Question

Discuss why diversification is important as risk management strategy within a portfolio of
investment.

Answer 1

Diversification is an important tool to reduce the unsystematic risk or security specific risk in the portfolio . While it is always wise not to put all the investment in a single asset class, diversification encourages the investors to invest and allocate the funds in different proportion in varied asset classes. While diversification cannot completely eliminate the risk , it sure minimizes the loss or safeguards the portfolio of investment in case of uncertainly .

Importance

Diversification into different investment classes as below can be achieved as per the risk appetite of the investor. Portfolio managers determine the risk averse coefficient (A) for each investors to determine the efficient allocation of resources into the following categories of the investment.

Although the diversifies portfolio may be costly for the investor as the cost of nesting in different asset classes is not the same , however diversification up to a extent provides considerable risk adjusted returns for the investors .

Correlation between asset classes and diversification .

Positively Correlated securities-(rho +1) These securities moves up/ done in the same direction at the same time. Hence diversification is low

Uncorrelated securities (rho 0)= In these securities , the movement of price of one is completely uncorrelated with the other .

Negatively correlated securities (rho -1) = While the price of one moves down the price of the other security moves in the opposite direction . therefore perfectly uncorrelated securities provide the best form of diversification in the portfolio of the investors.