Diversification in finance describes the process where a portfolio of correlated assets is built in such a way that produces a better risk/return profile than would be achievable with only one asset or with a basket of unrelated assets.
Diversification in Contemporary Finance
The concept of diversification is based on modern portfolio theory, which is the statistical analysis of the relationships between the risk and return rates of two or more assets.
Using complex mathematical formulas, investors can use diversification to build a portfolio of assets that complement each other’s expected performance.
With the enormous range of assets available for trading and the complex interrelationships among many of them, it is possible for investors to construct highly sophisticated portfolios that offer extremely exact risk/return profiles using the principle of diversification.
Suppose that asset A has a high rate of return and a high variance (risk rate), while asset B has a low rate of return and a low variance. Furthermore, these two assets are inversely related, so when the value of asset A goes up, the value of asset B goes down.
By combining a weighting of asset A and asset B into one portfolio, the investor can diversity away some of the risk involved in a range of rates of return.
Instead of a portfolio with a high rate of return and high risk rate or a low rate of return and low risk rate, the investor can use diversification to create a mixed portfolio with a medium rate of return and a medium risk rate.
Furthermore, the investor is able to create a better risk/return profile (the rate of risk for any given rate of return) using a mix of assets than he would be able to find from any one single asset in the market.
The most common example of diversification is that between stocks and bonds. Most investors desire the higher returns offered by equities, but they fear the long and pronounced downturns that the equity market regularly experiences.
Therefore, they invest the majority of their portfolio in equities, but save a significant proportion for investing in bonds as well.
This diversification may reduce the overall rate of return compared to a portfolio of pure equities, but it helps to smooth out the periodic downturns, as the price of bonds tends to rise as the price of equities falls.
Another common example of diversification is having a proportion of a portfolio invested in gold and other precious metals. While these assets have their own relationships with the business cycle, they tend to rise in value during times of risk and uncertainty and fall in value during times of higher inflation.
Therefore, gold and other precious metals are a useful tool in diversification, particularly when preparing for periods of extreme uncertainty in the markets.
A more recent addition to portfolio diversification is cryptocurrency. Cryptocurrencies tend to offer extremely high returns, but with a correspondingly high rate of variance.
Therefore, an allocation of 10% to 20% of a portfolio to cryptocurrencies is a common way to gain exposure to the potentially high returns of cryptocurrencies while protecting against their higher risk.
Cryptocurrencies also tend to have little or no correlation with the overall market, so they are a useful tool for weathering general market downturns.
Diversification and Trading
Diversification is an investment tool that does not apply to most day trading. However, it is important to understand how the drive for diversification affects the behavior of most other market participants, who are investors and not traders.
Investors who diversify will tend to buy and sell the same assets and asset classes in response to the same market events.
This means that market events that affect the portfolios of major market participants, such as pensions funds and investment firms, will be exaggerated by the repositioning of these large institutional investors.
Day traders who understand how these institutional investors respond to market events are well-positioned to predict short term price changes in the assets that are affected by the diversification efforts of these market participants.
Diversification is a central concept in contemporary finance that drives much of the behavior of market participants. Through diversification, investors are able to achieve favorable risk/reward profiles that would be impossible using just one asset.
Day traders who understand the nature of diversification are well-positioned to predict resulting price changes, as institutional investors rebalance their portfolios in response to market events.