One of the simplest concepts in finance theory is that of diversification. Diversification involves spreading a valuable asset over a variety of locations or situations such that loss of one part of the asset does not affect the other parts. In competitive capital markets, investors seek to diversify their investment portfolios such that if an unexpected event occurs reducing the value of one security, not all of the investor’s value is at risk.
Diversify to Offset Risk
If would be foolish for an investor to invest all of his money in one security, say in the stock of just one company. Market downturns specifically affecting the market in which the company competes could spell disaster for the investor because his wealth is directly dependent on the performance of one company. Investing in multiple companies within the same industry has a similar effect but is somewhat better because at least the investor is diversified enough to avoid losing all of his wealth if one of the companies falls on bad times.
Diversification has the direct effect of lessening the risk taken on by an investor. Keep in mind, however, that it lowers the risk of the investor; it does not lower the risk of the underlying securities. Risk is a matter of market trends, economic trends, currency trends, and other factors. There is no way that an investor can reduce the risk of securities themselves.
Large companies such as banks have some of the most diversified portfolios in the world. A portfolio is simply the collection of securities that make up the total investment decisions of a person, group, or organization. The more diversified a portfolio, the less total risk is taken on by its owner(s).
The concept of diversification is not limited to portfolios. Organizations diversify by competing in difference market, making unrelated products, and acquiring shares of other companies different from themselves. In addition, they diversify sources of supply, do business outside of their home country, and outsource non-essential operations to other companies. Investors benefit from this diversification because it lowers the risk of owning a part of the organization.
In competitive markets, diversification is not only a good idea, it is necessary to stay competitive. Investors who do not diversify are taking on more risk than is necessary for a given return and have a higher probability of losing everything because of a single event that solely affects the underlying security.
This post is part of the series: Financial Transactions: Principles and Theory
- The Risk/Return Trade-Off Principle
- Offsetting Capital Market Risk through Diversification of Your Portfolio
- The Effects of Information on Capital Market Efficiency
- Financial Markets and the Principle of the Time Value of Money