Diversification. What is it?

Diversification is an essential tool to reduce risk in your portfolio.

There are two broad categories of risk related to individual securities (stocks, bonds), systematic and non-systematic risk. The first, systematic risk, refers to the volatility associated with the economy at large, macroeconomic risk, the risk of the market. It is the oscillation of market returns throughout the business cycle. This risk is very difficult to diversify away.

Non-systematic risk or specific risk, however, relates to individual stocks, on the micro or firm level. All facets of the given business could be sources of potential risk: business risk, industry risk, supply chain risk and so on. Non-systematic risk what diversification aims to reduce.

Pooling of non-systematic risks through creating a portfolio multiple stocks and bonds is the key. The principle is that you're not putting all your eggs in one basket.

The theory is that this works by holding a portfolio of low-correlated or negatively correlated assets. Correlation is a statistical measurement that identifies the relationship between two variables (stocks or bonds in this case). The relationship in this case measures the extent to which the returns of two given assets move together. If the two assets move together in lock-step, one-for-one, this represents perfect correlation (+1, positive correlation). Uncorrelated assets have no clear relationship, returns vary in a seemingly random manner. Negative correlation would imply that returns between those two assets more in opposite directions.

Diversification seeks to build a portfolio with uncorrelated and negatively correlated assets, in this case stocks and bonds (two assets classes with that are traditionally and historically uncorrelated). We'll assume a 50-50 split between the two. So, for instance, if the stock market was to lose some steam (returns are negative), bond prices would rise (thus positive return). This would have the effect of softening the losses from equities, providing more consistent levels of returns over the long-run.

So, in summary, to reduce risk and volatility, diversification is key.

Happy Investing,
Michael