The risk of a portfolio can be divided into two categories: systematic risk (which is the risk of the general market) and diversifiable risk (which is unique to a security). Systematic risk cannot be avoided, but diversifiable or unique risk can be reduced through diversification.
Diversification is a means to reduce the risk of a portfolio by investing in different asset classes. As long as the different assets are not perfectly correlated (that is, do not move up and down in perfect harmony), a diversified portfolio will have less risk than the weighted average risk of the assets in the portfolio. The concept of diversification can be summarised by the expression “don’t put all your eggs in one basket”. The greater the number of securities in a portfolio, the less the portfolio is likely to lose value as the result of a single company’s misfortune.
For example, if a portfolio was 100% invested in one stock, Apple, the performance of the portfolio will depend entirely on the performance of Apple. If Apple were to become bankrupt, close down and cease trading, the entire capital invested in the portfolio would disappear.
Assume the portfolio is diversified by holding another stock, such as Novartis, which trades on another market and belongs to a different industry and was purchased alongside Apple. As the prices of these two stocks are unlikely to be influenced by the same events or announcements, movements in the price of Novartis and Apple are unlikely to be closely synchronised, and the risk of the portfolio will be reduced. The lower the correlation between Novartis and Apple, the larger the reduction in risk.
Given that correlations between asset classes are lower than securities within asset classes, a well diversified portfolio involves investing in different asset classes. Often, when equities fall, bonds rise, or for the least, resist the drop. The positive performance of some asset classes will neutralise the negative performance of others.
Below is a diagram of two perfectly negatively correlated securities (X and Y). A portfolio equally divided between the two securities will have zero specific stock risk or diversifiable risk and be left purely with systematic risk. It will therefore provide stable returns, growing at the risk-free rate, which is the maximum rate a risk-free investment can earn.
Although the average return of a diversified portfolio will be lower than investing 100% in the asset with the best performance, it allows an investor to reduce the volatility of his portfolio.