Meaning of Diversification:

Meaning of Diversification:
The process of adding securities to a portfolio in order to reduce the portfolio’s unique risk and thereby the portfolios total risk.

Forms (Techniques) of Diversification:
a) Simple Diversification:
“Not putting all eggs in one basket”
In simple diversification, securities are selected added on random basis for making portfolio. Simple diversification reduces a portfolio’s total diversifiable risk to zero and only the undiversifiable risk remains. It is found that 10 – 15 securities are sufficient for a portfolio to minimize the portfolio’s total risk to the undiversifiable level.

b) Diversification across industries
In this diversification portfolio is constructed by selecting assets from different industries rather than from one industry. For eg if someone selects the securities from hotel banking, insurance co’s and other industries to make portfolio then it is called diversification across industries. But, empirical research has shown that diversifying across industries is not much better than simple selecting securities randomly.

c) Superfluous diversification
From research study, it is found that 10 – 15 assets in the portfolio are sufficient for risk diversification. But if more than 10 – 15 assets are added in the portfolio then such diversification is called superfluous diversification. It should be avoided; superfluous diversification will usually result in the following portfolio management problems:

1. Impossibility of good portfolio management
2. High search cost
3. High transaction cost

d) Simple diversification across quality rating
Some rating agencies rate different companies and their assets on the basis of the possibility of default risk (the risk of bank rupt) Under this categories we select assets randomly from the homogeneous quality ratings. The highest quality portfolio (of randomly diversified stocks) will be able to achieve lower levels of risk than the simple diversified portfolio of lower quality stocks.

e) Markowitz Diversification
Markowitz Diversification may be defined as combining assets which are less than perfectly positively correlated ( i.e. ≤ + 1 ) in order to reduce portfolio risk without sacrificing portfolio returns. Markowitz diversification is more analytical than simple diversification and considers assets correlations. The lower the correlation between assets, the more than Markowitz diversification will be able to reduce the portfolio’s risk. Therefore the Markowitz diversification focuses on the correlation between assets.