Diversification and Portfolio Risk

Diversification is a cardinal rule when investing in securities, to reduce risk. Investors are advised to diversify their portfolio in order to reduce risk but without compromising much on the returns of the portfolio.

Just how much should an investor diversify to mitigate risk? We can use a graph to understand this. We can plot the riskiness of the portfolio by using the standard deviation (volatility of returns) on the y-axis and the number of stocks in the portfolio on the x-axis. You will notice that as the number of securities in the portfolio increases, theoverall risk keeps reducing. However, this reduction happens upto a point and after that adding more securities to the portfolio doesn’t further reduce the risk. Many experts suggest that this point where the risk stops reducing further is at somewhere having 20 to 50 different types of securities in a portfolio, however, this number may vary. The portfolio can be a mix of bonds and stocks from very different industries - oil and gas, banking, software and gold etc.

Diversifiable Risk

You will notice that the risk reduces upto a point but is not eliminated completely. This is because we still have other risk factors that can impact the portfolio. The risk cannot be eliminated completely. The risk that can be eliminated by diversification is referred to as non-diversifiable risk, or firm-specific risk.

Let’s say you have invested all your money in one company’s stock, let’s say, Tesla. In that case, you have only one stock in your portfolio and there is no diversification. When that happens, your portfolio return’s are completely tied to Tesla’s stock and if Tesla’s stock crashes for some reason, your investment will crash too. On the other hand, if your portfolio was well diversified, no one company’s movement could adversely impact the portfolio. By diversifying, we reduce the exposure to risk to any one stock.

Non-diversifiable Risk

Non-diversifiable risk on the hand is the risk that cannot be eliminated even if our portfolio is well diversified. This type of risk is called market risk. It comes from external factors like a war, climate crisis or any other market factor that will impact the market and your portfolio no matter what.

An economic recession is an example of non-diversifiable risk that impacts the entire portfolio. It is a sort of built-in risk.

So the total risk of the portfolio is the sum of diversifiable risk or firm specific risk and non-diversifiable risk. When we own a less diversified portfolio, we have to worry about total risk. If we have a well diversified portfolio we diminish the role of firm risk and we have to focus more on market risk. There are different ways to measure market risk and adopt methods to reduce it.