Question

Describe in your own words how diversification is achieved. Explain whether diversification lowers the expected returns on a portfolio.

Answer 1

Diversification is when you put your wealth in different assets and create a portfolio where the correlation between the assets are negative and so the risk can be reduced. The idea behind diversification is when you allocate your wealth in different asset with negative correlation in the movement of returns then the overall risk of the portfolio is reduced. Diversification is also something that is important from the perspective of CAPM model, the total risk which consist of systematic risk and non-systematic risk, by diversifying your portfolio you are able to eliminate the non-systematic risk and only the systematic risk remains in the portfolio. Diversification does have impact on the expected return of the portfolio, it does reduce the expected return to at certain extent depending on the weight allocation of each asset in the portfolio however the idea behind diversification is to reduce the risk per unit of return and not entirely focus on the reduction of expected return.