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Concept Version 6
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The Value of Diversification

The compensation adjustment for holding an asset of a given risk profile can be further enhanced through asset diversification.

Learning Objective

  • Explain the rationale for diversification


Key Points

    • Diversification strategies can be as simple as not "placing all your eggs in one basket" or be as complex as routine evaluation of investment correlation and risk and dynamic rebalancing of investment holdings.
    • Whether a common sense or highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance consistency of return. A diversified portfolio will earn a return that is always higher than its lowest performing asset.
    • Most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class.
    • Investors may enter into hedging strategies in order to ensure a constant return over market volatility. For a fee, a hedging strategy offers a constant return on an investment. The party on the other side of the hedge absorbs the volatility of the investment and pays out a consistent return.

Terms

  • asset clas

    A group of economic resources sharing similar characteristics, such as riskiness and return.

  • risk premium

    The minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset

  • prospectus

    A document, distributed to prospective members, investors, buyers, or participants, which describes an institution (such as a university), a publication, or a business and what it has to offer.


Full Text

Each asset class has specific investment objectives; these are typically stated in a prospectus or investment description. However, all investments have some degree of risk in meeting the stated investment objectives or return.

The risks that are inherent to a specific investment can be compensated for by a market-assessed risk premium, whereby market participants adjust the price of an asset, impacting its overall return, based on the risk characteristics of the asset. However, the compensation adjustment for holding an asset of a given risk profile can be further enhanced through asset diversification.

The Value of Diversification

Diversification strategies can be as simple as not "placing all your eggs in one basket. " It can also be as complex as a routine evaluation of investment correlation and risk, and dynamic rebalancing of investment holdings. However, whether a common sense or a highly quantitative approach is taken, the benefit of diversification is to limit risk and enhance consistency of return.

By holding varying investments, even if they are within the same company or sector, an investor still has the benefit of reducing risk inherent from the default of one asset. For example, stock and bonds provide different returns; while a stock may exhibit no growth for a period of time, the bond may continue to pay its coupon and provide a return. Through diversification, an investor's entire portfolio can perform better than its worst-performing asset.

In general, most asset managers would advocate holdings that are diversified across sectors and asset classes to further the benefit of growth and reduce the risk of performance volatility that may be attributable to a company, sector, or asset class . In some cases where the return on investment needs to be met, managers may advocate for the use of hedging instruments to transfer risk of return objectives being met to another party in lieu of a consistent return.

Hedging strategies can be relatively complex but, in general, they serve the role of insuring that an investor is able to meet investment performance objectives. Typically, an investor pays a fee and enters into the hedging strategy, which transfer the risk inherent in an investment for a constant return. The party on the opposite side of the hedge absorbs both the upside and downside return potential of the asset, along with the fee for taking on the risk of uncertainty, and pays the first party a constant return as part of the agreement.

Systematic Risk

It's important to note that diversification does not remove all of the risk from the portfolio. Diversification can reduce the risk of any single asset, but there will still be systematic risk (or undiversifiable risk). Systematic risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market. For example, government policy, international economic forces, or acts of nature can shock the entire market. Systematic risk will affect the portfolio, regardless of how diversified it is.

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