Question

discuss the role of diversification in making investment decisions with reference to portfolio theory.

Answer 1

Diversification is a way through which one can lower the risk by distributing investments among various sources, sectors, and other parameters. In finance and investment planning, portfolio diversification is the risk management strategy of combining a variety of assets to reduce the overall risk of an investment portfolio. It is also the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.

In addition, diversification of non-correlated assets can reduce losses in bear markets; preserving capital for investment in bull markets. Portfolio optimization can be achieved through proper diversification because the portfolio manager can invest in a greater number of risk assets (i.e. stocks) without accepting more risk than planned in the whole portfolio. Popular options for diversification are real estate, commodity, international market, sector diversification, debt/equity diversification etc.

Irrespective of your objective, your time frame, or your risk appetite, a diversified portfolio is the foundation of any smart investment strategy