In our article Risk versus Return we highlight how every investment has a risk attached. And how the higher the risk, the higher should be the expected return from any investment. This probably then imply that if you want to reduce the risk in your portfolio, the only choice for you is to move your investments into low yielding investments. Right? Wrong.
Diversification across investments is another way to reduce the risk of your portfolio.
To understand how, look at this simple example (it involves some basic statistical concepts but donít get turned off, its simple to understand and you can get into the calculations only if you want) -
Say, there are two assets A and B. Both assets have a potential return of 10% and a standard deviation (a statistical measure which measures the variability (i.e. risk) of the potential returns) of 20%. Also, the returns of both these assets are uncorrelated i.e. the performance of Asset A is not dependent at all on the performance of Asset B.
Now assume you invest equally in both these assets. Your weighted potential return (0.5 * 10% + 0.5 * 10%) will equal 10% - this is the same return as that for the individual assets. However, due to the fact that you have now spread your risk over two uncorrelated assets, the standard deviation (i.e. risk) of your portfolio will be 14.1% (lower than the 20% for each individual asset). Refer to the supporting Statistical Analysis if you want to understand how.
It is important to understand what this means.
You would have been able to reduce the risk profile of youíre the returns on your portfolio to 14.1% (from 20% for an individual asset) without having to compromise on your returns, merely by diversifying. So, by choosing two assets whose returns are not correlated (this is important) like say Stock A which is a pharmaceutical company and Stock B which is a software company, you can reduce your risk while not necessarily having to reduce your returns.
In summary, there are two things that are important to keep in mind while planning your investments -
1. Every asset has a risk attached to it.
And, the higher the risk, the higher should be its expected returns.
2. Donít put all your eggs in one basket.
By diversifying across assets, you can reduce your risk without necessarily having to reduce your returns. You donít have to get into calculating standard deviation of the return of your assets, you need to just be aware that if you diversify your portfolio, your overall portfolio risk will be lower.
To get the maximum benefit of reducing your risk through diversification spread your portfolio across different assets whose returns are not 100% correlated. Different assets should ideally span across different asset classes such as fixed income, equity, real estate, gold as well as different investment options within these asset classes e.g within equity shares, your exposure should be to companies in different sectors; or within fixed income investments, partly government risk and partly corporate risk.
As a thumb rule, diversify your investments across 15-20 different individual assets.