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Discussion on: Diversification to reduce the risk of a portfolio of assets

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ShantaMilan

Portfolio is a combination of two or more types of security having different various returns and risks. A good portfolio diversification looks at the best collective return with lowest risk. "When analyzing the risk associated with a capital expenditure, it is important to distinguish

between the total project risk and the portfolio or beta risk of that investment.” (Moyer, McGuigan, Rao, & Kretlow, 2012) One of the most famous investors, Warren Buffet, has said, "Do not put all your eggs in one basket.” This mean to diversify the type of securities you invest in so even if one does not give you return another will which will try and maintain equilibrium to your investment.

There are two types of risks, systematic risk and unsystematic risk. Systematic risk are those risks that are out of a company’s hands like, recession, natural calamity, war etc. which affects the stock of a company. On the other hand an unsystematic risk are those risks that can be reduced or managed by a company such as employee strike, new competitor etc. A good portfolio diversification will have unsystematic risk equal to zero or should be able to minimize to the lowest possible variable.

In a portfolio more than two securities will be invested in. Their weight of investment and average return are different and so are their individual risk. Risk is most likely higher when the return is also high. But mixing these higher risk with those with lower risk minimizes the chances of loss.

Well diversified risk may have higher risk but the beta of the security may show that most of risk are unsystematic risk which can be reduced. Beta also show the sensitivity of the stock to the market. One stock may be very sensitive while the other may not. Investing in stock that have Beta which are both sensitive and less sensitive will be a good diversification of risk as these stock will have negative correlation. "Correlation shows how the return of one asset moves in relationship to that of another. Positive correlation indicates that when the return for one asset is up (or down), the return for the other asset also will tend to be up (or down). (Peavy III & Vaughn-Rauscher, 1994)”

While diversifying therefore it is wise to look at the standard deviation as well as the beta to choose those securities which have good return and higher level of unsystematic risk and less systematic risk. Therefore diversification of portfolio reduces the individual security risk as a result of combined average weighted risk that gives the portfolio an average weighted risk less than individual security risk.

References

Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.

Peavy III, J., & Vaughn-Rauscher, M. (1994, September). Risk management through diversification. Trusts & Estates; New York , p. 42.