Question

Why, as an investor, should you try to hold a diversified portfolio?

Answer 1

Risk arises because the returns are not certain or fixed or cannot be predicted in advance. Risk is defined in terms of variability in expected returns. It must be noted that all the investments are subject to risk. There is indeed positive correlation between risk and return. Greater the risk, more the returns.

Risk is caused by host of external and internal factors. The total risk of an investment can be broken down into-

--> Unsystematic or diversifiable or company-specific risk, and

--> Systematic or non-diversifiable risk or beta or market risk

You can avoid unsystematic risk by diversification. You cannot avoid systematic risk.

All rational investors like returns but at the same time dislike risk. hence, all investors are risk averse. They want higher returns for every additional unit of risk. To avoid this risk Securities Portfolio concept come into picture.

In order to avoid risk, some investors invest in a large number of securities. The basic idea here is DONOT PUT ALL YOUR EGGS IN ONE BASKET. This will lead to risk reduction. If you donot hold a diversified portfolio there’s a greater chance you could lose some or all of your money. Hence, it is better to diversify so that risk can be reduced.