Diversification

How can you mitigate risk?

Question time: if you put together a portfolio with 2 stocks, each with a volatility of 20%, what’s the average volatility of your portfolio?

Answer: the vol of the portfolio will be lower than 20%. This is because using two stocks brings diversification to the portfolio. Maybe when one is dropping, the other rallies and therefore the mix of the two is less risky than each separately

This is the core of how diversification works. Read more about it here.

What is diversification in portfolio management? (aka not putting all your eggs in one basket)

One of the ways to reduce your exposure to the different risks in the market is by diversifying your portfolio, so that you are not heavily affected by one industry or company. Not only can you diversify your equities by investing in different markets, but you can diversify your entire portfolio by investing in different asset classes. By doing this, you reduce your overall portfolio risk. For example, many investors hold commodities in their portfolios as these assets are hedged against inflation.

For example:

Romain (an equity investor) diversifies his equity portfolio and reduces his overall portfolio risk by investing in technology, tourism and agricultural stocks. Specifically in each industry, he invests in a few companies, rather than one, to reduce his exposure to a single company.

Euri (a macroeconomic investor) diversifies her portfolio and overall risk by investing in different countries. In the case that one country faces negative returns, her portfolio won’t be as heavily affected because she has investments in other countries which have positive returns.

Essentially, by not putting all your eggs in one basket, your wins are able to offset your losses, reducing your overall loss and portfolio risk.