Diversification_(finance)

Diversification in finance involves spreading investments around into many types of investments, including stocks, mutual funds, bonds, and cash. Money can also be diversified into different mutual fund investment strategies, including growth funds, balanced funds, index funds, small cap, large cap, and sector-specific funds. Geographic diversification involves a mixture of domestic and international investments.

Diversification reduces the risk of a portfolio. It does not necessarily reduce the returns. This is why diversification is referred to as the only free lunch in finance.^{[citation needed]}

Diversification can be quantified as the intra-portfolio correlation. This is a statistical measurement from negative one to one that measures the degree to which the various assets in a portfolio can be expected to perform in a similar fashion or not.

Types

Horizontal Diversification

Horizontal diversification is when you diversify between same-type investments. It can be a broad diversification (like investing in several NASDAQ companies) or more narrowed (investing in several stocks of the same branch or sector).

Vertical Diversification

Vertical Diversification is the investment between different types of investment. Again, it can be a very broad diversification, like diversifying between bonds and stocks, or a more narrowed diversification, like diversifying between stocks of different branches.

While horizontal diversification lessens the risk of just investing all-in-one, a vertical diversification goes far beyond that and insures you against market and/or economical changes. Furthermore, the broader the diversification the lesser the risk.

Super-diversification

The highest degree of diversification occurs when institutional asset class funds are used to construct a financial portfolio. The term was first introduced in \'Wealth Without Worry\' by Jim Whiddon and Lance Alston (Brown Books, 2005) who apply the fundamental academic research of Eugene Fama and Professor Kenneth French. See also: diversification, efficient market hypothesis and market portfolio theory.

A super-diversified, asset class portfolio holds somewhere between 10,000 and 12,000 securities through a smaller number of institutional asset class funds. See also: dimensional fund advisors

Return Expectations while Diversifying

The average of all investment-parts will always be below the return of the top-performer-part. In some way, it\'s the price you have to pay for the insurance. However, strategies do exist that allow you to maximize the return by keeping the risk as low as possible. For example, by giving different portfolio weight to investments based on their risk and return expectations. By diversification you are reducing risk associated with portfolio.

In the above graph, the portfolio represented by point A is inefficient because there are other portfolio with the same risk but higher return; also, you can have same return with lesser risk.

Examples

Portfolio balance occurs as the sum of all intra-portfolio correlations approaches negative one. Diversification is thus defined as the intra-portfolio correlation or, more specifically, the weighted average intra-portfolio correlation. Maximum diversification occurs when the intra-portfolio correlation is minimized. Intra-portfolio correlation may be an effective risk management measurement. The computation may be expressed as:

Q = \frac{\sum_{i=1}^n\sum_{j=1}^n X_i X_j P_{ij}}{\sum_{i=1}^n\sum_{j=1}^n X_i X_j}

Where Q is the intra-portfolio correlation, $X\_i$ is the fraction invested in asset i, $X\_j$ is the fraction invested in asset j, $P\_\{ij\}$ is the correlation between assets i and j, and n is the number of different assets.

These figures from Table 1 in M. Statman, "How Many Stocks Make a Diversified Portfolio?" Journal of Financial and Quantitative Analysis 22 (September 1987), pp. 353-64. They were derived from E. J. Elton and M. J. Gruber, "Risk Reduction and Portfolio Size: An Analytic Solution," Journal of Business 50 (October 1977), pp. 415-37. Taken from Ross, Westerfield, and Jordan, "Fundamentals of Corporate Finance" 7th Edition (2006-11-14), pp. 406.

See also

Asset Allocation on Wikibook

• Modern portfolio theory
• Central limit theorem
• Dollar cost averaging
• List of finance topics

References

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