Question

Briefly explain what you understand by a portfolio of assets and an efficient portfolio. Also
explain in short ‘diversification’. Is there any relationship between diversification and efficient
portfolio? Please briefly explain.

Answer 1

Portfolio of Assets

An portfolio is a set of financial assets owned by a investor that may include bonds, stocks, currencies, cash and cash equivalents and commodities. The investor needs to make sure that there is a good mix of assets in order that balance in maintained, which helps foster capital growth with limited or controlled risk. A portfolio may contain the following:

Stocks: Stocks are the most common component of an investment portfolio. They refer to a portion or share of a company. It means that owner of the stocks is a part owner of the company. The size of the ownership stake depends on the number of shares he owns. They are also a source of income because as a company makes profits, it shares as portion of the profits through dividends to its stakeholders.

Bonds: When an investor buy bonds, he is loaning money to the bond issuer, such as the government, a company or an agency. A bonds comes with a maturity date, which means the date of the principal amount used to buy bond is to be returned with interest. Compared to stocks, bonds dont pose as much risk, but offer lower potential rewards.

Efficient Portfolio:

An efficient portfolio, is one that provides the best expected return on a given level of risk, or alternatively, the minimum risk for a given expected return. A good portfolio is more than a long list of stocks and bonds. It is a balanced whole, providing the investors with protections and opportunities with respect to a wide range of contingencies.

An efficient portfolio is one that is well diversified and adequately compensates you for risk. When it comes to putting together an efficient investment portfolio, reducing volatility is the name of the game. Experts advise diversifying your portfolio by including stocks from different industries.

Diversification:

Opinions vary as to how many stocks it takes to create a diversified portfolio. Whatever number you choose, your portfolio should hold a broad spectrum of stocks from different industries. Pairing a high-flying technology stock with a utility company stock is an example of diversification. The idea behind diversification is that when one stock is down, the other stocks in the portfolio pick up the slack. You will have to do homework when it comes to stock picking. This means researching the top three or four companies in each industry, reading financial and analyst reports to understand the financial outlook for each company, and picking the best company to add to your portfolio.

Relationship between diversification and efficient portfolio:

One can limit the volatility of portfolio by spreading out risk among different types of investments. In fact, by putting together a basket of risky or volatile stocks, the overall risk of the portfolio would actually be less than any one of the individual stocks in it. Diversification depends more on how the securities perform relative to one another than on the number of securities you own. The right kind of diversification requires that your own securities that dont behave alike. In other words, their price movements have low corrleation with each other.

An efficent portfolio is either a portfolio that offers the highest expected return for a given level of risk, or one with the lowest level of risk for a given expected return. Investors must examine their own risk/return preferences to determine where they should invest on the efficient frontier.