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Benefits of Portfolio Diversification

In many cases, it is beneficial for equity investors to diversify across companies and industries to mitigate risks. For most investors, diversification is the simplest and cheapest way to risk mitigation. Diversification is an established tenet for conservative investors and it is especially helpful when the returns of two or more investments are perfectly negatively correlated, resulting in substantial risk reduction. Negative correlation expresses the inverse relationship between the returns of two securities which means their returns move in opposite direction. On the contrary, in cases when returns of two investments are perfectly positively correlated, diversification will not provide risk reduction, only risk averaging. Positive correlation indicates that the returns of two securities move in the same direction that is, they tend to go together. If the return of one security goes up, the return of the other security also tends to increase and vice versa. Diversification can substantially reduce securityspecific risk, but not market risk. That is why for a well-diversified portfolio, security-specific risk is practically insignificant.

Some sophisticated and institutional investors go for international diversification, investing in securities in different countries. Of course, they have to take care of political risk and currency risk involved in such international securities. Institutional investors broadly consist of pension funds, sovereign wealth funds, endowments, insurance companies, banks and other financial institutions. Over-diversification is detrimental to an investors wealth. So is under-diversification. Many investors hold 15 to 30 different mutual fund schemes. A mutual fund itself holds a number of securities. So it does not make any sense to hold more than three or four mutual fund schemes belong to a particular asset class. For example, it is better to stick to holding not more than three or four equity schemes under equity asset class.
Portfolio Rebalancing

Suppose an investor in 2012 has 40 per cent of his assets in equities, 20 per cent in bonds, 35 per cent in real estate and 5 per cent in gold. After one year assume that the investors asset mix changes as equities 50% and bonds 10%; while real estate and gold remain the same proportionately. So in 2013, 10% of the wealth can be sold out of equities and the same can be ploughed back to bonds to restore the

original balance in the total portfolio. This is called portfolio rebalancing. Several mutual funds do this type of portfolio rebalancing through funds such as, balanced/hybrid funds, asset allocation funds and funds of funds. Some sophisticated and knowledgeable investors do portfolio rebalancing every year on their own.
Related: Understanding Asset Allocation 14Oct2012
Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:

http://ramakrishnavadlamudi.blogspot.in/
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