Question

How does the creation of a portfolio reduce risk? What type of assets should be included in a diverse portfolio? Why should they be included?

Answer 1

Solution:-

There is a common saying that 'Never put all your eggs in a single basket'. This is because if that one basket falls, you lose all your eggs.

Same is the case with your investments. If one invests all his money in one asset class, he stands a great risk of loss if that one asset class goes down. The various asset classes that can be invested in as part of portfolio management are as follows:

• Equity shares: These should be included because they offer the greatest opportunties of earning high returns with also high risk but a stable long-term performance historically speaking
• Preferred shares: These should be invested as they offera good balance of saefty and more than average return. They are slightly more risky than debt but also offer a slightly higher returns
• Fixed income investments includinh mortgage bonds: These should be invested for safety. An allocation of portfolio to these brings safety to the portfolio
• Real Estate investments: Offers a great way to invest money in real assets, offering a unique blend of saefty as well as opportunities for earning good rates of returns
• Gold and othe precious metals: Offers hedge against equities and complement well in the overall portfolio

Thus, there are various asset classes available to investors for the purpose of investing their portfolios.

The portfolio creation helps reducing risk because various asset classes carry different risks and by allocating money to just one of them exposes our money to the asset-specific risk. By allocating money across various asset classes diversify our exposure to multiple asset classes and thus reduce the risk as its far less likely that the risks related to all asset classes will show up as compared to the risk of one asset classes showing up.

Further, many asset classes act as a hedge against one another. For e.g.: when equities do bad, gold generally performs very well. Thus, allocating money to both in a potfolio hedge the investments against one another and reduce the overall risk of the portfolio.