by aC

Created on: November 07, 2008   Last Updated: April 23, 2012

Simply put, diversification is for the "investor" who knows not what he/she is doing. What is the popular phrase you always hear financial advisors or well-intentioned "seasoned" stock brokers say when they promote the virtues of diversification? "Diversification reduces risk!" they say. But how true is that statement?

Whether that statement is true or not depends on the correlation between the stocks in a particular portfolio. Having many stocks that are not correlated to each other reduces risk whereas having numerous stocks that are highly correlated to each other does not reduce risk at all. In fact, the latter increases your exposure to a particular sector. For example, assume you have a portfolio universe of only 2 stocks and the 1st stock being Exxon Mobil, an oil-related stock. If the second stock added to this portfolio is Chevron (another oil-related stock), both will move in tandem with current oil prices, and both will experience a downward price exposure should oil prices drop. In this case, diversification into Chevron stock increases your risk.

On the other hand, if the second stock added to this portfolio is an airline industry stock such as British Airways, your risk exposure actually decreases. Why is that so? This is because the British Airways stock will move in opposite direction with oil prices (Oil price increase leads to increase costs to fly airplanes which eats into the profits of the airlines.) Thus, in the event that oil prices drop, Exxon Mobil stock's price decrease will be counteracted by British Airways stock price increase.

However, it is important to note that even if one fills up his/her entire portfolio with stocks that have zero-correlation to each other, one cannot totally eliminate risk. This is because there is a non-diversifiable systematic risk known as the Beta coefficient. To avoid going into the technicalities of the Beta coefficient, simply define it as type of risk that cannot be reduced through the effects of diversification.

Now that it seems that diversification may not reduce risks and that it will definitely not eliminate risks altogether, what is another drawback of diversification? This is the other side of the coin (to Risk), and that is the Returns of the investment or portfolio. Diversification reduces the Returns of a portfolio.

To illustrate this point, compare the portfolio returns of a Diversified Investor versus that of a Focus Investor (defined as one who puts ALL his eggs into one singular basket).

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