investment and remain in tune with overall market conditions. :now what is happening to the companies you invest in. ,. 'eep a Wat-h.%l E/e o Co00"!!"o !5f you are not the trading type, understand what you are getting for the fees you are paying. Some firms charge a monthly fee, while others charge transactional fees. !e cogni$ant of what you are paying and what you are getting for it. ;emember, the cheapest choice is not always the best.
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REDUCTION OF PORTFOLIO RISK THROUGH DIVERSIFICATION NEEDS OF T1E DIVERSIFICATION:The portfolio should be spread among many different investment vehicles such as cash, stocks, bonds, mutual funds, and perhaps even some real estate. The securities should vary in risk. )ou"re not restricted to picking only blue chip stocks. 5n fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains offset losses in other areas. :eep in mind that this doesn"t mean that you need to .ump into high-risk investments such as penny stocks. The securities should vary by industry, minimi$ing unsystematic risk to small groups of companies. Another 3uestion people always ask is how many stocks they should buy to reduce the risk of their portfolio. The portfolio theory tells us that after 8'-8& diversified stocks, you are very close to optimal diversification. This doesn"t mean buying 8& internet or tech stocks will give you optimal diversification. 5nstead, you need to buy stocks of different si$es and from various industries. 5f we invest in a single security, our return will depend solely on that security# if that security flops, our entire return will be severely affected. 4learly, held by itself, the single security is highly risky. 5f we add nine other unrelated securities to that single security portfolio, the possible outcome changes < if that security flops, our entire return won=t be as badly hurt. !y diversifying our investments, we can substantially reduce the risk of the single security. Diversification substantially reduces the risk with little impact on potential returns. The key involves investing in categories or securities that are dissimilar. Diversification of investment means selecting multiple asset classes or investing in the different asset categories. 5t is a popular techni3ue employed by most investors to lower risk and increase the chances of good returns. >nfolding your investment in different areas develops a risk-proof portfolio, which means if one investment fails, another will balance it out. Diversified portfolio has certain built-in risks. %or e ample, stocks could be fickle in the short term. 2ven though you have carefully diversified your portfolio, there is always a percent chance of investors undergoing losses due to emergency conditions. Some of these factors include commodities meltdown, global financial crises, socio-political condition and others.
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REDUCTION OF PORTFOLIO RISK THROUGH DIVERSIFICATION PRINCIP3ES OF DIVERSIFICATION:5t has been said that diversification is the secret sauce of asset allocation. Diversification seems so obvious and so easyBCDont put all your eggs in one basket.C 5nvestment professionals suggest that you invest in a portfolio of non-correlated assets, which in simple terms refers to securities that generally do not change in price and direction at the same time. The idea here is that owning a portfolio of non-correlated assets allows an investor to reduce volatility and achieve better long-term risk-ad.usted performance. 5n the first two segments of this series on asset allocation we established that constructing the optimum portfolio depends on measuring risk, forecasting returns and calculating correlation. -e e plained the importance of replacing normal distributions with non-normal distributions in an effort to better understand the probability and severity of e treme events. -e also discussed how ?A;4+ analysis can improve an investment forecasting model the way Doppler radar improves weather forecasting, as it places more emphasis on recent data and takes into account the way in which the data has been changing. Diversity is a pretty general concept meaning simply a lack of similarity. -hen we want to speak technically with more precise language we use the statistical terms correlation and dependence, which describe and measure similarity. 4orrelation describes how pairs of securities act in relationship to each other over some period of time# if you can predict the change in one based on the change in the other, you have demonstrated dependence. As investors, we know that owning a portfolio of highly correlated assets does little to cushion the impact of down markets and we are told by our investment advisors that that owning non-correlated or negatively correlated assets will protect us from market crashes and dampen our losses in bear markets. Dne problem with correlation is the stubborn unwillingness of securities to remain at a fi ed level of correlation over time. 5n fact, the daily noise reflects real variations in behavior. )ou will often see negatively correlated securities become highly positively correlated, especially during market crashes and ma.or market rebounds. Seasoned professionals often remark, EThe only thing that goes up in a down market is correlation! 5n other words, the common pitfall of using correlation to do portfolio optimi$ation is assuming that correlation is fi ed and can be determined from long-term averages. @ust as we pointed out in the discussion of risk and return forecasting, the long-term average value is 3uite often not indicative of future results.
ADVANTA+ESThe advantage of diversification is that it broadens your e posure to market swings. The principle is that one sector Gor stockH may devalue, but not all sectors will devalue. 5n the long term, most sectors tend to e perience growth, so the total portfolio value of a diversified account should gradually grow. A diversified portfolio works by investing in different areas of industries where one industry cannot affect another industry should it have minimal to negative market activity. -ith diversification, investors lower the risk value of their assets and portfolio. Aost diversified portfolios work well with long-term investors to outlast economic storms. 1.A!!et Cho"-e!-hen your holdings are widely diversified, you can spread them out over widely divergent forms of assets, including securities such as stocks and bonds, commodities such as oil and minerals, real estate and cash. 2ach of these assets e hibits different strengths and weaknesses in terms of risk and profitability. Aaintaining holdings in all of these areas helps to create a stable portfolio that will increase in value over the long term. 2.3o*er Ma" te a -e5nvestments re3uire a certain amount of care and attention to keep them performing well. 5f you are playing high-stakes games with your assets and moving them around through risky ventures, you will probably be spending a fair amount of time watching the markets and dodging financial bullets. A diversified portfolio is less e citing and more stable. Dnce you have your investments settled into a wide variety of stocks and securities, they can remain there for e tended periods without re3uiring a lot of maintenance. This frees up your time to pursue other matters and reduces the market stress that may lead to burnout.
&.R"!4Portfolio diversification tends to reduce your long-term risk. Anytime you hold an investment, you risk losing its value. %or e ample, if you purchase a share of stock for 7,' and end up selling
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-hile investing might seem like one of those ho-hum chores, it"s not. 5n fact, your future, at least a financially secure one, depends largely on sound investing. A diversified mi of stock positions serves as the cornerstone of many successful investment portfolios. Step 1!uy various types of stocks. As @eremy ?laser of Aorningstar indicates in relation to your overall portfolio, it"s not about 3uantity, it"s about how your investments play against one another. The same goes for the stock portion of your holdings. Select stocks from different sectors and of different si$es that might perform differently during a market downturn, for e ample. %or instance, although individual specifics vary, you might be on the road to diversification if you hold a few technology growth stocks such as Apple, a few staples like Proctor Mamp# ?amble and AcDonalds, a couple small company stocks, a couple stocks from banking and real estate, a couple traditionally /safe/ stocks such as utility stocks and a few international plays. Step 2Try to emulate the makeup of ma.or stock market inde es, namely the SMamp#P ,''. %or instance, check out the how the Standard Mamp# Poor"s weights the SMamp#P ,'' by sector and by company si$e. Attempt to hold a number of stocks from each sector that correlates to how Standard Mamp# Poor"s divvies things up. Step &!uy mutual funds. 5f your head spins trying to find and track tens or hundreds of stocks from various sectors and of several si$es, leave it up to somebody else. And this does not necessarily mean a financial advisor. )ou can purchase mutual funds that provide diversification. %or e ample, stakes in an international or emerging markets fund, a large cap stock fund, a small cap stock fund, a fund focused entirely on growth stocks, a conservative value or balanced fund and an inde fund that tracks the Sample ,'' offer fantastic diversification minus the allocation of time and resources you might not have.
Diversification is a techni3ue that reduces risk by allocating investments among various financial instruments, industries and other categories. 5t aims to ma imi$e return by investing in different areas that would each react differently to the same event. Aost investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimi$ing risk. +ere, we look at why this is true, and how to accomplish diversification in your portfolio. 2fficient financial management combines safety of principal, alongside opportunities for growth. Diversified investment portfolios are designed to neutrali$e economic volatility and provide for steady returns amidst numerous economic scenarios. Still, all financial transactions carry distinct risks. 1.Ide t"."-at"o Diversification relates to asset allocation strategy that combines varying levels of stocks, bonds and cash within one investment portfolio. 4ommodities, real estate and derivatives are alternative investments that increase diversification. 2.$e e."t!Diversification is intended to manage the wild fluctuations in price associated with the stock market and individual investments. %urthermore, diversification allows for higher returns over inflation than certificates of deposit and bonds. &.Co !"derat"o !Proper diversification strategies are dynamic, and vary according to your personal risk tolerance and time frame towards particular goals. %or e ample, savers approaching retirement will favor portfolios that feature larger proportions of bonds. 4onversely, young savers prefer to invest for growth---with higher weightings for stocks. ).M"!-o -ept"o !Simply owning several different stocks and bonds does not e3uate to perfect diversification. 5nvestments should cover multiple industries and geography, so that different portions of the portfolio are profitable at each point during the economic cycle. ,.R"!4!Diversification cannot counter systemic risk. Systemic risk describes the collapse of the entire financial system.
S/!te0at"- R"!4 - Systematic risk influences a large number of assets. A significant political event, for e ample, could affect several of the assets in your portfolio. 5t is virtually impossible to protect yourself against this type of risk.
U !/!te0at"- R"!4 - >nsystematic risk is sometimes referred to as /specific risk/. This kind of risk affects a very small number of assets. An e ample is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect yourself from unsystematic risk.
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Cred"t or De.a%lt R"!4 - 4redit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. ?overnment bonds, especially those issued by the federal government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates.
Co% tr/ R"!4 - 4ountry risk refers to the risk that a country won"t be able to honor its financial commitments. -hen a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. 4ountry risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.
Fore"( -E#-ha (e R"!4 - -hen investing in foreign countries you must consider the fact that currency e change rates can change the price of the asset as well. %oreigne change risk applies to all financial instruments that are in a currency other than your domestic currency. As an e ample, if you are a resident of America and invest in some 4anadian stock in 4anadian dollars, even if the share value appreciates, you may lose money if the 4anadian dollar depreciates in relation to the American dollar.
I tere!t Rate R"!4 - 5nterest rate risk is the risk that an investment"s value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks.
Pol"t"-al R"!4 - Political risk represents the financial risk that a country"s government will suddenly change its policies. This is a ma.or reason why developing countries lack foreign investment.
Mar4et R"!4 - This is the most familiar of all risks. Also referred to as volatility, market risk is the the day-to-day fluctuations in a stock"s price. Aarket risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain
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&. The Port.ol"o R"!4-Re*ard Tradeo..The risk-return tradeoff could easily be called the iron stomach test. Deciding what amount of risk you can take on is one of the most important investment decision you will make. The risk-return tradeoff is the balance an investor must decide on between the desire for the lowest possible risk for the highest possible returns. ;emember to keep in mind that low levels of uncertainty Glow riskH are associated with low potential returns and high levels of uncertainty Ghigh riskH are associated with high potential returns. The risk-free rate of return is usually signified by the 3uoted yield of />.S. ?overnment Securities/ because the government very rarely defaults on loans. 6et"s suppose that the risk-free rate is currently O1. Therefore, for virtually no risk, an investor can earn O1 per year on his or her money.
!ut who wants O1 when inde funds are averaging 8&-8K.,1 per yearF ;emember that inde funds don"t return 8K.,1 every year, instead they return -,1 one year and &,1 the ne t and so on. 5n other words, in order to receive this higher return, investors much also take on considerably more risk. The following chart shows an e ample of the riskPreturn tradeoff for investing. A higher standard deviation means a higher risk9
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). D"2er!"./" ( The Port.ol"o To Red%-e The R"!4-ith the stock markets bouncing up and down ,1 every week, individual investors clearly need a safety net. Diversification can work this way and can prevent your entire portfolio from losing value. Diversifying your portfolio may not be the se iest of investment topics. Still, most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping you reach your long-range financial goals while minimi$ing your risk. :eep in mind, however that no matter how much diversification you do, it can never reduce risk down to $ero. ,. Port.ol"o R"!4Different individuals will have different tolerances for risk. Tolerance is not static, it will change as your life does. As you grow older tolerance will usually shrink as more and more obligations come up, including retirement. There are several different types of risks involved in financial transactions. 5 hope we"ve helped shed some light on these risks. Achieving the right balance between risk and return will ensure that you achieve your financial goals while allowing you to get a good night"s rest.
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REDUCTION OF PORTFOLIO RISK THROUGH DIVERSIFICATION CORRE3ATION DIVERSIFICATION REDUCES PORTFO3IO RIS':Diversifying across growth or value styles, market capitali$ations, regions or countries does not necessarily provide risk protection against the components of your portfolio moving up or down at the same time or to the same degree. Diversifying by correlation does help prevent all your portfolio components from marching in unison. 4orrelation is a statistical measure of how two securities move in relation to each other. 4orrelation is e pressed by numbers ranging from -8 to Q8. Perfect negative correlation means the two securities move lockstep in opposite directions. Perfect positive correlation means the two securities move lockstep in the same direction. *ero correlation means the two securities move randomly with respect to each other. -atching the portfolio soldiers marching shoulder-to-shoulder in an up market is a lovely thing, but that sets you up for them to march together in a down market B and that=s an ugly thing. Portfolios diversified as to correlation generally don=t go up as fast or far as non-diversified portfolios and they generally don=t go down as fast or far either. The chart below shows the correlation between the broad >S stock market and the growth and value styles for the whole market, for large-cap stock and for small-cap stocks R no hiding places there.
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The ne t chart shows that little in the way of correlation diversification is available by spreading assets between domestic and foreign stocks, whether in developed or emerging markets. 5t does show that bonds provide diversification through negative correlation.
The chart e presses the correlation of each 2T% to the broad >S stock market as represented by the ;ussell I''' through its pro y 2T%, 5-N. The other 2T%s are9 S G2%AH B AS45 2A%2 G2urope, Australasia, %ar 2astH S G22AH B AS45 2merging Aarkets S GA??H B 6ehman Aggregate !ond 5nde S G52%H B 6ehman T-8' )ear Treasury !onds
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REDUCTION OF PORTFOLIO RISK THROUGH DIVERSIFICATION SOME PRO$3EMS WIT1 PORTFO3IO DIVERSIFICATION:Simply put, diversification is not putting all your eggs in one basket# it is spreading your assets across multiple investment vehicles to reduce risk while trying to ma imi$e return. The term diversification is used interchangeably with asset allocation, although asset allocation pertains to having various classes of assets in your portfolio Gstocks, bonds, commoditiesH, while diversification refers to having several securities within the same class, such as several stocks in a stock portfolio. Portfolio diversification is supposed to protect you on the downside, but as the &''T-&''0 bear market demonstrated, it does not, with many diversified portfolios losing ,' percent or more. There are several problems with diversification as it is practiced in &'8'. 1.Part"al Prote-t"o Diversification provides partial protection against non-systemic risks. %or e ample, any stock you buy can go down to $ero at any time for any reason, but if you buy two stocks, you reduce your risk by ,' percent while your return may remain the same or even improve Gif the second stock does betterH. )our risks are further reduced when you increase your portfolio to five stocks, but after about &' stocks, your risk and return approach the market, meaning your portfolio will mirror the market on both the downside and the upside. 2.O2er-d"2er!"."-at"o !asic assets allocation calls for your portfolio to hold several classes of assets with limited correlation, i.e., assets that do not move in the same direction--for e ample, stocks, bonds and commodities. 2ven if each of those assets is risky, the assets" non-correlated moves can make your portfolio more stable overall. !ut many investors go beyond that and diversify within each class of assets for /further protection./ %or e ample, they can hold government bonds, corporate bonds, short-term bonds, intermediate term bonds and foreign bonds, which provides little protection, because when interest rates rise, all bonds decline. &.$elo* Mar4et Ret%r !5f you spread your assets across every conceivable asset class and fund, you effectively invest in the market as a whole, so your return is going to be the market return minus management fees and e penses.
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REDUCTION OF PORTFOLIO RISK THROUGH DIVERSIFICATION MEASURIN+ PORTFO3IO DIVERSIFICATION:5n the market place, diversification reduces risk and provides protection against e treme events by ensuring that one is not overly e posed to individual occurrences. -e argue that diversification is best measured by characteristics of the combined portfolio of assets and introduce a measure based on the information entropy of the probability distribution for the final portfolio asset value. %or ?aussian assets the measure is a logarithmic function of the variance and combining independent ?aussian assets of e3ual variance adds an amount to the diversification. The advantages of this measure include that it naturally e tends to any type of distribution and that it takes all moments into account. %urthermore, it can be used in cases of undefined weights G$ero-cost assetsH or moments. -e present e amples which apply this measure to derivative overlays.
8. They are not a function of the allocation to the additional investment. &. The sum of the diversification benefit and the return benefit e3uals the overall benefit. I. The return benefit always e3uals the difference between the e pected return of the additional investment and that of the e isting portfolio, which makes common sense. K. All benefits, including the diversification benefit, are measured in return terms. Since these are e pected returns, they are meaningful only when a risk reference is provided. G5ndeed, all benefits are e pressed at the risk level of the e isting portfolio.H ,. And lastly, when an infinitesimal amount of the additional investment is included in the e isting portfolio, the marginal benefits can be calculated per unit of allocation, making it possible to compare the benefits across investments in a consistent fashion.
!efore moving any money into stocks or bonds, however, @uan would want to set aside three to si months= worth of living e penses in an emergency cash fund, outside of his K'8GkH, .ust in case he should lose his .ob, have serious health issues, or become sub.ect to some other unforeseen crisis.
CONC3USION:%or asset investments, diversification is an effective tool in reducing the risk of investments in stocks, bonds, and other securities. >tili$ing the correlation structure among the assets,
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$I$3IO+RAP1=:-
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