Diversification has been a fundamental concept in asset management and asset-pri
ID: 2783481 • Letter: D
Question
Diversification has been a fundamental concept in asset management and asset-pricing theories. The concept is so essential that it has been popularized by the adage: “Don’t put all your eggs in one basket.” In finance, diversification implies that you can obtain the same expected returns but reduce your risk by investing in a portfolio of many assets rather than investing in only one or a few assets. ………What has been questioned is the applicability of diversification. In fact, in the 2007–09 financial crisis, portfolios that were supposed to be well diversified and, therefore, protected from the risk of large losses actually lost significant value. For example, those invested in the S&P 500, which is, in itself, highly diversified (but consisting entirely of equities), would have lost 57% from the market’s peak (9 October 2007) to its bottom (9 March 2009).
Briefly discuss whether you agree or disagree withMoonn’s concerns.
Explanation / Answer
I would disagree with Moonn’s concerns. Although the market tanked between 2007 and 2009, it was largely due to investors pulling out their money from the market altogether due to mass hysteria. On the other hand, diversification is a technique useful in protecting the investor from downside arising from a few sector's asset when he holds the assets of a large number of sectors.
Between 2007 to 2009, all the economic sectors were under stress and hence the diversification did not work. However, under normal market operations diversification would protect the investor from cyclical and sectoral downturns.
To sum up, diversification is ineffective only when unforeseen market conditions arise.