In the simplest terms, portfolio is a basket of varied financial assets. Stock trading is performed through financial assets at stock markets of a country. Perhaps, the most crucial task is the construction of a portfolio basket. It is because of this reason that portfolio management, the art and science of deciding on the right mix of financial assets, emerged as a separate field of study. It is important to note that in any economy, there are thousands of companies that float their share in the stock market. Henceforth, the selection of right mix of shares from the available pool is a pivotal task in stock trading.
It is a worth mentioning fact that skill in stock trading is manifested when the investor is in the position of identifying the shares of the companies that have an upward growth potential. Individual and company investors who are keen in stock trading prefer to take the help of various specialized financial professionals, in order to decide on the right mix of investment basket. This is done by keeping in view the strengths, weaknesses, opportunities and threats, in making a choice among dimensions like, debt and equity, domestic and international, growth and safety, while confronting with other tradeoffs, in an attempt to maximize returns at a given appetite for risk.
How to construct the portfolio basket to maximize the returns and minimize the unsystematic risk in stock trading? In an attempt to answer this question, there is a need to consider various techniques, available for the construction of stock portfolios. Diversification is one such technique that ensures the construction of a balanced and profitable portfolio for all types of investors in stock trading. So, what is diversification and how it ensures an efficient make up of investment portfolios is the crust of this article.
There are a lot of different factors that characterize the overall ambiance of a stock market. Thus, every financial asset is a result of different market forces. A professional portfolio manager will perform his duties in lieu of the wills and visions of the investors in deciding the asset mix and successive ratios of the instruments. Diversification is a technique that helps in reducing the risk element. Through diversification, the investor can make a choice between assets of different kinds of instruments. It is important to note that risk cannot be completely eliminated. The construction of a portfolio basket creates total risk. Total risk is characterized as an amalgamation of systematic and unsystematic risk.
Total Risk = Systematic Risk + Unsystematic Risk
Hence, through diversification we can cut down on unsystematic risk by promoting returns for a given level of risk in the portfolio. Now how can the risk be spread through diversification? The use of diversification allows the risk to be spread through a number of different companies and industries by selecting the right scrip for fabricating the investment basket. There are various different ways to practice diversification consider, for example, the following aspects:
|Assets||Real estate, gold, government securities, corporate securities, etc|
|Industries||Pharmaceuticals, information technology, cement, steel, chemicals, plastic, heavy machinery, etc|
|Companies||New companies, growing companies|
Diversification can be understood with the help of the centuries old financial idiom, do not put all your eggs in one basket, as if the basket falls to the ground you are left with nothing but broken eggs. Hence, diversification is little like an insurance against the falling basket. It is more risky to invest in a single company, industry or asset in comparison to two or more options. Diversification works by investing in companies whose prices fluctuates in opposite directions or exhibit price movements that are different from each other. By investing the saving in various options the risk is spread across various different investment alternatives. Thus, negative fluctuations in one instrument are offset by stability or an upward trend in others. This is how risk can be reduced.
Diversification provides a number of advantages to the investing companies. Spreading the risks, smoothing the returns and avoiding timing errors are some of the benefits that can be pursued through this technique. A properly diversified portfolio will help the company capture most of the market’s gains while reducing volatility. Investing in a single stock can provide tremendous returns, but it can also result in wiping out most or entire investment. Henceforth, the advantage of diversifying across asset classes is that it provides a cushion against market turmoil as each asset class is exposed to varied risks, rewards and tolerance to economic events. Investments whose price movements are opposite to each other are negatively correlated. Hence, when negatively correlated assets are combined in a portfolio, the volatility of the basket is reduced.
By choosing securities of different companies in different industries, risks can be minimized that are associated with a particular company’s bad luck. If an investing company pools all of its investment in the stocks of a single company and the company goes bust, the investing company can literally go bankrupt. Summing it up, diversification provides two main advantages: minimizing the impact of individual losses, and facilitating investing companies in spreading their investments. However, diversification does not guarantee the highest possible returns. By spreading the investment across different options there are chances of some lagging investments reducing portfolio’s potential returns.