Cresto Narang Wealthfront.pdf
1.2 Annex B - Portfolio Diversification
Diversification is a technique that reduces risk by allocating investments among various
financial instruments, industries and other categories. It aims to maximize return by investing
in different areas that would each react differently to the same event. Most investment
professionals agree that, although it does not guarantee against loss,diversification is the
most important component of reaching long-range financial goals while minimizing risk. Here,
we look at why this is true, and how to accomplish diversification in your portfolio.
1.2.1 Different Types of Risk
Investors confront two main types of risk when investing:
Undiversifiable - Also known as "systematic" or "market risk," undiversifiable risk is
associated with every company. Causes are things like inflation rates, exchange rates,
political instability, war and interest rates. This type of risk is not specific to a
particular company or industry, and it cannot be eliminated, or reduced, through
diversification; it is just a risk that investors must accept.
Diversifiable - This risk is also known as "unsystematic risk," and it is specific to a
company, industry, market, economy or country; it can be reduced through
diversification. The most common sources of unsystematic risk are business risk and
financial risk. Thus, the aim is to invest in various assets so that they will not all be
affected the same way by market events.
1.2.2 Why one should diversify
Let's say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots
are going on an indefinite strike, and that all flights are canceled, share prices of airline stocks
will drop. Your portfolio will experience a noticeable drop in value. If, however, you
counterbalanced the airline industry stocks with a couple of railway stocks, only part of your
portfolio would be affected. In fact, there is a good chance that the railway stock prices would
climb, as passengers turn to trains as an alternative form of transportation.
But, you could diversify even further because there are many risks that affect both rail and
air, because each is involved in transportation. An event that reduces any form of travel hurts
both types of companies - statisticians would say that rail and air stocks have a strong
correlation. Therefore, to achieve superior diversification, you would want to diversify across
the board, not only different types of companies but also different types of industries. The
more uncorrelated your stocks are, the better.