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 portfolio
Personal Financial Planning
- Most Individual Investors Are Poor Personal Portfolio Managers (Most individual investors are poor investment portfolio managers
Investors more easily understand investment costs that are directly measurable, such as fees deducted on investment statements. However, many investors ignore or are unaware of the “opportunity costs” of their sub-optimal investment behaviors. Opportunity costs are usually much more difficult to measure directly, but these investment costs can [...])
- Avoiding Financial Advisor Frauds and Scams – Part 1 (
Part 1 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 adviser selection, contracts, signatures, and ownership title of your assets.
You should never do certain things with [...])
- 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 [...])
- 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 [...])
- Two Examples of the Tax Assets Graphic in VeriPlan (Two examples of the Tax Assets graphic in VeriPlan
TAX ASSETS: Taxable and Tax-Advantaged Financial Assets (real $/yr)
Below are two examples of the blue-tabbed TAX ASSETS graphic, which come from VeriPlan's "Sue and Sam Saver" tutorial. This graphic separates their cash, bond, and stock assets by account taxability throughout their lifetime projections. Assets are separated [...])
- Risk-Free Investment Money Is Fantasy Money (
For Individual Investors Risk-Free Investment Money Is Fantasy Money
Securities with low investment risk and high investment returns are just fantasies.
No "risk-free" investment money is consistently and reliably available to individuals. Luck dominates skill in the securities markets. Clever investment selection is vastly over-hyped, and only the promoters tend to benefit. On average over long periods, [...])
- Publish your blog news articles on traditional media center and newspaper websites (
An easy way to publish and syndicate your best news articles on some of the big news and media websites
Web content is more plentiful that grains of sand on the beach. However, really good and newsworthy web content is much more scarce. The cyberspace audience is discerning, but it takes time to attract them, and [...])
- Nationwide S&P 500 Index Fund – Class A Shares (GRMAX) fetch 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 [...])
- Avoid Very Large Actively Managed Mutual Funds (
Avoid very large actively managed mutual funds
Big actively managed mutual fund portfolio positions and higher percentage ownership of any company’s bonds or common stock are not good things for actively managed mutual funds. Nor, are these big positions and high percentages good for you.
Large portfolio size constrains how efficiently an actively managed mutual fund can [...])
- Understand Your Lifetime Personal Savings Requirements (VeriPlan helps you to understand your lifetime personal savings requirements and whether your current savings rate is sufficient
How much you earn, spend, and save are by far the most dominant determinants of your long-term financial well-being.
You need a means to evaluate your current sustainable lifecycle consumption rate. VeriPlan provides such a means. VeriPlan projects your [...])
- How Investment Securities Are Valued – Snapshots in Time (
Snapshots in time - How investment securities are valued
Every securities market transaction requires a buyer and seller with differing viewpoints.
Markets can operate, because there are differences between investors in their assessments of the intrinsic value and risk of securities.
Current investment values vary in the eyes of the many beholders of investment market securities. Knowledgeable participants [...])
- 10 Personal Financial and Investment Planning Steps in the Right Direction (Increase your knowledge and accelerate your ability to take leadership in the management of your own personal finances and lifetime investing.
This ten-step personal financial planning process will help you optimize the management of your financial planning and investment management affairs over your lifetime, while greatly reducing the unnecessary waste of your money and your time.
- Schwab S&P 500 Index Fund – Select Shares (SWPIX) achieve a +8 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 [...])
- Part 3 of the Never-Do List – What Not to Do with a Financial Advisor (
Part 3 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 unsolicited advice, sales pressure, and account decision-making discretion.
You should never do certain things with a financial [...])
- 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 [...])