Diversification As a form of Risk Management

Every investor should know what is called diversification. Diversification is one method of risk management in investing. Why do investors need to diversify? Then how to do diversify? Consider the following answer in writing.

Risk Return Trade-off
In investing, investors must expect the return. However, in investment you are faced with the fact, that is a risk-return trade off. If you want get high returns, of course the risk is also high. Similarly, if you want a safe investment and low risk, then the return is small.

In every investment, it must contain the risk. Whether you invest it in stocks, bonds, even though safe as bank deposits. Therefore, you certainly can not avoid the risk of investing. However, you can still try to manage and minimize risks, one of way is diversification.

Risk itself is divided into two types, that are, systematic risk and unsystematic risk. First, the systematic risk or market risk is the risk that is `given` and `embed` in the market as a whole. These risks can not be diversified. Second, the unsystematic risk is risk owned by a company or industry specific, so that each investment has a different risk. This unsystematic risk can be minimized through proper diversification.

Portfolio Management Strategies
People often ignore diversification. The reason, minimize the potential for diversification of their return. So they chose to hold only one type of asset, such as stocks. The result, of course they have a large potential return. But if a sudden decline in market conditions significantly, of course, they also exposed to enormous losses.

How diversification can minimize your risk?
Diversification is a strategy in portfolio management to minimize the risk by combining a variety of different investment which have correlation as small as possible. Do not forget that the risk that can to diversify here is unsystematic risk.

What is correlation? Correlation describes how much the relationship between the movement of two assets. If the correlation is 1.0 for both the asset moves right direction. Meanwhile, if the correlation is 0, then the second movement of these assets had nothing to do, or can be called random. Then, if the correlation is -1.0 so the two assets move in exactly the opposite direction.

It is difficult to find correlations just right opposite direction of -1.0, so we try to make a portfolio with assets as low as possible. Why do we want a low correlation between asset? This is due to the lower correlation, then return the assets do not move in the direction. So, when the return of an asset to weaken, then the return from other assets less weak, or actually even stronger. Examples are stocks and bonds, which both have a low correlation. As the stock soared, then bond prices lower. Meanwhile, when the stock fell, the bond becomes the best choices.
Thus, poor performance of one asset in the portfolio can be covered by the performance of other assets. Thus, the portfolio is expected to produce maximum performance, and can minimize the risk so can avoided extreme losses.

After understanding the principle of correlation, now how can you diversify? Diversification generally can be done in two ways.

First, vertical diversification, the investment allocated to various asset classes, ranging from cash, bonds, property, stocks and other asset types. These assets have different characteristics, thus creating a different return in accordance with the conditions occur.

Second, horizontal diversification, such as you allocate different investments in one asset class. Here, you try to minimize the risk of specific sectors and specific companies, such as investing in stocks.

Diversification, in practice difficult to produce an optimal portfolio, ie the optimal return with low risk. In theory you can accomplish with the efficient frontier method, which produces the most efficient combination of assets. In fact, normally diversified portfolio will produce a composition of lower risk with a moderate return. With diversification, you will not only minimize the risks, but also maintain and enhance your investment in the long run.