Question

What is the role of diversification in an asset portfolio? Explain with examples.

Answer 1

Diversification is a technique employed by investors where they try to deploy their capital across multiple asset class, business, geographies, etc. to collective risk of their portfolio. If an investor has his funds concentrated in one asset and adverse news hits the market, then the portfolio is exposed to maximum loss. On the contrary, if the portfolio is diversified, only a part of the portfolio will bleed, reducing the investor's risk. In real life, it is practically impossible to predict news and events in the market. Hence diversification reduces the overall risk of the portfolio.

Suppose an investor has invested only in equities, and the government in the federal budget increase the capital gains tax on equities traded publicly, it would be taken negatively by the markets and the stock prices would fall. This would mean the investor has to suffer a loss. But if the investor had diversified his portfolio across asset classes, such as bonds, bank deposits, gold, real estate, alternative investments and equities, only a part of his portfolio would be at loss. In fact, asset classes such as gold and bonds would appreciate n value due to such a measure by the government, This approach reduces the risk of the portfolio.

Although diversification does not eliminate the risk of the portfolio, it helps to reduce the risks drastically.