Diversification
"It eliminates risk without reducing returns"
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Diversification
"It eliminates risk without reducing returns" |
|
Returns
|
Year |
Stock M |
Stock W |
Portfolio MW |
|
1 |
29 % |
-9 % |
10 % |
|
2 |
26 % |
-6 % |
10 % |
|
3 |
- 12 % |
32 % |
10 % |
|
4 |
- 7 % |
27 % |
10 % |
|
5 |
37 % |
-17 % |
10 % |
|
6 |
-13 % |
33 % |
10 % |
|
Return (Ave) |
10 % |
10 % |
10 % |
|
Risk (Std Dev) |
23 % |
23 % |
0 % |
|
The letters M and W were chosen because they are opposite. It shows one stock which rises when the other falls. Combining them to form portfolio MW reduces the standard deviation. It falls from 23 % to 0 %. Importantly, average returns remain unchanged at 10 %. It means that risk has been reduced with no loss of returns. This result is sometimes called "The magic of diversification". |
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Advanced Knowledge:
1) In actual practice, it is hard to find stocks like M and W which move exactly opposite one another. Therefore, a 70 or 80 per cent risk reduction is more common and easier to achieve than a 100 per cent reduction.
2) A little diversification goes a long ways. There is no need to buy a fund with hundreds of stocks. You can eliminate 90 per cent of financial risk with just 15 to 20 shares.
3) Another risk – systematic risk – cannot be eliminated by diversification because it affects all companies. An example is the risk of a worldwide recession.
But even this rather stubborn risk can be reduced. How? Simply hold your investments for a long time, like 10 to 20 years. (No recession lasts forever.)
4) Should you extend your diversification to other countries and currencies? Unless you are super-rich, there is no need to do this. It makes more sense to keep your money in your home country since that is where you spend it.
Besides that, our local shares are well-diversified since most Singapore companies already have extensive overseas holdings.
5) For most of us, our biggest asset is our earning potential. It equals all the wages we will earn in our lifetime. Economists call it human capital.
Unfortunately, there is only one you, so reducing your risks by diversifying your human capital is not possible. The same goes for a spouse. You have only one and it is probably best to not even think about diversification. (Ha, ha.)
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