Diversification is one of the most important strategies when it comes to share market investing.
Diversification in one’s view is when investors reduce their exposure to stock specific risk while maximizing potential returns by increasing the chances of picking a winner.
By spreading investments across different shares, sectors, and asset classes, investors can mitigate the impact of individual share price volatility. But is there science behind the madness? Well there is and I will stress the importance of diversification in share market investing, as I aim to show how diversification can help investors achieve better risk-adjusted returns and reduce portfolio risk.
Understanding Diversification in Share Market Investing
Diversification in share market investing refers to constructing a portfolio that includes a variety of assets, such as shares from different industries or countries, to reduce exposure to unsystematic risk. Unsystematic risk, also known as “stock-specific” or “sector-specific” risk, arises from events that affect individual companies or sectors, such as management decisions or industry downturns. For example being invested solely in Iron Ore for the last 12 months. By investing in a range of equities, the negative price performance of one share or sector can be offset by positive performance elsewhere, reducing overall portfolio volatility.
Diversification, however, cannot eliminate systematic risk, which is the risk inherent to the entire market, such as economic recessions or geopolitical events. This limitation highlights the need for a thoughtful approach to diversification, as investors must not only focus on spreading risk but also on optimizing returns.
Modern Portfolio Theory and Diversification
At University, I learnt a lot about Modern Portfolio Theory (MPT) which was created by a chap named Harry Markowitz in 1952. Despite the countless studies since, it remains a foundational concept in understanding diversification in the share market.
MPT proposes that investors can achieve optimal portfolios by balancing risk and return. According to MPT, the key to reducing risk lies in holding a portfolio of assets that are not perfectly correlated. If one asset performs poorly, another may perform well, smoothing out the overall portfolio performance (Markowitz, 1952).
This MPT theory introduced the concept of the "efficient frontier," which represents the set of optimal portfolios offering the highest expected return for a given level of risk. Diversification allows investors to move closer to the efficient frontier by reducing…
