What is diversification and how does it work?

In a recent post I sad that understanding the concept of risk was fundamental to understanding much of the assumptions that we make about other concepts in finance.  Today I will be discussing diversification - understanding what risk means in a financial theory perspective is important to this so I would read the old post first and come back to this post.

Overview

Intuitively most of us understand diversification - at the simplest of levels it is spreading your bets so that no one adverse event can negatively affect your outcomes.  Intuition, however, only takes us so far.  Using the definition I just gave of diversification it would suggest that this necessarily means that your potential gain from your bet is lower.

However in a financial sense this is not completely true of diversification.  In an investment sense diversification is defined as:

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.

The above definition is one given on Investopedia, and whilst I have posted before on how you can never completely trust what Investopedia says - in this case they had the most concise, correct definition of diversification that I could find.

What are the key parts in that definition?

1. Diversification will result in a higher yield AND lower risk than any individual investment in the portfolio
2. This is only true if the returns are not perfectly correlated

Why is the definition of risk so important to understanding diversification?

If you read the above definition without truly understanding risk, in a financial sense, diversification sounds like the best thing since sliced bread.  You get higher returns and lower risk - what could anyone else possible ask for?

However if you read my post on risk you will have noticed that the problem with the financial definition of risk is that it defines risk as a deviation from the expected outcome.  This means that an investment is risky even in the unlikely scenario that all the risk is on the upside.  In this case we are not separating positive risk and negative risk.

Once we think about that we see that while diversification reduces risk, it is also reducing the positive risk in a portfolio.  That is, it is reducing the risk that your portfolio will significantly outperform what is expected.

Does this mean that the definition of diversification is wrong or bad?

No - diversification is still an important downside risk management tool.  If you go back to the intuitive definition of diversification which is that of spreading your bets so that any one adverse event doesn't overly impact your outcome then we see that diversification does this however it is not the holy grail that many make it out to be.

The intuitive definition actually falls squarely within the second important component of diversification - around that of non perfect correlation.  Most assets are not perfectly correlated (i.e. move together either upwards and downwards) however many are influenced by the same factors.  For example

• All property valuations in a certain location will be impacted by certain events such as interest rates, availability of debt even though the individual investment propositions may be quite different
• All airline stocks will be impacted by terrorist attacks or diseases or civil unrest overseas even though the

You do not need the stocks to be uncorrelated (i.e. not move with each other at all) or negatively correlated (i.e. one goes up when the other goes down) for your risk to be mitigated.  All that you require is that they do not move together perfectly and you get the 'spreading the bets' benefit I have described above.

Final comments

Many who are reading this who understand finance and diversification more intimately may want to point out that I have missed several points and nuances in this post.  I do not intend this to be a complete dissertation or critique on diversification - I just want those readers who hear the concepts to know what it means and some ways in which it is flawed (and also where they are correct).

If you feel I am fundamentally wrong though in any way (or would like more information) please feel free to comment below

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