Question

Please make sure the answer isn't copied from a previous answer.

Define diversification and explain how it is used to reduce risk. Additionally, explain how different asset classes and the number of securities can influence risk management.

Answer 1

Diversification means to add more and more securities in your portfolio with an intention to minimize the risk. Invest across securities and not into just one or select few. Business diversification means adding more geographies, products, customers etc. to your already existing ones. Risk can be minimized by choosing negatively or uncorrelated securities in portfolio. This is the power of diversification.

Let's demonstrate this by starting with a two stock portfolio:

For the time being, let’s assume there is a portfolio of two securities:

Sl. No.	Parameter	Security 1	Security 2
1.	Investment proportion	w1	w2
2.	Expected Return	E(R1)	E(R2)
3.	Standard Deviation	σ1	σ2

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Hence,

Now following inferences can be easily derived:

• Covariance describes the co-movement between the returns of two different investments in a portfolio. It can range from negative to positive infinity and are expressed in terms of square units.
• Variance is nothing but covariance of a variable with itself
• Portfolio risk is dependent upon correlation between the return of individual securities
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• Thus by choosing securities properly, portfolio risk can be optimized

Additionally, explain how different asset classes and the number of securities can influence risk management.

• By adding more and more securities negatively correlated with each other, risk can be minimized. This is called diversification. But adding securities beyond 30, incremental benefit of diversification is minimal.

Whatever you do, the risk of the portfolio will not fall below the difference of the weighted risk in this case. This implies diversification can’t eliminate all the risks. Systematic risks cannot be eliminated by diversification and hence they are called undiversifiable risk.