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How diversification reduces risk

Updated: Apr 17


Article by marco

Author: Marco Murenu

Date of Publication: 28/03/2023




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Investors always say that investment diversification minimizes risk. But why does this happen?


What’s the risk and how is it measured?


risk, variability, variance, standard deviation, portfolio

The risk, in finance, is the probability of yielding less than expected. In reality, it is impossible to completely eliminate the risk. This is because you cannot know the exact outcome of the investment. In fact, the real profit of a single investment (or an investment portfolio), can be greater or lower than expected. In particular, the deviation of actual returns from expected returns is called variability. So, variability in return is often used to quantify risk and is measured by Variance and Standard Deviation (SD).


risk, variability, variance, standard deviation, portfolio

risk, variability, variance, standard deviation, portfolio





As you may have noticed, the standard deviation is nothing more than the square root of variance. Often, we prefer to use the standard deviation as a measure of risk. This is because unlike the variance, it has the same unit of measurement of the observed values.Therefore, calculating these two measures is the first step in assessing risk.


The second step is to interpret the values obtained. Generally speaking, when the SD is high the risk is also high. That’s because the differences between the single returns and the average returns are high. On the contrary, if the differences between the single returns and the average return are low, then the SD value is also low. So, this means that the risk is low.


Diversifying the portfolio to mitigate risk


All investors know that the best strategy to apply is to focus on more assets to invest in rather than on single ones. The set of assets held by a single investor (shares, bonds, etc.) is called an investment portfolio. So, to minimize risk, the portfolio must be properly diversified.


Moreover, building a well-diversified portfolio means dividing it between different financial instruments like stocks and bonds. Also, it means splitting it into different sectors such as energy, automotive and industrial or into countries. In this way, different types of investment are mixed together.


Aim


The aim of the above is to reduce the potential negative impact of each of them. Therefore, diversification offers greater growth potential. This is because the portfolio doesn’t depend on the performance of individual companies, countries or sectors.


For example, if one of the investments goes through a difficult period, the others offset the losses with better performance. So, this reduces the overall risk. Therefore, it’s clear that the lower the correlation among individual investments brings a lower the portfolio risk.



Diversification considerations to reduce risk


In summary, assessing the correlation among investments in the portfolio is crucial. This is because it allows you to understand how one financial asset will move with respect to the other. For example, you can see if it increases, decreases or remains indifferent to the fluctuation of the value of another investment.


Specifically, the correlation can take values between -1 and 1.

  • Correlation = -1. In this case the financial assets move in the opposite direction. For example, if one goes up the other goes down and vice versa.

  • Correlation = +1. It means that if one rises, the other also rises and vice versa.

  • Correlation = 0. A zero correlation indicates that the development of an investment doesn’t influence the development of another investment and vice versa.


Specific risk & Systematic risk


As seen, diversification reduces risk, but isn’t able to completely cancel it. This is due to the fact that the risk can be divided into specific risk and systematic risk. So, the specific risk is related to the individual company on which it is decided to invest and can be reduced through diversification.


On the other hand, systematic risk refers to market risk as a whole and cannot be eliminated by diversification. Indeed, if the market were to collapse, this would have an effect on all companies in every sector. Therefore, in such a case, diversification couldn’t avoid the negative outcome of the investments.




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