What investment diversification and how does it reduce risk?

1. WHAT IS INVESTMENT DIVERSIFICATION AND HOW DOES IT REDUCE RISK?

3. We often hear the phrase “don’t put all your eggs in one basket”, putting all your eggs in one basket is like investing every single penny in one asset and if that asset’s value falls to zero you will lose all your money. In contrast, if you diversify your investment in a few assets, you will still have some value if any one of your asset’s value falls. Investing in different assets is an important concept called diversification.

4. Investment diversification is a range of various assets that give the highest rate of return with minimum loss. It is a set of or mixture stocks fixed income and commodities. The investment diversification always works because there are different types of assets that react differently to market conditions. It lowers the risk because no matter how bad is the economic event some assets will definitely benefit as the assets don’t correlate with each other so if one asset’s value increases then others fall and vice versa. The risk is also reduced because all the asset’s value cannot go down in any single event. Investment diversification is a lifesaver during financial crises.

5. There are two ways of investment diversification:

6. We can invest in multiple asset classes 1.

7. Within each asset class, we can invest in multiple assets 2.

8. Investment diversification does not guarantee any protection against losses but it can definitely reduce overall risk.

9. How does diversification reduce risk? The key is between the asset classes or assets.

10. Let’s understand correlation better with finance example: On a rainy day sales of umbrellas goes up. Therefore the rain and the sale of the umbrella are positively correlated. In finance, A and B are positively correlated their returns move in the same direction. Both assets lose or gain value together. When they are negatively correlated then their returns move in the opposite directions. A loss in one asset can be compensated by the gain in second to a certain extent. Therefore we gain more diversification benefits when assets are negatively correlated.

11. Ideally, we should buy negatively correlated assets or asset classes. For instance, bonds have shown some negative correlation with stocks during certain periods in various markets, however, in practice, it’s hard to find investments that are always negatively correlated. Even bonds have shown a positive correlation with stocks during certain periods and in recent years. The best we can do is diversify our investments across multiple assets or asset classes that are least positively correlated.

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