Question

Explain in detail why is it important for a normal, rational investor to hold a fully diversified portfolio. Use precise language (correct finance terminology) and describe what happens in your portfolio as you go from holding one stock to being fully diversified. DO NOT use the wording "put all your eggs in one basket" at any time in your answer or you will suffer a 5-point penalty.

Answer 1

It is very important for a rational investor to hold a fully diversified portfolio. The reasons are as under-

1. The unpredictability of Market: The market has always been very unpredictable. The constant amalgamation of several chunks of information regarding govt policy, revenues, economic growth pattern and investors emotions is the factor which makes market difficult to ascertain and predict. This information when couples with bigger events like military war-like scenario, currency appreciation or depreciation or a sudden government change make it harder for the market to remain constant.

2. Returns in all seasons: Compared to a concentrated portfolio which brings returns in a particular situation, a well-diversified portfolio always provides good returns as most of the risks are minimized by proper due diligence at the time of diversification. Diversification of an asset enables the portfolio to capture the upside of the assets which might be performing well at any particular point in time. This keeps the investor from the contact of those assets with might not perform well throughout.

3. Investor’s emotions: An investor’s decisions also determine its success of the investment. The ‘prospect theory’ by Nobel laureate Daniel Kahneman states that individual investors are more like to get affected by short-term volatility. They don’t sit and wait for the long-term benefits. The human emotions like fear and greed drive them to make wrong and irrational decisions. A bull trader can risk high and put reasons aside in order to go by his belief of gaining better.

4. Reduced Volatility: The volatility gets reduced because of a well-diversified portfolio. It focuses on obtaining the highest level of return on a given risk taken. Taking an example of a shopkeeper who sells both Umbrella and sunblock. He sells the umbrella on rainy days and sunblocks otherwise. He understands that the nature of day is not in his control but his range of diversified products can be controlled by him.
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