Question

Question 2: Explain why diversification is important when creating a strategic asset allocation but not as important when creating a tactical asset allocation?

Question 3: In question 2 above, you have explain the benefits of diversification, now explain if there is a cost associated with diversifying a portfolio?

Only do Q3, as detail as possible plz.

Answer 1

Q3:

Diversification is a way of managing risk associated to a portfolio. The idea is to invest in assets especially for strategic allocation such that the different assets have a cushioning effect during different market conditions.

There is lost of tangible as well as oppurtunity costs associated with diversifying a portfolio.

• Too much diversifying can significantly reduce the return: Ultimately we are making investments not for a place to deposit money but as an instrument to earn returns. Having too much diversification can impact the expected return of the portfolio which if not rebalanced might underperform.
• Diversification using low quality assets can be unstable and can show significant deviation from historical risk profiles
• Slippages and errors while selecting assets can occur and affect the efficiency of diversification.
• There are transaction costs, brokerage etc that you have to pay for holding different class of assets and hence diversification increases these cost also increases. This can affect in the profit potential.
• Diversifying is not a one time exercise and for a stable portfolio you need to frequently rebalance your portfolio which can result in additional charges.
• Liquidity of asset classes can be a big issue and due to low liquidity of some assets you might end up paying a premium for acquiring such assets and might have to sell it for a discount.
• Many cases you might not be having good knowledge about all type of assets and because of this you need to consult a financial advisor who can charge a hefty price for their asset recommendations.