Diversification refers to the reduction in the overall risk of an investor's portfolio even when it is comprised of a number of highly risky individual investments. The risk in a group of investments may be lower than the risk associated with any individual element in the group. Diversification occurs because there are unique factors associated with individual securities that are not related.
The concept of diversification of risk has a long history as evidenced by the adage "don't put all of your eggs in one basket." The mathematics of diversification were formalized in 1952 by Harry Markowitz (1927-) and influence the practice of portfolio management on its most fundamental level.
The explanation for diversification can be either statistical or economic. From a statistical perspective, the volatility, or variance, of the price changes and cash flows associated with an individual security can be quite high. The actual changes in these amounts, however, will not coincide perfectly for any two securities. More specifically, as the correlation of the returns generated by two securities weakens, the potential for significant diversification of risk increases for an investor holding both.
From an economic perspective, consider the simple example of an investor who buys stock in an airline and an oil company. If fuel prices rise, the oil company's stock will likely perform well and the airline stock will perform poorly (since high fuel prices will reduce airline profits). If fuel prices fall, the fortunes of the two firms are reversed. In this example, the investor's portfolio will likely have lower risk than either of the individual elements because of the distinct response each has to the common factor. More specifically, any security's price is affected by unique factors that are very firm specific (e.g., strikes, departure of key employees, inaccurate forecasts of demand). But price is also affected by broad economic factors that influence all securities in a similar manner (e.g., economic growth, changes in tax code, inflation, new regulations). For example, both the airline and the oil company will thrive in a robust economy. Diversification occurs because an investor holding a large number of securities has essentially neutralized most of the impact of unique risk contributed by each one. The aggregate portfolio will behave more like the entire market since all securities are influenced in a similar manner by common factors. The diversifiable component of an individual security's risk is often referred to as unsystematic while the component that remains is labeled systematic risk.
There are a variety of methods to implement this diversification strategy. Naive diversification refers to the reduction in total risk that takes place when securities are randomly added to a portfolio. Studies have shown that approximately 75 percent of the total risk of a typical U.S. security is unsystematic. A portfolio containing 30 stocks chosen randomly effectively eliminates that risk component. If securities are selected from around the world, this same strategy will eliminate approximately 88 percent of the total risk exhibited by a typical security.
There are, however, more effective methods of diversifying risk. Rather than selecting securities randomly, investors can purposely select securities from different industries, different countries, and at different stages in their growth cycles. By actively identifying sets of securities that have weakly correlated returns, the diversification effect can be accelerated. The ability to perceive and exploit the potential diversification of risk is important because individual securities will not reflect any compensation for bearing their unique, or unsystematic risk. This is because some investors will be able to diversify it away.
The benefits of diversification are clearly delineated. There is, however, also a cost. Investors who diversify sacrifice the potential for very high returns from the individual securities experiencing the most favorable conditions unique to their individual situation. By accepting the benefits of diversification, the investor has also accepted the increased likelihood of a portfolio return closer to the market average.
[ Paul Bolster ]
Evans, John L., and Stephen N. Archer." Diversification and the Reduction of Dispersion: An Empirical Analysis." Journal of Finance, December 1968, 761-67.
Markowitz, Harry. "Portfolio Selection." Journal of Finance, March 1952, 77-91.
Solnik, Bruno. International Investments. 3rd ed. Reading, MA: Addison-Wesley, 1996.