Question

Explain in detail why is it important for a normal, rational investor to hold a fully diversified portfolio. Use precise language (correct finance terminology) and describe what happens in your portfolio as you go from holding one stock to being fully diversified. DO NOT use the wording "put all your eggs in one basket" at any time in your answer or you will suffer a 5-point penalty.

Answer 1

The primary objective of investment is to gain return out of it. Let's see a situation where we invest in only one stock means i.e. we are investing fully in that particular stock which belongs to a specific asset class and industry. Some day, things go wrong in that industry which affects the stock held by us, as a result of which we suffer loss. Now, if we think what we could have done differently to avoid the situation. If we had put our investments in different stocks i.e. assests belonging to different types of industries, economic fluctuation in one industry might have not affected another industry and in this way, our loss could have been reduced to an extent.

Hence, when we invest in different types of assets in same asset class or within same asset class across different industry sectors, this is called portfolio diversification. This way we reduce the risk of loss considering the fact that if one investment performs poorly over a certain time period, our other investments might do well over the same period. Risk reduction happens when we go from holding one stock to being fully diversified. Hence it is important for a normal, rational investor to hold a fully diversified portfolio and not concentrate all his capital under one investment.