The benefits and limitations of portfolio diversification
Diversification is a method of reducing risk within an investment portfolio. This is achieved by spreading investments across different asset classes, fund managers, fund manager styles and many other variables.
This is based on the theory that whilst some of these investments may perform poorly in any given period, it is unlikely that all investments will perform equally as poorly in a well diversified portfolio.
Diversification comes in many different forms. Within a direct share portfolio you can diversify across a number of different sectors, across a number of different companies within a certain sector, or a combination of both.
Likewise with a portfolio of managed funds, you may diversify across a number of different fund types, fund managers and fund manager styles. A greater level of diversification can be achieved by having a diversified range of investment types, with proper diversification within each investment type.
Whilst there are a number of benefits to diversification, there are also a number of limitations. Examples of both are listed below:
There is a reduced chance that all investments within a diversified portfolio will perform equally as poorly within any given period.
"By investing in a larger range of investments, you may gain exposure to investments enjoying a strong rate of return which you may not have otherwise been exposed to.
In the case of a small value portfolio, there may not be sufficient funds to meet the minimum investment amount for each individual investment, limiting the number of investments available.
Some investors have strong feelings about what they are and aren't willing to invest in. If a client is not willing to invest in anything other than cash and fixed interest for example, the scope for diversification becomes more limited (but not impossible).
Number of Investments
As the number of investments increase beyond a certain point, the benefits of diversification begins to plateau. The reason for this is that beyond a certain point (say 20-25 unrelated shares in a share portfolio) the likelihood that more than one investment within a portfolio will be affected by the same risk begins to increase.
Whilst the example used relates to direct shares, the same is true of other asset classes and combinations of asset classes.