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DIVERSIFICATION
DEFINITION:Portfolio diversification is the practice of spreading out portfolio capital into several different
areas. A portfolio of ten different stocks is more diversified than a portfolio of five different
stocks. Spreading investment capital over multiple financial markets such as stocks, bonds and
futures is another form of portfolio diversification.
INTRODUCTION:Diversified portfolios greatly reduce risk while smoothing investment returns by including many
securities across a wide range of industries. This allows investors to participate in a wide variety
of investment opportunities while reducing the risk of large losses due to any one security.
Diversification is an investment strategy in which you spread your investment dollars among
different sectors, industries, and securities within a number of asset classes.A well-diversified
stock portfolio, for example, might include small-, medium-, and large-cap domestic stocks,
stocks in six or more sectors or industries, and international stocks. The goal is to protect the
value of your overall portfolio in case a single security or market sector takes a serious down
turn.
Diversification can help insulate your portfolio against market and management risks without
significantly reducing the level of return you want. But finding the diversification mix that's right
for your portfolio depends on your age, your assets, your tolerance for risk, and your investment
goals. A risk management investment strategy in which a wide variety of investments are mixed
within a portfolio; the rationale is that a portfolio of different investments will, on average, yield
higher returns and pose a lower risk than any individual investment within the portfolio.
Diversification strives to smooth out unsystematic risk in a portfolio so that the positive
performance of some investments will neutralize the negative performance of others. Therefore,
the benefits of diversification will hold only if the securities in the portfolio are not correlated.
The main purpose of diversification is to lessen risk. For example, if someone has 20 percent of
her portfolio invested in XYZ stock, she stands to lose a significant percentage of her portfolio
value if XYZ declines. However, if the investor diversifies by investing in other stocks and
leaves only 5 percent of her portfolio in XYZ, she will lose a much smaller percentage of
portfolio value in the event of a decline.
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ADVANTAGESThe advantage of diversification is that it broadens your exposure to market swings. The
principle is that one sector (or stock) may devalue, but not all sectors will devalue. In the long
term, most sectors tend to experience growth, so the total portfolio value of a diversified account
should gradually grow.
A diversified portfolio works by investing in different areas of industries where one industry
cannot affect another industry should it have minimal to negative market activity. With
diversification, investors lower the risk value of their assets and portfolio. Most diversified
portfolios work well with long-term investors to outlast economic storms.
1.Asset ChoicesWhen your holdings are widely diversified, you can spread them out over widely divergent forms
of assets, including securities such as stocks and bonds, commodities such as oil and minerals,
real estate and cash. Each of these assets exhibits different strengths and weaknesses in terms of
risk and profitability. Maintaining holdings in all of these areas helps to create a stable portfolio
that will increase in value over the long term.
2.Lower MaintenanceInvestments require a certain amount of care and attention to keep them performing well. If you
are playing high-stakes games with your assets and moving them around through risky ventures,
you will probably be spending a fair amount of time watching the markets and dodging financial
bullets. A diversified portfolio is less exciting and more stable. Once you have your investments
settled into a wide variety of stocks and securities, they can remain there for extended periods
without requiring a lot of maintenance. This frees up your time to pursue other matters and
reduces the market stress that may lead to burnout.
3.RiskPortfolio diversification tends to reduce your long-term risk. Anytime you hold an investment,
you risk losing its value. For example, if you purchase a share of stock for $50 and end up selling
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DISADVANTAGES-
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While investing might seem like one of those ho-hum chores, it's not. In fact, your future, at least
a financially secure one, depends largely on sound investing. A diversified mix of stock
positions serves as the cornerstone of many successful investment portfolios.
Step 1Buy various types of stocks. As Jeremy Glaser of Morningstar indicates in relation to your
overall portfolio, it's not about quantity, it's about how your investments play against one another.
The same goes for the stock portion of your holdings. Select stocks from different sectors and of
different sizes that might perform differently during a market downturn, for example. For
instance, although individual specifics vary, you might be on the road to diversification if you
hold a few technology growth stocks such as Apple, a few staples like Proctor & Gamble
and McDonalds, a couple small company stocks, a couple stocks from banking and real estate, a
couple traditionally "safe" stocks such as utility stocks and a few international plays.
Step 2Try to emulate the makeup of major stock market indexes, namely the S&P 500. For
instance, check out the how the Standard & Poor's weights the S&P 500 by sector and
by company size. Attempt to hold a number of stocks from each sector that correlates to how
Standard & Poor's divvies things up.
Step 3Buy mutual funds. If your head spins trying to find and track tens or hundreds of stocks from
various sectors and of several sizes, leave it up to somebody else. And this does not necessarily
mean a financial advisor. You can purchase mutual funds that provide diversification. For
example, stakes in an international or emerging markets fund, a large cap stock fund, a small cap
stock fund, a fund focused entirely on growth stocks, a conservative value or balanced fund and
an index fund that tracks the Sample 500 offer fantastic diversification minus the allocation of
time and resources you might not have.
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Credit or Default Risk - Credit risk is the risk that a company or individual will be
unable to pay the contractual interest or principal on its debt obligations. This type of risk
is of particular concern to investors who hold bonds in their portfolios. Government
bonds, especially those issued by the federal government, have the least amount of
default risk and the lowest returns, while corporate bonds tend to have the highest amount
of default risk but also higher interest rates.
Country Risk - Country risk refers to the risk that a country won't be able to honor its
financial commitments. When a country defaults on its obligations, this can harm the
performance of all other financial instruments in that country as well as other countries it
has relations with. Country risk applies to stocks, bonds, mutual funds, options and
futures that are issued within a particular country. This type of risk is most often seen in
emerging markets or countries that have a severe deficit.
Foreign-Exchange Risk - When investing in foreign countries you must consider the
fact that currency exchange rates can change the price of the asset as well. Foreignexchange risk applies to all financial instruments that are in a currency other than your
domestic currency. As an example, if you are a resident of America and invest in some
Canadian stock in Canadian dollars, even if the share value appreciates, you may lose
money if the Canadian dollar depreciates in relation to the American dollar.
Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as
a result of a change in interest rates. This risk affects the value of bonds more directly
than stocks.
Political Risk - Political risk represents the financial risk that a country's government
will suddenly change its policies. This is a major reason why developing countries lack
foreign investment.
Market Risk - This is the most familiar of all risks. Also referred to as volatility, market
risk is the the day-to-day fluctuations in a stock's price. Market risk applies mainly to
stocks and options. As a whole, stocks tend to perform well during a bull market and
poorly during a bear market - volatility is not so much a cause but an effect of certain
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3. The Portfolio Risk-Reward TradeoffThe risk-return tradeoff could easily be called the iron stomach test. Deciding what amount of
risk you can take on is one of the most important investment decision you will make.
The risk-return tradeoff is the balance an investor must decide on between the desire for the
lowest possible risk for the highest possible returns. Remember to keep in mind that low levels
of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty
(high risk) are associated with high potential returns.
The risk-free rate of return is usually signified by the quoted yield of "U.S. Government
Securities" because the government very rarely defaults on loans. Let's suppose that the risk-free
rate is currently 6%. Therefore, for virtually no risk, an investor can earn 6% per year on his or
her money.
But who wants 6% when index funds are averaging 12-14.5% per year? Remember that index
funds don't return 14.5% every year, instead they return -5% one year and 25% the next and so
on. In other words, in order to receive this higher return, investors much also take on
considerably more risk.
The following chart shows an example of the risk/return tradeoff for investing. A higher standard
deviation means a higher risk:
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4. Diversifying The Portfolio To Reduce The RiskWith the stock markets bouncing up and down 5% every week, individual investors clearly need
a safety net. Diversification can work this way and can prevent your entire portfolio from losing
value.
Diversifying your portfolio may not be the sexiest of investment topics. Still, most investment
professionals agree that while it does not guarantee against a loss, diversification is the most
important component to helping you reach your long-range financial goals while minimizing
your risk. Keep in mind, however that no matter how much diversification you do, it can never
reduce risk down to zero.
5. Portfolio RiskDifferent individuals will have different tolerances for risk. Tolerance is not static, it will change
as your life does. As you grow older tolerance will usually shrink as more and more obligations
come up, including retirement.
There are several different types of risks involved in financial transactions. I hope we've helped
shed some light on these risks. Achieving the right balance between risk and return will ensure
that you achieve your financial goals while allowing you to get a good night's rest.
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The next chart shows that little in the way of correlation diversification is available by spreading
assets between domestic and foreign stocks, whether in developed or emerging markets. It does
show that bonds provide diversification through negative correlation.
The chart expresses the correlation of each ETF to the broad US stock market as represented by
the Russell 3000 through its proxy ETF, IWV. The other ETFs are:
(EFA) MSCI EAFE (Europe, Australasia, Far East)
(EEM) MSCI Emerging Markets
(AGG) Lehman Aggregate Bond Index
(IEF) Lehman 7-10 Year Treasury Bonds
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Before moving any money into stocks or bonds, however, Juan would want to set aside three to
six months worth of living expenses in an emergency cash fund, outside of his 401(k), just in
case he should lose his job, have serious health issues, or become subject to some other
unforeseen crisis.
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CONCLUSION:For asset investments, diversification is an effective tool in reducing the risk of investments in
stocks, bonds, and other securities. Utilizing the correlation structure among the assets,
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BIBLIOGRAPHY:-
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xecutive Summary
Diversification is a way to reduce risk by investing in a variety of assets or business ventures.
Systematic risk is not diversifiable, while idiosyncratic risk can be reduced or even eliminated.
Portfolio diversification depends on risk-aversion and time horizon, and the portfolio mix must be rebalanced
periodically.
Introduction
To diversify is to do things with variety in order to improve well-being. Diversification is thus a common and fundamental
concept in both daily life and business. However, the practice is primarily known as a way of reducing risk by investing in a
variety of assets or business ventures. Buying one utility stock in the East coast and one in the West will minimize local
shocks, while maintaining roughly the same return as buying either of the two alone. A shop at a resort selling both
umbrellas and sunglasses clearly will have a less variable income whether a sunny or a rainy day comes up.
To obtain the optimal strategy of diversification, the risk must be defined and the associated investment opportunities
modeled. In addition, the utility or investors risk tolerance and investment horizon must be specified. In terms of asset
allocation and portfolio choice, the risk is usually defined as the standard deviation of the portfolio return. This measures the
variability of the return relative to the expected value of the return. Given a fixed level of expected return, the strategy that
generates the minimum variance is preferred. To achieve this, the optimal diversification among the assets will usually be
required. The risk tolerance of an investor determines the trade-off between return and risk, as well as the level of risk to
take.
Without a formal framework, naive diversification calls for an allocation of an equal amount of money across N assets, and
thus it is also known as the 1/N rule. This rule goes back to as early as the fourth century, when Rabbi Issac bar Aha
suggested: One should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to
hand. Naive diversification is clearly not optimal in general. For example, when investing in a money market and a stock
index, few investors will allocate 50% to the money market.
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Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V., Fundamentals of Investment,
3rd Edition, Pearson Education. Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P.
Investments, 6th Edition, Tata McGraw-Hill. Bhole, L.M., and Mahakud, J. (2009), Financial
institutions and markets.5th Edition, Tata McGraw Hill (India). Fisher D.E. and Jordan R.J.,
Security Analysis and Portfolio Management, 4th Edition., Prentice-Hall. Jones, Charles, P.,
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