Did your grandmother ever warn you not to put all your eggs in one basket? Did you know what she was talking about? The implication is obvious. If you put all your eggs in one basket, and that basket breaks, you are stuck with nothing to fry up into an omelet. Grandma wasn’t telling you to grow up and be an omelet chef, she was actually giving you some sage advice that applies to your future as a portfolio manager. We have talked about diversification previously, and this section will follow from that.
Remember, we talked about every particular investment having an expected return and a variance. If you are managing a pool of assets, you want to get positive returns without being in danger of “losing your shirt.” The probability that one stock goes belly up is much higher than that the whole stock market does.
Diversification relies on the lack of a tight positive relationship among the assets’ returns, and works even when correlations are near zero or somewhat positive. On the flip-side, hedging is the tactic that relies on negative correlations among assets. Diversification comes with a cost associated with it, and some might point out that it is possible to over-diversify. The idea is that you can only diversify away so much risk, that the marginal returns on each new asset are decreasing, and each transaction has a cost in terms of a transaction fee and also research costs. At some point, it just isn’t worth it anymore. The risk that can be diversified away is called unsystematic risk or diversifiable risk.
Some investors like to call themselves fans of active or passive management. In fact, two of the biggest mutual fund managers, Fidelity and Vanguard, take opposite stances on this issue and use it as a selling point to customers.
Recall that previously we talked about the security market line and the implication that investors require more compensation for extra risk. One might pay the same amount for a safe investment as for an investment carrying more risk; however, the riskier investment will, in theory, provide a higher return. This is the principle behind the security market line.
Diversification is a technique for reducing risk that relies on the lack of a tight positive relationship among the returns of various types of assets. By diversifying a portfolio of assets, an investor loses the chance to experience a return associated with having invested solely in a single asset with the highest return. On the other hand, the investor also avoids experiencing a return associated with having invested solely in the asset with the lowest return — sometimes even becoming a negative return. Thus, the role of diversification is to narrow the range of possible outcomes. As a result, the portion of risk that is unsystematic — or risk that can be diversified away — does not require additional compensation in terms of expected return.
Now, imagine that these 50 corporations are all given a lesser credit rating because of the risk of their overall market segment. In this case, the individual is still at risk to lose some or all of the initial investment.
This type of risk cannot be diversified away, and is referred to as systematic risk. This is the portion of risk that pays the risk premium, because the risk associated with this particular segment of the market is more tightly linked to the risk of the market as a whole. This risk is present regardless of the amount of diversification undertaken by an investor.
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Diversification” TUTORIAL.