by Christina Pomoni

Created on: September 24, 2007

Diversification leverages investment risk. A diversified portfolio allocates investment risk in different classes of assets offsetting losses from one asset with the gains in another asset of the portfolio. Risk diversification evokes that the risk of the portfolio declines as the number of different assets in the portfolio increases.

Financial assets are classified into:

Stocks
By buying stocks you buy ownership (equity) in a corporation or a share of the company. Stocks are viewed as riskier than all other assets because they are subject to more frequent and sharper fluctuations and market volatility.

Mutual Funds
By buying mutual funds, you buy a portion of a broader portfolio that includes more investments than you could afford to buy individually. It is a pool of money from different individual investors used from the fund to buy stocks. Mutual funds are less risky than all other assets exactly because the fund diversifies its portfolio.

Bonds
Buying a bond is similar to lending money to a government or corporation to raise funds and in return you get a fixed interest rate. Bonds are risky as they are subject to interest fluctuations: the longer the investment horizon the riskier the investment because there are more chances that the market interest rates are higher than the bond fixed interest rate resulting in a portfolio value decline. It is more profitable to invest in short-term bonds as to anticipate the increase of interest rates.

Cash
The rule here is to consider the time value of money. You can certainly invest any amount of money today, but you cannot expect this amount to have the same value when you withdraw it even if the new amount is higher. The reason is because cash is subject to inflation fluctuations. If you invest today $100 at an interest rate of 5%, after one year you will have $105. However, the purchasing power of $105 after one year will not be the same as today as it is subject to inflation rate at that time. Therefore the expected return on your cash investment should always exceed the inflation rates.

The general rules of risk diversification are:
1. Spread your portfolio value among different classes of assets In particular:

2. Do not concentrate on stocks/securities of the same industry: when a stock holding a significant weight in a particular industry declines, the industry follows the downward trend. The decline of one heavy stock causes the industry to decline. Hence, holding stocks across industries minimizes portfolio risk.

3. Do not choose same risk stocks/securities. Different investments with expected rates of return are mole likely to offset the losses of your portfolio

4. Buy on average 10-12 diversified stocks. Statistics show that this diversification level is the optimum provided you follow also steps 2 and 3.

5. Check the Standard Deviation of your diversified portfolio.
For individual assets, standard deviation measures how much the annual return of an individual investment deviates from the expect return. In a diversified portfolio, where more and different assets are included, the aim is to have a portfolio standard deviation lower than the average standard deviation of each individual asset.

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