Diversification - what's the point?

Diversification is best summed up by the old adage “don’t put all your eggs in one basket”.  Spreading risk is an easily understood principle.   But it is one thing to explain a principle and another to show investors how implementing this in practice can help their portfolio. 

What is risk?

Risk is an unavoidable part of investing.  Before thinking about diversification reducing risk, we should think about what risk itself means.  There are two different definitions of risk that are helpful here.  The first comes from Ben Graham – the legendary value investor.  He described risk as “the probability of not getting your capital back”.  That is how most retail investors in NZ approach risk – what are my chances of facing a total loss?  In this article we will call this “catastrophe risk”.

A second view on risk comes from Harry Markowitz, the Nobel prize winning pioneer of modern portfolio theory. He described risk as the volatility of return – this has little to do with the loss of capital.  Volatility as a measure of risk is familiar to fund managers, advisers and analysts – but is not how retail investors approach risk.