Portfolio Diversification

 Diversification is an important aspect in any investment avenue. The need for diversification arises when the portfolio need to be risk free. The risk is reduced by investing in different form of asset rather than investing the entire amount in the same form of asset. The asset invested in a diversified portfolio is less risky than the one invested in a monotonous portfolio. The investor world wide follows diversification for risk aversions. It is one of the two risk aversion technique the other being hedging. Incase of diversification the value of the asset in reduced and the yielded money from it is diversified to other asset, whereas in case of hedging the extra investments are made in order to reduce the risk. Shorting is done usually to reduce the risk using hedging technique.

Return expectation on a diversified asset is almost same as the undiversified asset. Investor expects the same investment as that from the undiversified asset, the advantage being the reduction of the risk. The logic behind this diversification is that even if one asset did not perform as per the expectation the other asset are expected to perform better there by matching the expectation as a whole from the portfolio. Having invested in a diversified portfolio investor not only looses the chance of getting the maximum from the best asset but also avoids the chance of getting the maximum loss from the most worst performing asset. If the diversified asset is all high yielding then diversification will yield the same level as that of the undiversified asset.

Maximum diversification with the portfolio having the most profitable asset is the thing which most of the investor like to have. Unfortunately it is not easy to identify the most profit making asst. The investor who can predict the portfolio with maximum return and less risk can be the most successful investor.

It should be noted that all the risk cannot be diversified. Some of the risk cannot be diversified they are market risk, systematic risk and beta risk. The undiversified risk will be there in the entire asset. It is important for the investor to select such an asset which has a less impact due to these risks

Question

• What are needs for diversification?
• What are return expectation from a diversified asset by an investor?