Putting Your Eggs in Different Baskets – Diversification

Diversified Portfolio

You should acquire a group of investments with different patterns of returns over time, or in other word, two assets are not perfectly correlated.  If chosen carefully, such portfolios minimize risk for a given level of return because low or negative rates of return on some investments during a period of time are offset by above-average return on others.  The goal is to build a balanced portfolio of investments with relatively stable overall rate of return.  Thus the use different assets class such as cash, stocks, bonds and alternative investments (e.g. global stocks, real estate, commodities, future, hedge fund, etc.) are necessary.

Elimination of Unsystematic/Stock-specific Risk

By adding stocks to the portfolio that are not perfectly correlated with stocks of the portfolio, you can reduce the overall standard deviation/risk of the portfolio, but you cannot eliminate systematic/market risk.  The standard deviation of the portfolio will eventually reach the level of the market portfolio, where you will have diversified all the unsystematic risk, but you still have the market risk.  You cannot eliminate the variability and uncertainty of macroeconomic factors (e.g. country economic growth, inflation, interest rate, etc.) that affect all risky assets.  However you can attain a lower level of market risk by diversifying globally versus only investing in Malaysia because some of the macroeconomic factors are not correlated with market risk variables in other countries.  As a result, if you diversify globally you eventually get down to world market-risk level.