Diversification is often looked to as a finance buzzword for many investors, as this relatively simple concept is often overused in daily parlance.
It appears to me that many real investors out there today do not have a very good understanding of what diversification is and/or how diversification can improve the risk-adjusted returns of a portfolio.
The idea is simple, but executing true diversification can be difficult. In finance terms, volatility refers to the size of the upside/downside swings in a given company’s stock price. The higher the volatility, the higher the risk.
Correlation refers to the direction of stock price swings, as compared to something (usually a benchmark index) and is denoted by the Greek symbol beta.
A beta of 1 means a stock moves in the exact same direction as the market (i.e. the market goes up/down by 5%, the stock goes up/down by 5% in the same direction). Low beta stocks (say 0.5) only would increase by 2.5% in either direction on such moves, and negative correlation investments (like inferior goods, for example) may go down when the market goes up, and vice versa.
A company’s stock has an overall correlation to the market, but also to other stocks. The goal of diversification is to get the overall portfolio correlation as low as possible (i.e. as stable as possible), while also offering the highest return (alpha) possible.
This is the idea behind risk-adjusted returns, and most investors spend a lot of time thinking too much about beta with respect to a benchmark index rather than the correlation between holdings.
Owning 30 oil stocks might have a low market beta but would have very high co-correlation, leading to amplified portfolio risk. Ensure you have investments spread out across multiple sectors, geographies (go global) and investment types (equities are only one type of investment vehicle) - think about bonds, real estate, etc.
Invest wisely, my friends.
