Diversification

In general, diversification can reduce risk without negatively impacting expected returns.

Did your grandmother ever warn you not to put all your eggs in one basket? Did you know what she was talking about? The implication is obvious. If you put all your eggs in one basket, and that basket breaks, you are stuck with nothing to fry up into an omelet.

Grandma was not telling you to grow up and be an omelet chef; she was giving you some sage advice that applies to your future as a portfolio manager. We have talked about diversification previously, and this section will follow from that. Remember, we discussed every investment with an expected return and a variance.

If you manage a pool of assets, you want to get positive returns without being in danger of "losing your shirt." The probability that one stock goes belly up is much higher than the probability that the whole stock market goes belly up. In finance, systematic risk is associated with risk that can be diversified away by investing in a broader pool of assets.

Diversification relies on the lack of a tight positive relationship among the assets' returns and works even when correlations are near zero or somewhat positive. On the flip side, hedging is a tactic that relies on negative correlations among assets.

Diversification comes with a cost, and some might point out that it is possible to over-diversify. The idea is that you can only diversify away so much risk that the marginal returns on each new asset are decreasing, and each transaction has a cost in terms of a transaction fee and research costs. At some point, it just isn't worth it anymore. The risk that can be diversified away is called "unsystematic risk" or "diversifiable risk."

Some investors like to call themselves fans of active or passive management. In fact, two of the biggest mutual fund managers–Fidelity and Vanguard–take opposite stances on this issue and use it as a selling point to customers. Proponents of passive management say the market knows best, and they seek a portfolio that has an underlying pool that mimics a benchmark index (think S&P 500).

The other guys–active managers–believe that their fundamental analysis yields them a competitive advantage. They might decide Microsoft's stock is underpriced based on changing demographics to the labor supply in Seattle, or they might decide that political stability has improved emerging markets in Sub-Saharan Africa. Still, the yield on their bonds hasn't considered that. This debate is all held on the margins. Research has shown that there is a clear advantage in any portfolio to hold at least 30 different positions.

An Empirical Example Relating Diversification to Risk Reduction

In 1977, Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3,290 securities available for possible inclusion in a portfolio and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset for various values of n.

Their results are summarized in the following table. It can be seen that most of the gains from diversification come for n≤30.

Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-risk-and-return-8/diversification-81/index.html
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