Question

Explain how diversification can reduce the risk in your retirement portfolio. Give an example

Answer 1

Diversification - We should not invest our wealth in a single stock. We should invest in a portfolio. Whenever we combine two or more assets in a portfolio the risk gets reduced. The extent of risk reduction depends on correlation.

Correlation refers to the strength of liner relationship between two variables. It lies between -1 and +1. Lower the correlation, greater the benefit of diversification in the form of risk reduction. Therefore maximum benefit from diversification will occur when correlation coefficient is -1.

Diversification can reduce the Unsystematic risk component.

Unsystematic Risk - It is the volatility of a stock on account of internal company specific factors. This risk can be avoided through diversification. The greater the number of stocks in the portfolio the greater is the chance of Unsystematic Risk getting cancelled out.

A well-diversified retirement portfolio will safeguard against the market volatility as the portfolio will comprise of different stocks. Therefore even if one stock suffers due to volatility it would be protected by the other stocks in the portfolio. Example - Invest in stocks of different unrelated sectors, add bond investment to your portfolio or add risk free investment such T-bills issued by the government. Lower the correlation among these investments the higher will be the benefit of risk reduction.