by Dorian Wales

Created on: September 12, 2007

Investment Basics Diversification as a Tool to Minimize Risk

Think about betting 10,000$ on one coin toss with the possibility of winning 25,000$ and loosing everything. Now think about betting 1$ on each of 10,000 coin tosses with the possibility of wining 2.5$ and loosing 1$ each time. That is diversification in a nutshell. While participating in both bets yield, on average, the same gain (7,500$) the second bet seems much more inviting. The appeal of the second bet is due to the fact each one of the 10,000 bets is a small version of the large one thus reducing risk of losing everything in one big bet.

Risks of Financial Assets

Same principal goes for investing in financial assets. Each financial asset has a risk factor that should be taken into account. If simplified each financial asset yields a certain return with certain odds. Think of biotech company which has a chance of 1/100 of succeeding and yielding 100,000% return on investment and 99/100 chance of loosing the initial investment. This is a risky investment although profitable on average. The problem is getting to that average.

Financial Risk as Variability

As demonstrated above a financial asset's risk is influenced by the variability attributed to the various return on investment scenarios this financial asset is thought to have. Ranking financial assets by risk is usually done as follows: Derivatives will be ranked highest, growth and small company stocks next (high possible return and a considerable chance of failure), blue-chip company stocks, company bonds, government bonds and last a bank deposit where the outcome of the investment is almost 100% certain.

A Diversified Portfolio

Simply put, a diversified portfolio is a portfolio which has many "bets", each with a relatively low investment when compared to the sum of the portfolio. The risk level of the entire portfolio can still be high (all stock for example) but a diversified risky portfolio is, of course, better then having just a risky portfolio.

How to Achieve Diversification

Diversification can be and should be achieved across various variables as each variable has its own specific risks. Specific risk, in finance, is the variability in the return on a security due to exposure to risks relating to that security in isolation (bankruptcy of a certain company for example). Good diversification eliminates specific risks. Each variable of investment carries its own specific risk and should be diversified. By variables I'm referring to:

1) Industry

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