Question

How does diversification affect portfolio design, risk, and returns? Why does introducing international investments and such asset types as real estate, commodities, and bonds play a role in this? Specifically include the concepts of risk measurement and correlation between returns on various securities in your answer.

Answer 1

Diversification will affect the portfolio design because it will mean that the assets are put into different classes to minimise the overall risk associated with them and it is also focusing at maximizing the overall rate of return.

Diversification of a portfolio is always aimed at not concentrating assets into one asset class, and diversifying it into different assets so that it can be hedged against adverse economic scenarios as the risk will be minimised associated with the portfolio, and the return capability will be maximized.

Introduction of international investments, real estate and bonds will lead to Investments diversification because these are different asset classes and investment in international assets will also hedge against exchange rate risk and inflation in real estate and bonds will hedge against asset class risks.

Correlation between different asset can also be used to minimise the overall risk as a low correlation will be helpful in diversigication and high correlation means higher exposure.