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Diversification

What Diversification Is

It is rare to find rational investors concentrating their entire wealth in a single security or investment.  Instead, they  tend  to invest  in  a diversified  portfolio  of securities.  The reason  is  that pooling  imperfectly correlated stocks  together helps to diversify away diversifiable (unique or non-systematic) risks. It has been found that risk of a portfolio is less than the sum of the risks of the individual stocks within the portfolio.

When  security  returns  have  perfect  positive  correlation,  the  returns  of  the securities  in  the  portfolio  move  in  the  same  direction.  Therefore, it is not possible to reduce risk without sacrificing some returns. When  securities  returns  have  perfect  negative  correlation,  returns  always move  in  different  directions.  Therefore,  the  portfolio  may  contain  too  risky stocks, but the portfolio may not be risky at all. This is because a fall in the return of one stock will be compensated for by a rise in the return of the other. The more negative the correlation, the higher the possibility of risk reduction.

Diversification is the process of combining securities or investments in a portfolio with  the  aim  of  reducing  total  risks  (market  risk  plus  unique  risk)  without sacrificing portfolio return. It is a form of corporate strategy whereby a company seeks to increase profitability through greater sales volume obtained from new products and/ or new markets.

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