Investment Portfolio Diversification Is Essential Essay

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Likewise, a young investor may hold mainly equities.

Investor risk tolerance is another impediment to achieving asset class diversification. Investors will low risk tolerance, for example, are unlikely to hold high equity positions and even less likely to utilize more obscure securities like hedge funds. Yet, portfolios without equities may be highly susceptible to changes in the prevailing interest rates and therefore lack diversification. Indeed, for many investors a fully-diversified portfolio across asset classes is not desirable for their investment objectives, time frame and risk tolerance.

Lastly, asset class diversification can be hampered by knowledge of asset classes. Even without considering emerging asset classes, many classes require specialized knowledge - commodities, forex, real estate to name a new -- that may dissuade investors from utilizing them. Even relatively common asset classes such as preferred shares, zero coupon bonds or mutual funds can be sufficiently confusing. The degree of willingness of an investor to use an asset class is directly related to the investor's ability to understand the class.

Achieving geographic diversification also comes with its own set of impediments. There is, in particular, a domestic bias in equity holdings among investors (Rowland, 1996). Investors are more familiar with domestic firms, understand their operating environment better, and have better access to information about those companies.

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Moreover, domestic firms are all subject to the same reporting requirements -- the reporting methods and structures for international firms may not be familiar to the investor, resulting in a knowledge gap.

Transaction costs -- beyond those associated with rebalancing -- are also a factor unique to geographic diversification. Purchasing international equities is much more difficult than purchasing domestic equities and comes with higher transaction costs as a result. Investors may be hesitant to absorb these costs and seek to find geographic diversification in other ways, such as through mutual funds.

Knowledge and transaction costs are recurring themes -- these contribute to investor's unwillingness to fully adopt portfolio diversification. Investors prefer to put their money into instruments and companies they understand. The solution is to broaden the investor's knowledge, a difficult task at times. Investors may balk at transaction costs, and therefore there must be a rational economic decision made with respect to the benefits of diversification vs. The costs. The impediments to diversification can be overcome, once the investor understands the importance of building a fully diversified portfolio in terms of risk reduction.

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