From the perspective of holding a well-diversified investment portfolio according to scientific investment principles, the objective of diversification is to minimize or eliminate ‘unsystematic risk’ or those risks that are not related to the price volatility of the overall securities markets.
When people speak of investment diversification, they may mean different things. Therefore, clear definitions are important. Unsystematic risk is the risk that relates to company-specific risk factors, such as new or increased competition, labor strikes, faulty management decisions, adverse technological changes, etc.
By holding a very broadly diversified portfolio containing the securities of numerous companies in different economic spheres, the risk in your portfolio can be dramatically reduced. By holding the full market in your portfolio through broad-based index funds, unsystematic risk can be fully eliminated.
Unsystematic risk can be eliminated, because there is not a one-to-one correlation between the opportunities and risk factors that affect each particular firm. To the extent that you hold more than one firm in your portfolio and particularly a very large number of them, then company specific price movements tend to cancel out the securities price fluctuations of other firms. When fully diversified, securities market risk measured by its market price volatility will remain.
When you hold the entire market as your investment portfolio, then you achieve a very significant reduction in the price volatility of your overall personal investment portfolio.
What remains then is only the ‘systematic risk’, or the impact of broader economic, policy, and political risk factors, such as general changes in economic growth, monetary policy, inflation, taxation, wars, exchange rate fluctuations, etc. A well-diversified portfolio is still subject to these systematic risks.
In summary, you diversify to eliminate the company specific risks to your investment portfolio. You also do this, because the market does not compensate you for company specific risk. Equity risk premiums are paid to investors, because they are willing to expose themselves to market risks and not to company specific risk.
Sometimes investors believe that diversification means holding a hodge-podge of mutual funds or exchange-traded funds ( ETF ) with different styles such as growth, value, small cap, balanced, international, emerging markets, etc.
While holding multiple mutual funds of differing styles can contribute significantly to diversification in the investment science sense, the real question is whether this is the most efficient approach after investment costs and taxation are taken into account. Instead, the overall market portfolio is the fully diversified benchmark of investment science, which fully eliminates unsystematic securities investment risk. The full market portfolio is global and includes all investment styles.
Holding broad market indexes through multiple very low-cost, fully passively managed index mutual funds or exchange-traded funds is the individual investor’s point-of-reference for optimal diversification. Investors should evaluate their investment strategy alternatives in the light of always having the choice of buying broadly diversified mutual funds and ETFs with relatively inexpensive trading and very low recurring management fees.
These related articles may also be useful to you:
- Investment securities markets do not pay you for the risks of holding individual common stocks and bonds
- Why is diversification valuable to individual investors?
- What is a well-diversified portfolio?
- Is the average individual investor’s portfolio well diversified?
- Can a limited number of equities provide complete portfolio diversification?
- How many common stocks are needed for a well-diversified portfolio?
- What is the cost to individual investors of sub-optimal portfolio diversification?
- How do changes in common stock price volatility affect diversification?
- How does the size of the common stock risk premium affect diversification?
- How many mutual funds are needed for a well-diversified portfolio? – evidence
- How many mutual funds are needed for a well-diversified portfolio? – a commentary
Tags: diversified investment portfolio
Personal Financial Planning
- The Birth of Yet Another Darn Asset Class – Infrastructure (The Birth of Yet Another Darn "Asset Class" - "Infrastructure"
Recently, The Skilled Investor published two articles:
The first article discussed how the financial industry keeps manufacturing new asset classes for brokers and investment advisors to sell to individual investors. The Skilled Investor raised the question of whether these new asset classes are likely to serve the [...])
- Stay Invested in Securities Markets to Earn Risk Premiums (You must stay invested in the securities markets to earn market return risk premiums
Securities markets pay risk premiums to risk takers
You have to have your money invested and at risk to be paid a risk premium. Attempting to avoid risk or losses by jumping in and out to "time the markets" does not work. Scientific [...])
- Conclusion of the Biggest Personal Finance Story of the Past 30 Years ( < <-- Go to Part 4
The Biggest Personal Finance Story of the Past 30 Years - Conclusion
This article concludes our series on the greatest personal finance story of the past thirty years. In this article, we discuss whether the dramatic growth in equity value of the financial services sector indicates that securities markets are [...])
- Own Investment Mutual Funds and ETFs – Not Individual Securities (Own Investment Mutual Funds and ETFs - Not Individual Securities
Owning individual stock and bond securities is just a big waste of your valuable time and money
Individual investors tend to be terrible investment portfolio managers. Almost everyone can hire an index fund manager to do a much better job for far less time, money, risk, and [...])
- Choose Lower Mutual Fund and ETF Management Fees (Choose mutual funds and ETFs with MUCH LOWER investment management expenses
Investment fund management fees can only be justified by individual investors, if higher net returns more than compensate for these fees. Sadly, this is most often not the case with actively managed equity and bond mutual funds and exchange-traded funds (ETFs). In addition, you have [...])
- Your Valuable Assets Are Simply Your Evolving Estate (
Your investment portfolio and other property assets are simply your evolving estate
A previous financial article, “The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient,” suggested that investors are much better off with a well-considered financial plan. A stable set of financial beliefs can [...])
- American Funds – Income Fund of America – Class A Shares (AMECX) rate a +2 Fund Authority Score (Fund Authority Scores rate mutual funds and exchange traded funds (ETFs) on the most important economic factors that influence individual investors' net long term diversified investment fund performance. The Skilled Investor developed the Fund Authority Score system to provide individual investors with concise and objective summaries of mutual funds and ETFs for comparisons within investment [...])
- Schwab S&P 500 Index Fund – Select Shares (SWPPX) capture the Best +10 Fund Authority Score (
Fund Authority Scores rate mutual funds and exchange traded funds (ETFs) on the most important economic factors that influence individual investors' net long term diversified investment fund performance. The Skilled Investor developed the Fund Authority Score system to provide individual investors with concise, objective, and realistic summaries of mutual funds and ETFs for comparisons within [...])
- The Biggest Personal Finance Story of the Past 30 Years (
The Biggest Personal Finance Story of the Past 30 Years - Part 1
What could the biggest personal finance story of three decades be?
The growth of mutual funds and ETFs? Nope.
The dot com boom and bust? Nope.
Vanishing pensions? Nope.
The not-so-high quality of mortgage bonds? Nope.
A 0% personal savings rate nationally? [...])
- 2006 and 2007 Personal Income Tax Rates for the 50 States and DC (
2006 and 2007 personal income tax rates for the 50 states and D.C.
The Skilled Investor has made available for downloading a spreadsheet that contains graduated personal income tax rates and other personal income tax rate information for the 50 states and the District of Columbia.
If you want to know about specific U.S. state personal graduated [...])
- Understand the Confusing Securities Market Motion Picture (
Securities markets are usually very quick to adjust prices to reflect new information. However, this price adjustment process may take longer and be more volatile, if the new information is ambiguous.
At any point in time, market participants will already have used more or less rigorous valuation methods to judge their expected risk-adjusted value of securities. [...])
- Retirement Savings Needs of Renters Without Financial Planning Improvements (Retirement savings needs of renters prior to any financial planning improvements
Starting to plan with a non-optimal baseline projection
Fran and Fred Frugal, both age 30, are a married working couple with $100,000 in combined annual earned income. They want to understand how valuable different personal finance strategies could be to their lifetime finances and retirement security. [...])
- American Funds – AMCAP Fund – Class A Shares (AMCPX) fetch a +1 Fund Authority Score (The table below in this article presents The Skilled Investor's Fund Authority Score and other information for the American Funds - AMCAP Fund - Class A Shares.
The diversified investment fund strategy of the American Funds - AMCAP Fund - Class A mutual fund shares (AMCPX)
According to its prospectus filing on the U.S. Securities and Exchange [...])
- Vanguard Institutional Index Fund (VINIX) captures the Best +10 Fund Authority Score (The table below in this article presents The Skilled Investor's Fund Authority Score and other information for the Vanguard Institutional Index Fund.
The diversified investment fund strategy of the Vanguard Institutional Index mutual fund (VINIX)
According to its prospectus filing on the U.S. Securities and Exchange Commission EDGAR system, the investment strategy of the Vanguard Institutional Index [...])
- Taking the Snake Oil Out of Mutual Fund Evaluation (Superior mutual fund and ETF performance charts are the sales tools of modern financial snake oil salesmen
Historical performance charts allow investment fund promoters to market selectively their supposedly superior funds and to allege that their excessively high fees are worth it. Lured in by superior past performance, most often individual investors will get mediocre future [...])