Question

Investment diversification is a principle that investors follow. Is the principle of investment diversification that is used by investors in our society based upon biblical principles or are there other motives for investment diversification

Answer 1

According to biblical principles, we need to invest in at least 7 to 8 asset classes to minimize risk as it is little known what disaster might occur and its main advice is "Don't put all your eggs in one basket".

The total risk is composed of systematic risk and unsystematic risk.

The unsystematic risk of the portfolio can be reduced to 0 if we diversify our portfolio. For example, if the investor invests 100% assets in a company that offers high return, there are chances that the investment could result in lower returns if some adverse event takes place. Thus, the portfolio is subject to the unsystematic risk that the company will under perform due to company specific factors. However, if we diversify and divide our many in several asset classes, the unsystematic risk cancels out each other across investments and we are then just subjected to systematic risk that affects all market participants. Systematic risk is nothing but the adverse market movements not related to any particular company or asset class.

Thus, diversification leads to higher returns for a given level of risk and lower risk for a given level of return.