What Is Investment Portfolio Diversification?
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
Personal Financial Planning
- Tax-Advantaged Retirement Investing Is Good for Most People (Tax-advantaged investing is very good for most people at most times
A previous article, “The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient,” suggested that individuals are much better off with a well-considered financial viewpoint. A stable set of financial beliefs can help you [...])
- The Heavy Burden of Recurring Investment Expenses and Fees (
The heavy burden of recurring investment fees (Part 1 of 2)
Recurring investment costs can significantly impact the long-term value of your retained investment portfolio assets.
Recurring fees, such as asset management fees, 12b-1 marketing fees, and advisory/asset custody fees are charged periodically, as a percent of your investment assets. The relative cost-efficiency of your investment portfolio [...])
- Efficient Market Pricing in the Investment Securities Markets (
Efficient market pricing is the theory that all known information is already reflected in current securities prices.
Efficient securities market pricing has become very widely accepted within the investment community. The preponderance of evidence is that securities markets are efficient and tend to reflect available information. Whether you believe markets are efficient is very important to [...])
- Monitor and adjust your financial plan in a time-efficient manner – Step 9 of 10 Financial Planning Steps in the Right Direction (CLICK HERE TO READ THE SKILLED INVESTOR's OTHER ARTICLES ABOUT THESE "10 FINANCIAL PLANNING STEPS IN THE RIGHT DIRECTION
Time in life is the most precious and perishable asset that a person has. It should be spent enjoyably and efficiently. Scientific investment strategies that rely on relatively efficient financial markets allow people to minimize their time [...])
- Part 2 of the Biggest Personal Finance Story of the Past 30 Years (< -- Go to Part 1
The Biggest Personal Finance Story of the Past 30 Years - Part 2
To understand what has happened to the market valuation of the financial services sector, particularly over the last 30 years, you should view Figure 4 on page 16 of the financial study by Jeremy Siegel and Jeremy Schwartz [...])
- The Never Do List – Avoid Financial Advisor Frauds and Scams (
Part 2 of the The Never-Do List - 22 Good Ways to Avoid Financial Advisor and Investment Counselor Frauds and Scams
This article discusses things that you should “never do” with a financial planner or investment advisor, and it covers fees, payments, and proprietary investments.
You should never do certain things with a financial planning or investment [...])
- Screening Index Mutual Funds with IndexUniverse.com (Screening index mutual funds on-line with IndexUniverse.com
In this article, The Skilled Investor discusses how to screen index mutual funds on-line. This article focuses on using the free index mutual fund screener and database available at IndexUniverse.com.
We also discuss how to apply our seven scientifically based mutual fund screening criteria.
In a previous article, The Skilled Investor [...])
- 22 Ways to Avoid Financial Advisor and Investment Counselor Frauds and Scams (Avoiding financial advisor and investment counselor frauds and scams - Overview
The best way to avoid being defrauded or scammed by a financial or investment advisor is to investigate carefully several different advisers before hiring one of them.
If you carefully choose a financial adviser or investment counselor, you have a far greater chance of finding one [...])
- 10 Lower Cost S and P 500 Index Mutual Funds (10 Lower Cost S&P 500 Index Mutual Funds
Regular readers know that The Skilled Investor advocates a very boring, low cost, broad market, passive index investment strategy. Costs less. Gets the broad market return -- whatever that will be. Narrows the range of outcomes and therefore the risk to your long-term personal financial plan. Takes far [...])
- Savings Rates for Renters and Investment Cost Reductions (Pre-retirement savings rates for renters - with and without investment cost improvements
Improving on Fran and Fred's lifetime financial plan through lower investment costs
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 [...])
- Allocate investments across the primary asset classes – Step 5 of 10 Financial Planning Steps in the Right Direction (CLICK HERE TO READ THE SKILLED INVESTOR's OTHER ARTICLES ABOUT THESE "10 FINANCIAL PLANNING STEPS IN THE RIGHT DIRECTION
Appropriately setting your personal investment asset allocation in line with your personal investment risk tolerance is a critical decision for every individual investor.
Because the average risk-averse investor holds the average portfolio asset allocation, this becomes the starting [...])
- 15 Value-Added Individual Investor Activities (Before estimating the investment value that you might add or take away from your portfolio, you first need to determine whether your strategies are or are not likely to lead to optimal risk-adjusted investment returns.
This value estimation is separate from any hourly opportunity cost related to spending time on your investments versus an alternative use [...])
- The Heavy Burden of Recurring Investment Expenses and Fees – Part 2 (
The heavy burden of recurring investment fees (Part 2 of 2)
< < -- Go to Part 1
By charging fees as a percent of your assets, the investment industry can make their recurring fees seem small – like they are “just a few” percent.
Furthermore, by charging fees against your assets the industry can still bill you [...])
- American Funds – The Investment Company of America – Class A Shares (AIVSX) net a +3 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 [...])
- The John Bogle Blog and His Financial Article About ETFs (John C. Bogle's Blog and his article about ETFs
This article is a heads-up to people interested in investment blogs and personal finance blogs.
John C. Bogle, the founder of The Vanguard Group, Inc., has a blog called The Bogle eBlog. (If you are wondering about "eBlog," it is an anagram of Bogle.) Mr. Bogle just posted [...])
Comments are closed.