Define Simple Diversification

Simple Diversification

Portfolio risk can be reduced by the simplest kind of diversification. Portfolio means the group of assets an investor owns. The assets may vary from stocks to different types of bonds. Some times the portfolio may consist of securities of different industries. When different assets are added to the portfolio, the total risk tends to decrease. In the case of common stocks, diversification reduces the unsystematic risk or unique risk. Analysts opine that if 15 stocks are added in a portfolio of the investor, the unsystematic risk can be reduced to zero. But at the same time if the number exceeds 15, additional risk reduction cannot be gained. But diversification cannot reduce systematic or undiversifiable risk.

The naive kind of diversification is known as simple diversification. In the case of simple diversification, securities are selected at random and no analytical procedure is used.

Total risk of the portfolio consists of systematic and unsystematic risk and this total risk is measured by the variance of the rates of returns over time. Many studies have shown that the systematic risk forms one quarter of the total risk.

The simple random diversification reduces the total risk. The reason behind this is that the unsystematic price fluctuations are not correlated with the market’s systematic fluctuations. The figure shows how the simple diversification reduces the risk. The standard deviations of the portfolios are given in Y axis and the number of randomly selected portfolio securities in the X axis.

The standard deviation was calculated for each portfolio and plotted. As the portfolio size increases, the total risk line Starts declining. It flattens out after a certain point. Beyond that limit, risk cannot be reduced. This indicates that spreading out the assets beyond certain level cannot be expected to reduce the portfolio’s total risk below the level of undiversifiable risk.

Problems of Vast Diversification

Spreading the investment on too many assets will give rise to problems such as purchase of poor performers, information inadequacy, high research cost and transaction cost.

Purchase of Poor Performers

While buying numerous stocks, sometimes the investor may also buy stocks that will not yield adequate return.

Information Inadequacy

If there are too many securities in a portfolio, it is difficult for the portfolio manager to get information about their individual performance. The portfolio manager has to be in touch with the details regarding the individual company performance. To get all the information simultaneously is quite High research cost If a large number of stocks are included, before the inclusion itself the returns and risk of the individual stock have to be analysed. Towards this end, lot of information has to be gathered and kept in store and these procedures involve high cost.

High Transaction Cost

When small quantities of stocks are purchased frequently, the investor has to incur higher transaction cost than the purchase of large blocks at less frequent intervals. In spite of all these difficulties big financial institutions purchase hundreds of different stocks. Likewise, mutual funds also invest in different stocks.