What is diversification and why is it important?

Diversification is the application of the adage "Do not put all your eggs in one basket." In finance, it means is investing in various financial assets simultaneously to reduce the overall risk of loss of your portfolio.

In 1952, Harry Markowitz Nobel prize has shown that a person who invests in two different companies, each with the same return on investment and the same risk, holds a portfolio less risky but with the same performance than a person that invests exclusively in one of these companies. Diversification therefore eliminates some of the financial risk while generating the same return on investment. Markowitz added that stock prices of both companies must be “de-correlated" to observe a reduced risk.

To illustrate this concept, consider two listed companies: AirlineCo and FuelCo. AirlineCo is an airline that carries passengers by air from point A to point B. FuelCo is an oil company which provides the fuel needed by AirlineCo to fly its planes.

It is easy to understand that AirlineCo FuelCo and are de-correlated. Indeed, when the oil price is low, fuel costs less to AirlineCo, allowing it to generate more profit pushing its stock price higher. In contrast, FuelCo see its stock price decline, because the cheap sale of its fuel to AirlineCo reduced its profit margin.

In contrast, when the oil price is high, AirlineCo buys its fuel at a higher price, reducing its margin and its stock price. FuelCo, meanwhile, sell its fuel at a higher price, increasing its margin and its stock price. The fortunes of AirlineCo and FuelCo are de-correlated: they move in opposite directions. The happiness of one is the misfortune of the other, and vice versa.

But why is it important for an investor? To understand, consider the following numerical example. Let's say a given year, AirlineCo share price increases by 20%, while that of FuelCo decreases by 10%. Say the following year, the opposite occurs: AirlineCo loses 10% while FuelCo earns 20%. This scenario is summarized in the following table:

The table below shows the result for three investors: Riri, Fifi, and Loulou. All investing € 200 but each following a different strategy. Riri invests all, non-diversified manner, in AirlineCo. For its part, Fifi invests everything in FuelCo. Finally, Loulou decided to diversify his investments and put half his money in AirlineCo and half in FuelCo.

After two years, which of the three has done the best investment? They each got a return on investment of 8%. Thus, all investment strategies were similar and as good, is not it? Wrong!

Loulou, who chose to diversify its investment portfolio, did not face any financial loss over the two years, unlike Riri, Fifi who have each, at one point, lost 10% of the value of their portfolio. By diversifying its investments, Loulou took less financial risk. Its return on investment experienced smaller changes and was less volatile. Finally, he could get out of his investment at the end of the first year with a profit, unlike Fifi who would have suffered a loss.

This is why diversification is important. It allows an investor to reduce its risk of financial loss without affecting its potential return on investment. Knowing this, diversification should appear as evident necessity to most investors…