Question

Explain what is meant by diversification? Is this the same as asset allocation? Why or why not? Why are these terms important to you as an investor? What can happen if you do not properly diversify/allocate? What life considerations must be taken into account when developing a diversification / allocation strategy? How do any of the financial instruments you have learned about so far in this course help accomplish these needs?

Answer 1

Diversification is done to reduce the underling risk taken by the investment in single asset by investing in diversified assets so that the total risk can be reduced. The portfolio helps in diversification of assets and reduces the unsystematic risk associated with the assets which was otherwise not possible with holding single stocks. By reduction of unsystematic risk, a well-diversified portfolio is only exposed to systematic risk or market risk and total risk of the portfolio get reduced. The asset allocation is different from diversification; asset allocation is done by allocating different portions of fund to different asset classes like stocks, bonds, commodities etc. based on expected return, time horizon and risk tolerance of investors. While diversification is selection of securities in different asset categories so that investors can achieve its investment objective.

Diversification and asset allocation is important for the investors because it helps them to achieve their investment objective by optimum allocation of the resources. If investors will not properly diversify/allocate their portfolio then they will expose to non-systematic risk also which is specific to the securities and can be reduced through diversification. The total risk of the portfolio will get increased. The life considerations that must be taken into account when developing a diversification / allocation strategy are the risk aversion level of investors. According to that the diversification / allocation strategy of investment in value or growth stocks should be followed.

Therefore are many financial instruments like futures contracts and options which can be used to help control financial risk. These instruments derive their value from the value of underlying assets, stocks, bonds, commodities, currencies or mortgages and it helps achieve the investor’s financial goals or needs.