An investment fund with wide range of securities in order to reduce the risk involved in it is called a Diversified fund. When an event affects one sector, it is likely to affect the entire portfolio. This can be prevented by maintaining diversification and hence large losses are minimized.
These are totally opposite to the focused or specialized funds which focus on stock in a particular sector (for example pharmaceuticals, biotechnology) or a particular region (for example Asia). According to the Modern Portfolio Theory, optimal diversification is achieved when 20th stock is added.
Need of Diversification
- Every fund is subject to risk and unexpected changes. It becomes more risky if money is invested in only one sector.
- Changes in the market are unpredictable. Anytime a strong sector can fall and a small sector may flourish. In order to minimize the risk, money in different types of funds should be invested.
- One fund invests in big companies and one in small companies.
- Investing in international stocks is a smart move.
- So, diversification is an attempt to minimize the risk by investing in various sectors. Though the risk cannot be reduced to zero, but it can be reduced to a very low value. Diversification provides insurance against risk.
There are meagerly two types of risks in Diversification
Undiversifiable risks are the risks arising from exchange rates, interest rates, political instability or inflation rates and these risks are associated with almost all the companies. Investors have to bear these risks. These risks cannot be removed through
Diversifiable risks are the systematic risks and are associated with a particular company or industry. These risks can be easily eliminated through diversification. Business risk and financial risks contribute to it. The remedy for these risks is to invest in many assets so that all assets are not affected in the same way and the portfolio stays balanced.
How to diversify Unsystematic Risks
As asset becomes riskier when the portfolio moves sharply. Volatility can be measured by a statistical concept called standard deviation.
- Average risk of a portfolio of one stock is 49.2%. When we increase the number of stocks in a well balanced portfolio, the standard deviation i.e. risk is reduced to 19.2% Once the number of stocks reaches 20, the risk is reduced to 20%.
- However, adding stocks between 20 and 100, will only reduce the risk further merely by 0.8%.
- Hence, it is concluded that the risk can only be reduced up to a certain level beyond, which there is no benefit in risk minimizing even if you increase the stocks.
How to maintain Perfect Diversified fund?
Diversified Funds are maintained by the following mentioned steps:
- Cost effective level with least risk is achieved by maintaining a diversified portfolio of 25-30 stocks
- By further investing in more securities, one can get more diversification benefits, however the benefits will be at a smaller rate
- Investment between $5000 - $6000 makes a portfolio evenly and fairly diversified
- Foreign securities which are less closely related to national investments will reduce the risk to a very low value.
For example, if American economy faces a down turn, it will not affect Indian economy much as it will affect American Investors. Thus Indian Investor is little protected against his American counterpart.
Disadvantage of over diversification
An expensive index fund is created when too many funds are put together.
- The impact that single fund have on performance is negated by the fact that to many funds are involved in the portfolio.
- Apart from this the expense ratio of many funds added together is more than the average.
- Hence, ultimately the expense ratio increases and at the same time the performance is mediocre.
How the Diversified bond works
It is very important for the investor to understand how a diversified bond works which is explained below:
Portfolio managers leverage specified market research to identify relative value within and across sectors
- Sector rotation
- Active risk management
- Investment grade corporate
- Commercial mortgage-backed securities
- Asset backed securities
- US Govt/Agency issues
- Security Selection
Active risk management
- Sector exposure
- Industry exposure
- Issuer concentration
- Security Selection
Broad diversification Focus on fundamentals, market pricing and technical analysis.
Dedicated short duration portfolio management team supported by research, risk management and trading functions.