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Problem 2 What is diversification in the field of financial investment? Does diversification eliminate all types of risk? Justify your answer with a graph

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Answer #1

Diversification in the field of financial investment means if we hold a portfolio with different stocks in it we can reduce the risk of portfolio. Diversification does not reduce all risk but only unsystematic risk which is specific to company or industry or market. Some of the examples of this type of risk is business and financial risk.


Reducing Risk Through Diversification Increasing the number of stocks reduces firm specific risk 50 OE 40 2 o 30 S t 20 10 But market risk remains. 20 30 40 10 # of stocks in portfolio

The above graph explains as we increase the number of stocks we hold in our portfolio the standard deviation of portfolio can be reduced but not the market risk which will still remain

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