Portfolio Diversification – The Key to Success on Financial Markets

In financial markets, there are two types of risks: market risk (systematic risk) and the risk associated to the firm (specific risk). Note that the performance of your portfolio will depend more on market profitability than individual equity returns. Thus, having in your portfolio shares with high potential does not matter as much as investing when the market is in an uptrend.When purchasing shares in a listed company, you always bear the risk of seeing the company go bankrupt, revenues could collapse or a factory might even burn. On the other hand, the overall market will never go bankrupt, and the total combined turnover has little chance of collapsing. The only way to reduce the specific risk is to diversify your portfolio.Having more lines in your portfolio will obviously not prevent one of your holdings from going bankrupt, but the potential loss will be lower in relative terms because more lines in your portfolio also means less weight on each one of them. By managing a portfolio of 10 to 15 lines, you significantly decrease your specific risk to the benefit of a systematic risk you just can’t escape from anyway. Take the example of October 1987: all the stocks fell sharply regardless of which industry they belonged to.Stock selection for portfolio managersIn their investment selection, most portfolio managers do not seek primarily a stock that outperforms the market, but:A selection of financial assets: An individual should act the same way as the portfolio manager, even though the sums involved are rarely the same. It is much easier for the manager to invest his portfolio in U.S. Treasury bills or Russian bonds than it would be for the private individual. In this process, he calculates the optimal distribution of his portfolio based on the nature of investments needed (stocks, bonds, currency, real estate…). If he fears a fall in the stock markets he will invest a larger percentage of his portfolio in bonds.A selection of sectors: Once the asset allocation is made (let’s estimate our portfolio is 60% invested in equity), the manager chooses the sectors that should outperform the market. He may very well choose oil, automotive, construction, or the technology sector. These choices are dictated by sector analysis carried out mostly by financial analysts. Let’s suppose that our portfolio manager decides to invest 10% of his portfolio in the New Technology industry.A selection of Locations: The geographical selection can be conducted in parallel with the selection of sectors. It forces the manager to choose between different exchanges. The globalization of the economy is the globalization of financial markets. Hundreds of billions can switch countries in just a few days. Thus, the manager can choose between Wall Street, emerging countries, the Paris stock exchange, or even Tokyo.A selection of securities: That’s where individuals spend the most time, just like the portfolio managers. But much of the profitability of a portfolio is made with the first three selections. The selection of stocks or stock pricing is not vital to the profitability of a portfolio. Let’s suppose that our manager decides to allocate 10% of his New Technology portfolio in “Yahoo”, then it represents 10% (Yahoo) x 10% (New Tech Industry) x 60% (Shares) = 0.6% of his entire portfolio.