Why Diversification Is Important In Investing

Diversification reduces portfolio volatility and can possibly boost returns.

What is Diversification?

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. Most investment professionals agree that although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. 

Diversification simply means not putting all your eggs in one basket. Some investment gurus believe in the power of diversification.

Warren Buffett believes that there should be 5 to 10 stocks in your portfolio provided you are a know-something investor, able to understand business economics and to find sensibly priced companies that possess an important long-term competitive advantage.

Benjamin Graham believes to have 10 to 30 stocks in the portfolio with each company being large, prominent, and conservatively financed.

Seth Klarman recommended having 10 to 15 stocks in the portfolio. He believed that it is better to know a lot about a few investments than to know only a little about each of a great many holdings.

​Peter Lynch said, "Owning stocks is like having children don't get involved with more than you can handle."

What are the reasons why investors need to do a diversification strategy?

• For growth in business operations.
• As not all investments perform well at the same time.
• Diversification enables you to have securities whose risk is smaller than individual securities.
• Different types of investment are affected differently by different economic factors.

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Pros of Diversification

• Create a balance as investing in different industries may save an investor from market risk.
• Help to prevent unsystematic risk.
• Better returns or increase in return rate.

Cons of Diversification

• Require new skill or expertise knowledge (if not invested in mutual funds).
• More transaction costs are involved.
• More brokerage commission.

What are the Methods of Diversification?

Random Diversification

There should be some sought of randomness during the selection of companies and industries to invest in as randomness is a statistical technique in which by placing companies in a specific order one can randomly pick them. It may be led to a reduction of risk as a statistical error of choosing the wrong company may reduce.

Markowitz Diversification

Markowitz emphasized on the right amount of securities neither too high nor too low just an appropriate amount. Also, Markowitz wants to reduce unsystematic risk arising out of companies' policies or performance so many risks can be reduced by optimum selection of companies and industries.

Adequate Diversification

It is a traditional approach as it involves many industries or companies. The principle of adequate diversification is to bring the risk to zero by having more securities.

Naive Diversification

It refers to diversification by simply picking stocks at random. This may or may not lead to a reduction in risk to an optimal level. The number of stocks in a portfolio may increase randomly, it is possible to reduce risk up to a point. Diversification only reduces unsystematic risk but naive diversification does not even lead to proper diversification of the portfolio.

International Diversification

This is by investing in more than one nation. By diversifying across nations whose economic cycles are not perfectly correlated, investors can typically reduce the variability of their returns. The easiest and most common way to invest in foreign markets is by purchasing exchange-traded funds (ETFs) or mutual funds that hold a basket of international stocks and bonds.

The usefulness of International Diversification

• Size may widely vary for securities.
• Scope for larger investment larger diversification.
• Returns in foreign currency are more profitable than in domestic currency.
• EPS of the developing country may provide chances for upliftment.
• Chances of risk may reduce and returns may increase.

Risk related to International Investment

• The political factor of the different economy or social development may cause a problem
• The economy and monetary policies of a different nation are risk factors.
• Unforeseen development such as wars, and conflicts.
• The risk of currency fluctuation may also create major risk.​