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: investment principles
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