Will the formation of a portfolio always lead to a risk reduction? Provide reasons

Expert Solution

Formation of a Portfolio will not always lead to risk reduction because formation has to be properly diversified in order to reduce the risk of a Portfolio and these stocks which are to be selected to portfolio had to be representative of various sectors, who are providing at diversification benefits against each other.

Diversification is the prime motive of portfolio formation because diversification will be reducing the unsystematic risk of the portfolio and these unsystematic risk will be firm specific risk which will be eliminated once the portfolio is formed, and proper representation into various factors is done but systematic risk is not reduced by portfolio formation

When there is improper allocation of securities like there is too much exposure to 1 sector only,and there is not proper diversification and they are trying to take the exposure into concentrated sectors then it would be not leading to diversification because it can even lead to double exposure as the portfolio is just exposed to a single sector and in this case the downside of that sector is not protected against upside of another sector so it is not diversified so it can be said that formation of the portfolio will not always leading to risk reduction because there has to be a proper allocation of assets in order to diversify the portfolio in order to reduce the risk.

For example,if one is making a Portfolio related to American economy and he is allocating all his money in the technological space, which is going up right now, like he is exposing himself into companies like Amazon and Apple and Netflix and forming a Portfolio, but when the market will be going down the defensive stocks like pharmaceutical industries or retail sector will be going up, so he will not be having exposure in these sectors and he will be having a high exposure to downside because of high concentration into 1 sector, and hence in such scenarios, portfolio formation is not leading to reduction of risk.

jeff jeffy answered 2 years ago

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