Lecture 2: Portfolio Diversification

1. Concept of Diversification and Its Importance in Risk Reduction

• Definition: Diversification is a risk management strategy that involves spreading investments across various assets, sectors, or regions to minimize exposure to any single risk.

• Importance:

  • Reduces the impact of poor performance from a single investment.

  • Balances risk and return by avoiding over-concentration.

  • Based on the principle: "Don’t put all your eggs in one basket."

2. Types of Diversification

a. Asset Class Diversification

• Allocating investments across different asset classes (e.g., stocks, bonds, real estate, commodities, cash).

• Example: Combining equities (high risk/return) with bonds (lower risk/stable income).

b. Diversification Within an Asset Class

• Spreading investments within a single asset category.

• Equities: Diversify across industries (tech, healthcare, energy) or company sizes (large-cap, mid-cap, small-cap).

• Bonds: Mix government bonds (low risk) with corporate bonds (higher risk).

c. Geographic Diversification

• Investing in multiple regions/countries to mitigate country-specific risks (e.g., political instability, currency fluctuations).

• Example: Holding U.S., European, and emerging market assets.

3. Diversification and Risk Reduction: Systematic vs. Unsystematic Risk

• Unsystematic Risk (Idiosyncratic Risk):

  • Specific to a company, industry, or region.

  • Can be reduced through diversification (e.g., a tech stock crash offset by stable utility stocks).

• Systematic Risk (Market Risk):

  • Affects the entire market (e.g., recessions, interest rate hikes, pandemics).

  • Cannot be eliminated by diversification but can be managed through asset allocation (e.g., adding safe-haven assets like gold).

4. Practical Examples of Building a Diversified Portfolio

Example 1: Basic Diversified Portfolio

• Equities (60%):

  • 40% U.S. stocks (mix of sectors: tech, healthcare, consumer goods).

  • 20% International stocks (Europe, Asia, emerging markets).

• Bonds (30%):

  • 15% U.S. Treasury bonds.

  • 10% Corporate bonds.

  • 5% International bonds.

• Alternatives (10%):

  • 5% Real estate (REITs).

  • 5% Commodities (gold, oil ETFs).

Example 2: ETF-Based Diversification

• Use low-cost ETFs to achieve instant diversification:

  • Equities: S&P 500 ETF (U.S. stocks), MSCI World ETF (global stocks).

  • Bonds: Aggregate Bond ETF (mix of government/corporate bonds).

  • Geographic: Emerging Markets ETF.

Example 3: Rebalancing Strategy

• Start with a 70% stock/30% bond allocation.

• Rebalance annually to maintain the target ratio, selling overperforming assets and buying underperforming ones.

Key Takeaways

• Diversification reduces unsystematic risk but does not eliminate market risk.

• A well-diversified portfolio balances growth (equities) and stability (bonds/alternatives).

• Regularly review and adjust allocations based on market conditions and personal financial goals.

Tools for Implementation:

• Robo-advisors for automated diversification.

• Index funds/ETFs for broad market exposure.

• Geographic diversification through global funds.

By applying these principles, investors can build resilient portfolios tailored to their risk tolerance and objectives.