A simple yet highly scientific explanation of what is diversification, why is it important, and how should you achieve it?
What is diversification?
As the old saying goes “You should not keep all your eggs in the same basket”. Diversification is keeping your eggs in different baskets.
Diversification lowers risk. Risk can be measured by ‘variance’. Therefore, diversification reduces variance.
The below write up about variance looks a little mathematical to begin with, but trust me – it is not complex mathematics. If you read it a few times, you will understand it well. Even if you do not understand the math, continue to read and you will get the gist of this post.
What is Variance?
In most simple terms, variance is nothing but a measure of how far individual values are from the average value.
Look at two portfolios below – both have the same average return (as we will soon confirm) but Portfolio-1 has a higher variance: the returns in individual years are ‘spread’ further from the average (mean) of 5%.