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DEFINITION:Portfolio diversification is the practice of spreading out portfolio capital into several different
areas. A portfolio of ten different stocks is more diversified than a portfolio of five different
stocks. Spreading investment capital over multiple financial markets such as stocks, bonds and
futures is another form of portfolio diversification.

INTRODUCTION:Diversified portfolios greatly reduce risk while smoothing investment returns by including many
securities across a wide range of industries. This allows investors to participate in a wide variety
of investment opportunities while reducing the risk of large losses due to any one security.
Diversification is an investment strategy in which you spread your investment dollars among
different sectors, industries, and securities within a number of asset classes.A well-diversified
stock portfolio, for example, might include small-, medium-, and large-cap domestic stocks,
stocks in six or more sectors or industries, and international stocks. The goal is to protect the
value of your overall portfolio in case a single security or market sector takes a serious down
turn.
Diversification can help insulate your portfolio against market and management risks without
significantly reducing the level of return you want. But finding the diversification mix that's right
for your portfolio depends on your age, your assets, your tolerance for risk, and your investment
goals. A risk management investment strategy in which a wide variety of investments are mixed
within a portfolio; the rationale is that a portfolio of different investments will, on average, yield
higher returns and pose a lower risk than any individual investment within the portfolio.
Diversification strives to smooth out unsystematic risk in a portfolio so that the positive
performance of some investments will neutralize the negative performance of others. Therefore,
the benefits of diversification will hold only if the securities in the portfolio are not correlated.
The main purpose of diversification is to lessen risk. For example, if someone has 20 percent of
her portfolio invested in XYZ stock, she stands to lose a significant percentage of her portfolio
value if XYZ declines. However, if the investor diversifies by investing in other stocks and
leaves only 5 percent of her portfolio in XYZ, she will lose a much smaller percentage of
portfolio value in the event of a decline.

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IMPORTANCE OF DIVERSIFICATION:Diversification is not a new concept. We should remember that investing is an art form, not a
knee-jerk reaction, so the time to practice disciplined investing with a diversified portfolio is
before diversification becomes a necessity. By the time an average investor "reacts" to the
market, 80% of the damage is done. Here, more than most places, a good offense is your best
defense and in general, a well-diversified portfolio combined with an investment horizon of three
to five years can weather most storms.
1. Spread the WealthEquities are wonderful, but don't put all of your investment in one stock or one sector. Create
your own virtual mutual fund by investing in a handful of companies you know, trust, and
perhaps even use in your day-to-day life. People will argue that investing in what you know will
leave the average investor too heavily retail-oriented, but knowing a company or using its goods
and services can be a healthy and wholesome approach to this sector.
2. Consider Index or Bond FundsConsider adding index funds or fixed-income funds to the mix. Investing in securities that track
various indexes make a wonderful long-term diversification investment for your portfolio. By
adding some fixed-income solutions, you are further hedging your portfolio against market
volatility and uncertainty.
3. Keep BuildingAdd to your investments on a regular basis. Lump-sum investing may be a sucker's bet. If you
have $10,000 to invest, use dollar-cost averaging. This approach is used to smooth out the peaks
and valleys created by market volatility: you invest money on a regular basis into a specified
portfolio of stocks or funds.
4. Know When to Get OutBuying and holding and dollar-cost averaging are sound strategies, but just because you have
your investments on autopilot does not mean you should ignore the forces at work. Stay current
with your investment and remain in tune with overall market conditions. Know what is
happening to the companies you invest in.
5. Keep a Watchful Eye on CommissionsIf you are not the trading type, understand what you are getting for the fees you are paying. Some
firms charge a monthly fee, while others charge transactional fees. Be cognizant of what you are
paying and what you are getting for it. Remember, the cheapest choice is not always the best.

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NEEDS OF THE DIVERSIFICATION:The portfolio should be spread among many different investment vehicles such as cash, stocks,
bonds, mutual funds, and perhaps even some real estate. The securities should vary in risk.
You're not restricted to picking only blue chip stocks. In fact, the opposite is true. Picking
different investments with different rates of return will ensure that large gains offset losses in
other areas. Keep in mind that this doesn't mean that you need to jump into high-risk investments
such as penny stocks.
The securities should vary by industry, minimizing unsystematic risk to small groups of
companies. Another question people always ask is how many stocks they should buy to reduce
the risk of their portfolio. The portfolio theory tells us that after 10-12 diversified stocks, you are
very close to optimal diversification. This doesn't mean buying 12 internet or tech stocks will
give you optimal diversification. Instead, you need to buy stocks of different sizes and from
various industries.
If we invest in a single security, our return will depend solely on that security; if that security
flops, our entire return will be severely affected. Clearly, held by itself, the single security is
highly risky. If we add nine other unrelated securities to that single security portfolio, the
possible outcome changes if that security flops, our entire return wont be as badly hurt. By
diversifying our investments, we can substantially reduce the risk of the single security.
Diversification substantially reduces the risk with little impact on potential returns. The key
involves investing in categories or securities that are dissimilar.
Diversification of investment means selecting multiple asset classes or investing in the different
asset categories. It is a popular technique employed by most investors to lower risk and increase
the chances of good returns. Unfolding your investment in different areas develops a risk-proof
portfolio, which means if one investment fails, another will balance it out.
Diversified portfolio has certain built-in risks. For example, stocks could be fickle in the short
term. Even though you have carefully diversified your portfolio, there is always a percent chance
of investors undergoing losses due to emergency conditions. Some of these factors include
commodities meltdown, global financial crises, socio-political condition and others.

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Diversification can be used with many types of investments, and it allows the investor to still
earn a profit, or limit her losses, even if one investment performs badly. For example, a
farmer can grow corn, soybeans and wheat, so if a corn beetle eats all of the corn in the
farmer's field, the farmer still has soybeans and wheat available to sell.
1.Geographical DiversificationGeographical diversification protects an investor from problems in the local market. For
example, a restaurant owner may build restaurants in Pasadena, San Diego and San Jose. If many
companies in San Jose lay off their employees, reducing the number of customers at the San Jose
restaurant, the restaurant owner can still collect revenue from his Pasadena and San Diego
restaurants.
2.Cross-sector DiversificationCross-sector diversification protects an investor if one type of company's sales decline. A
business conglomerate can own unrelated businesses, such as a pencil factory, a potato farm and
a motorcycle dealership. If customers decide to purchase pens instead of pencils, the
conglomerate does not have all of its resources invested in the pencil factory.
3.Intra-sector DiversificationAn investor can purchase multiple types of investments in the same sector. For example, a real
estate developer can build condominiums in one development, single-family houses in another
and apartments in a third. A real estate investment trust obtains funds from many investors, so it
can afford to purchase several types of real estate, which is difficult for a homeowner who can
only pay the mortgage on a single house.
4.TaxesDiversification may provide tax benefits. If the pencil factory doesn't sell enough pencils in one
year to earn a profit, the conglomerate reports a loss for the pencil factory, which reduces the
amount of income taxes it has to pay that year on its successful potato farm and motorcycle
dealership.
5.Seasonal DiversificationDiversification can improve the cash flow of a seasonal business. Many customers want to
purchase pumpkins right before Halloween, but demand will be lower during the rest of the year.
The pumpkin farmer can grow another crop that he can sell in the spring, such as apples, so he
doesn't have to wait until Halloween to have cash available.

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PRINCIPLES OF DIVERSIFICATION:It has been said that diversification is the secret sauce of asset allocation. Diversification seems
so obvious and so easyDont put all your eggs in one basket. Investment professionals
suggest that you invest in a portfolio of non-correlated assets, which in simple terms refers to
securities that generally do not change in price and direction at the same time. The idea here is
that owning a portfolio of non-correlated assets allows an investor to reduce volatility and
achieve better long-term risk-adjusted performance.
In the first two segments of this series on asset allocation we established that constructing the
optimum portfolio depends on measuring risk, forecasting returns and calculating correlation. We
explained the importance of replacing normal distributions with non-normal distributions in an
effort to better understand the probability and severity of extreme events. We also discussed how
GARCH analysis can improve an investment forecasting model the way Doppler radar improves
weather forecasting, as it places more emphasis on recent data and takes into account the way in
which the data has been changing.
Diversity is a pretty general concept meaning simply a lack of similarity. When we want to speak
technically with more precise language we use the statistical terms correlation and dependence,
which describe and measure similarity. Correlation describes how pairs of securities act in
relationship to each other over some period of time; if you can predict the change in one based
on the change in the other, you have demonstrated dependence. As investors, we know that
owning a portfolio of highly correlated assets does little to cushion the impact of down markets
and we are told by our investment advisors that that owning non-correlated or negatively
correlated assets will protect us from market crashes and dampen our losses in bear markets.
One problem with correlation is the stubborn unwillingness of securities to remain at a fixed
level of correlation over time. In fact, the daily noise reflects real variations in behavior. You will
often see negatively correlated securities become highly positively correlated, especially during
market crashes and major market rebounds. Seasoned professionals often remark, The only
thing that goes up in a down market is correlation! In other words, the common pitfall of using
correlation to do portfolio optimization is assuming that correlation is fixed and can be
determined from long-term averages. Just as we pointed out in the discussion of risk and return
forecasting, the long-term average value is quite often not indicative of future results.

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A diversified portfolio is a collection of asset classes. Asset classes refer to distinctly different
types of securities such as stocks, bonds, commodities, international investments, cash and real
estate. The purpose of the diversified portfolio should be to offer maximum return while
minimizing the overall risk of the portfolio.
1.Asset Classes Make a Diversified PortfolioCommon asset classes are stocks, bonds, commodities and currencies. Asset classes are a unique
group of stocks that have common properties. Stocks and preferred stocks can be considered
different classes but they are not as diversified as a combination of stocks and foreign currencies.
2.Diversify Within Each Asset ClassOwning a stock portfolio is better than owning a single stock. Owning a stock and bond fund
adds another new asset class. Adding a third asset class, commodity exchange traded funds,
further spreads risk and smoothes returns.
3.Diversified Portfolio is a Core Principle of InvestingInvesting is not being smarter than the market. It is about riding the market trends as profitably
as possible under a variety of circumstances. Diversified portfolios help ride out market
uncertainty.
4.Indices are Diversified PortfoliosYou can buy an index fund of stocks, bonds, or other asset classes that is a proportionate sample
of all the securities in that index. Exchange traded funds are low cost replicas of many asset
classes. Purchased together, a cost-effective diversified portfolio of many asset classes can be
assembled.
5.The Alternatives to a Diversified PortfolioOwning securities that are very similar or highly correlated provides irregular returns and high
risk. Investors suddenly needing to convert their asset to cash at inopportune times will have no
choice but to accept the current market price.

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As an investor, you are well advised to spread your money among a number of instruments. This
way, you don't risk putting all your eggs in one basket. Even if you lose money on one
investment, you could make up the loss in another. Diversifying among and within asset
classes is a way to create a healthy portfolio, as is investing in mutual funds.
1.Diversifying Among Asset ClassesThere are a number of asset classes for investors to choose from. You could invest in stocks or
bonds, the two best known classes. You could also choose real estate or commodities. How about
precious metals? Each asset class has its own risks and rewards. When stocks do well, bonds
may not. Your diversification will prevent your portfolio from going down all at once.
2.Diversifying Within Asset ClassesEven if your portfolio is made up of a number of asset classes, you may not be adequately
diversified within them. If you have a number of stock holdings, they should be in companies
operating in different industries. If you have exposure to just one industry, you will lose money if
that industry does not do well. Also, spread your investments among established companies,
which are less likely to default, and startups, which come with a higher level of risk.
3.Mutual FundsConsidering that it is difficult for an individual investor to buy a large number of stocks and
bonds on a limited budget, a mutual fund is a good option as a portfolio diversification tool. A
fund invests the money in many individual stocks and could also give you access to investments
you may not be able to buy on your own. You could buy a stock fund that gives you exposure to
different industries and even different countries.
Be aware, though, that you should have diversity in your mutual fund choices as well. There are
also mutual funds that invest in bonds of different companies. There are mutual funds that invest
in alternative investments such as commodities, precious metals and real estate. These are
typically run by managers with expertise in those sectors

ADVANTAGES & DISADVANTAGES OF PORTFOLIO


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A diversified portfolio is having a collection of financial instruments carefully spread in different
industries, fields and ensures minimal attachment or effects against each other. Diversification of
portfolios had allowed investors to gain more profit and lessen the impact of their losses.
However, there are also some disadvantages to a diversified portfolio.

ADVANTAGESThe advantage of diversification is that it broadens your exposure to market swings. The
principle is that one sector (or stock) may devalue, but not all sectors will devalue. In the long
term, most sectors tend to experience growth, so the total portfolio value of a diversified account
should gradually grow.
A diversified portfolio works by investing in different areas of industries where one industry
cannot affect another industry should it have minimal to negative market activity. With
diversification, investors lower the risk value of their assets and portfolio. Most diversified
portfolios work well with long-term investors to outlast economic storms.
1.Asset ChoicesWhen your holdings are widely diversified, you can spread them out over widely divergent forms
of assets, including securities such as stocks and bonds, commodities such as oil and minerals,
real estate and cash. Each of these assets exhibits different strengths and weaknesses in terms of
risk and profitability. Maintaining holdings in all of these areas helps to create a stable portfolio
that will increase in value over the long term.
2.Lower MaintenanceInvestments require a certain amount of care and attention to keep them performing well. If you
are playing high-stakes games with your assets and moving them around through risky ventures,
you will probably be spending a fair amount of time watching the markets and dodging financial
bullets. A diversified portfolio is less exciting and more stable. Once you have your investments
settled into a wide variety of stocks and securities, they can remain there for extended periods
without requiring a lot of maintenance. This frees up your time to pursue other matters and
reduces the market stress that may lead to burnout.

3.RiskPortfolio diversification tends to reduce your long-term risk. Anytime you hold an investment,
you risk losing its value. For example, if you purchase a share of stock for $50 and end up selling
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it for $35, you incur a loss. Now imagine that you own two shares of stock. You purchase one
stock for $50 and end up selling it for $35. The second stock costs $10 and you sell it for $25. In
this example, you eliminate your loss through diversification. Most diversified portfolios do not
achieve complete elimination of loss -- only reductions in its potential.
4.Higher ReturnsA diversified portfolio could result in higher returns. Between January 1, 2001 and November
30th, 2011, the Standard and Poor's 500 Fund Index returned a 1.4 percent gain. Investors with
diversified portfolios returned an average 5.4 percent gain during the same time period,
according to "USA Today." A larger percentage of bonds were in the diversified portfolios.
Higher returns from diversification tend to be seen with longer periods of time. Diversification
does not always increase returns in the short term, however. If the overall health of the
investment market is poor, diversification may still result in a negative return.
5.AdjustmentsAn advantage of diversification is that you can adjust your investment mix. A more risky,
growth-oriented strategy makes more sense when you're young. You have more time to tolerate
ups and downs in the market. A growth-oriented diversification strategy for 20- to 30-year-olds
might consist of 90 percent stocks and 10 percent bonds, according to USA Today. If your
diversification strategy is more advanced, you might invest heavily in the stocks of small and
emerging U.S.-based companies.
6.BalanceBehavioral portfolio theory states that investments either protect from loss or provide highgrowth potential. According to the theory, your portfolio represents a pyramid when you
diversify. A diversified portfolio has a higher percentage of low-risk, income and value
investments. At the top of the portfolio pyramid is a lower percentage of "blend" and growth
funds. "Blend" funds are a combination of high-risk and risk-averse investments. Portfolio
diversification allows you to achieve more than one financial goal. The income and value
investments can provide you with stability and regular payments. Blend and growth funds can
help you increase your wealth. Of course, any of these can incur risk; positive returns are never
guaranteed.

DISADVANTAGES-

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The disadvantage of diversification is that a portfolio focused on a single sector or stock can
have some super growth, naturally this comes with increased risk. Another disadvantage is that
diversification can be difficult for small investors. (It doesn't need to be, but it can be.
A diversified portfolio spreads assets too thinly. When risk is lower, this also means the gain is
lower. An investor also lessens the chance of having growth from industry booms because they
have less investment on such fields. While diversified portfolios do not easily shake with daily
market fluctuations, they also guarantee lower returns and profit for the investor.
1. Reduces QualityThere are only so many quality companies and even less that are priced at levels that provide a
margin of safety. The more stocks you put into your portfolio the less concentrated your portfolio
will be in the best opportunities.
2. Too ComplicatedMany investors include so many assets in their portfolio they dont really understand whats in
them. Diversification in investing is important,but keep your portfolio simple enough that you
can stay on top of your investments.
3. IndexingIf you have too many assets in your portfolio it essentially becomes an index fund. If you want
an index fund, buy an index fund; dont waste transaction fees on purchasing numerous assets
that morph into an index fund.
The more stocks you own the more correlated your portfolio will be to market returns. While
passive management or indexing might work in bull markets it does not work well in flat or bear
markets. Most indices are skewed toward stocks that have already risen and underweight stocks
that have fallen, and may be at bargain prices.
4. Market RiskBefore you buy an index fund be sure you understand how the mathematics of portfolio volatility
lowers your portfolio performance. Few investors ever achieve even close to average returns
because of volatility caused by market risk.
5. Below Average Returns-

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Indexing and over diversification are disadvantages of diversification because quality suffers
when you own inferior investments along with good investments. Below average returns result
from transaction fees or mutual fund expenses. In addition to portfolio volatility lowering
returns, many investors let their emotions cause them to buy high and sell low.
6. Bad Investment VehiclesMost investors, who over diversified use investment vehicles such as index funds, or even worse,
actively traded mutual funds. Actively managed mutual funds trade in and out of stocks and have
a tendency to focus on short term trading instead of value. Studies show these funds
underperform market indices in the long run.

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While investing might seem like one of those ho-hum chores, it's not. In fact, your future, at least
a financially secure one, depends largely on sound investing. A diversified mix of stock
positions serves as the cornerstone of many successful investment portfolios.
Step 1Buy various types of stocks. As Jeremy Glaser of Morningstar indicates in relation to your
overall portfolio, it's not about quantity, it's about how your investments play against one another.
The same goes for the stock portion of your holdings. Select stocks from different sectors and of
different sizes that might perform differently during a market downturn, for example. For
instance, although individual specifics vary, you might be on the road to diversification if you
hold a few technology growth stocks such as Apple, a few staples like Proctor & Gamble
and McDonalds, a couple small company stocks, a couple stocks from banking and real estate, a
couple traditionally "safe" stocks such as utility stocks and a few international plays.
Step 2Try to emulate the makeup of major stock market indexes, namely the S&P 500. For
instance, check out the how the Standard & Poor's weights the S&P 500 by sector and
by company size. Attempt to hold a number of stocks from each sector that correlates to how
Standard & Poor's divvies things up.
Step 3Buy mutual funds. If your head spins trying to find and track tens or hundreds of stocks from
various sectors and of several sizes, leave it up to somebody else. And this does not necessarily
mean a financial advisor. You can purchase mutual funds that provide diversification. For
example, stakes in an international or emerging markets fund, a large cap stock fund, a small cap
stock fund, a fund focused entirely on growth stocks, a conservative value or balanced fund and
an index fund that tracks the Sample 500 offer fantastic diversification minus the allocation of
time and resources you might not have.

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Diversification is a technique that reduces risk by allocating investments among various financial
instruments, industries and other categories. It aims to maximize return by investing in different
areas that would each react differently to the same event. Most investment professionals agree
that, although it does not guarantee against loss, diversification is the most important component
of reaching long-range financial goals while minimizing risk. Here, we look at why this is true,
and how to accomplish diversification in your portfolio.
Efficient financial management combines safety of principal, alongside opportunities for growth.
Diversified investment portfolios are designed to neutralize economic volatility and
provide for steady returns amidst numerous economic scenarios. Still, all financial
transactions carry distinct risks.
1.IdentificationDiversification relates to asset allocation strategy that combines varying levels of stocks, bonds
and cash within one investment portfolio. Commodities, real estate and derivatives are
alternative investments that increase diversification.
2.BenefitsDiversification is intended to manage the wild fluctuations in price associated with the stock
market and individual investments. Furthermore, diversification allows for higher returns over
inflation than certificates of deposit and bonds.
3.ConsiderationsProper diversification strategies are dynamic, and vary according to your personal risk tolerance
and time frame towards particular goals. For example, savers approaching retirement will favor
portfolios that feature larger proportions of bonds. Conversely, young savers prefer to invest for
growth---with higher weightings for stocks.
4.MisconceptionsSimply owning several different stocks and bonds does not equate to perfect diversification.
Investments should cover multiple industries and geography, so that different portions of the
portfolio are profitable at each point during the economic cycle.
5.RisksDiversification cannot counter systemic risk. Systemic risk describes the collapse of the entire
financial system.

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With the markets moving up and down like a Six Flags roller coaster, is there anything you can
do to stomach the risk? Have you carefully considered the various risks that are associated with
each investment you make?
The fact is, many people either have no desire or no knowledge about how to protect themselves
from unneeded risk. In this tutorial, we'll introduce you to risk and give you a good foundation to
understand the relationship between return and risk
1.Portfolio Risk and DiversificationWhether it is investing, driving, or just walking down the street, everyone exposes themselves to
risk. Your personality and lifestyle play a big role in how much risk you are comfortably able to
take on. If you invest in stocks and have trouble sleeping at night, you are probably taking on too
much risk.
Risk is defined as the chance that an investment's actual return will be different than expected.
This includes the possibility of losing some or all of the original investment.
Those of us who work hard for every penny we earn have a harder time parting with money.
Therefore, people with less disposable income tend to be, by necessity, more risk averse. On the
other end of the spectrum, day traders feel if they aren't making dozens of trades a day there is a
problem. These people are risk lovers.
When investing in stocks, bonds, or any investment instrument, there is a lot more risk than
you'd think. In the next section, we'll take a look at the different kind of risk that often threaten
investors' returns.
2.Types Of Portfolio Risk

Systematic Risk - Systematic risk influences a large number of assets. A significant


political event, for example, could affect several of the assets in your portfolio. It is
virtually impossible to protect yourself against this type of risk.

Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This


kind of risk affects a very small number of assets. An example is news that affects a
specific stock such as a sudden strike by employees. Diversification is the only way to
protect yourself from unsystematic risk.

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Now that we've determined the fundamental types of risk, let's look at more specific types

of risk, particularly when we talk about stocks and bonds.

Credit or Default Risk - Credit risk is the risk that a company or individual will be
unable to pay the contractual interest or principal on its debt obligations. This type of risk
is of particular concern to investors who hold bonds in their portfolios. Government
bonds, especially those issued by the federal government, have the least amount of
default risk and the lowest returns, while corporate bonds tend to have the highest amount
of default risk but also higher interest rates.

Country Risk - Country risk refers to the risk that a country won't be able to honor its
financial commitments. When a country defaults on its obligations, this can harm the
performance of all other financial instruments in that country as well as other countries it
has relations with. Country risk applies to stocks, bonds, mutual funds, options and
futures that are issued within a particular country. This type of risk is most often seen in
emerging markets or countries that have a severe deficit.

Foreign-Exchange Risk - When investing in foreign countries you must consider the
fact that currency exchange rates can change the price of the asset as well. Foreignexchange risk applies to all financial instruments that are in a currency other than your
domestic currency. As an example, if you are a resident of America and invest in some
Canadian stock in Canadian dollars, even if the share value appreciates, you may lose
money if the Canadian dollar depreciates in relation to the American dollar.

Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as
a result of a change in interest rates. This risk affects the value of bonds more directly
than stocks.

Political Risk - Political risk represents the financial risk that a country's government
will suddenly change its policies. This is a major reason why developing countries lack
foreign investment.

Market Risk - This is the most familiar of all risks. Also referred to as volatility, market
risk is the the day-to-day fluctuations in a stock's price. Market risk applies mainly to
stocks and options. As a whole, stocks tend to perform well during a bull market and
poorly during a bear market - volatility is not so much a cause but an effect of certain

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market forces. Volatility is a measure of risk because it refers to the behavior, or
"temperament", of your investment rather than the reason for this behavior.

3. The Portfolio Risk-Reward TradeoffThe risk-return tradeoff could easily be called the iron stomach test. Deciding what amount of
risk you can take on is one of the most important investment decision you will make.
The risk-return tradeoff is the balance an investor must decide on between the desire for the
lowest possible risk for the highest possible returns. Remember to keep in mind that low levels
of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty
(high risk) are associated with high potential returns.
The risk-free rate of return is usually signified by the quoted yield of "U.S. Government
Securities" because the government very rarely defaults on loans. Let's suppose that the risk-free
rate is currently 6%. Therefore, for virtually no risk, an investor can earn 6% per year on his or
her money.

But who wants 6% when index funds are averaging 12-14.5% per year? Remember that index
funds don't return 14.5% every year, instead they return -5% one year and 25% the next and so
on. In other words, in order to receive this higher return, investors much also take on
considerably more risk.
The following chart shows an example of the risk/return tradeoff for investing. A higher standard
deviation means a higher risk:

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4. Diversifying The Portfolio To Reduce The RiskWith the stock markets bouncing up and down 5% every week, individual investors clearly need
a safety net. Diversification can work this way and can prevent your entire portfolio from losing
value.
Diversifying your portfolio may not be the sexiest of investment topics. Still, most investment
professionals agree that while it does not guarantee against a loss, diversification is the most
important component to helping you reach your long-range financial goals while minimizing
your risk. Keep in mind, however that no matter how much diversification you do, it can never
reduce risk down to zero.
5. Portfolio RiskDifferent individuals will have different tolerances for risk. Tolerance is not static, it will change
as your life does. As you grow older tolerance will usually shrink as more and more obligations
come up, including retirement.
There are several different types of risks involved in financial transactions. I hope we've helped
shed some light on these risks. Achieving the right balance between risk and return will ensure
that you achieve your financial goals while allowing you to get a good night's rest.

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CORRELATION DIVERSIFICATION REDUCES PORTFOLIO
RISK:Diversifying across growth or value styles, market capitalizations, regions or countries does not
necessarily provide risk protection against the components of your portfolio moving up or down
at the same time or to the same degree. Diversifying by correlation does help prevent all your
portfolio components from marching in unison.
Correlation is a statistical measure of how two securities move in relation to each other.
Correlation is expressed by numbers ranging from -1 to +1. Perfect negative correlation means
the two securities move lockstep in opposite directions. Perfect positive correlation means the
two securities move lockstep in the same direction. Zero correlation means the two securities
move randomly with respect to each other.
Watching the portfolio soldiers marching shoulder-to-shoulder in an up market is a lovely thing,
but that sets you up for them to march together in a down market and thats an ugly thing.
Portfolios diversified as to correlation generally dont go up as fast or far as non-diversified
portfolios and they generally dont go down as fast or far either.
The chart below shows the correlation between the broad US stock market and the growth and
value styles for the whole market, for large-cap stock and for small-cap stocks no hiding
places there.

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ETFs shown are:
(IWV) Russell 3000
(IWZ) Russell 3000 Growth
(IWD) Russell 1000 Value
(IWM) Russell 2000
(IWO) Russell 2000 Growth

(IWW) Russell 3000 Value


(IWB) Russell 1000
(IWF) Russell 1000 Growth
(IWN) Russell 2000 Value

The next chart shows that little in the way of correlation diversification is available by spreading
assets between domestic and foreign stocks, whether in developed or emerging markets. It does
show that bonds provide diversification through negative correlation.

The chart expresses the correlation of each ETF to the broad US stock market as represented by
the Russell 3000 through its proxy ETF, IWV. The other ETFs are:
(EFA) MSCI EAFE (Europe, Australasia, Far East)
(EEM) MSCI Emerging Markets
(AGG) Lehman Aggregate Bond Index
(IEF) Lehman 7-10 Year Treasury Bonds

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SOME PROBLEMS WITH PORTFOLIO DIVERSIFICATION:Simply put, diversification is not putting all your eggs in one basket; it is spreading your assets
across multiple investment vehicles to reduce risk while trying to maximize return. The
term diversification is used interchangeably with asset allocation, although asset allocation
pertains to having various classes of assets in your portfolio (stocks, bonds, commodities),
while diversification refers to having several securities within the same class, such as
several stocks in a stock portfolio. Portfolio diversification is supposed to protect you on
the downside, but as the 2007-2008 bear market demonstrated, it does not, with many
diversified portfolios losing 50 percent or more. There are several problems with
diversification as it is practiced in 2010.
1.Partial ProtectionDiversification provides partial protection against non-systemic risks. For example, any stock
you buy can go down to zero at any time for any reason, but if you buy two stocks, you reduce
your risk by 50 percent while your return may remain the same or even improve (if the second
stock does better). Your risks are further reduced when you increase your portfolio to five stocks,
but after about 20 stocks, your risk and return approach the market, meaning your portfolio will
mirror the market on both the downside and the upside.
2.Over-diversificationBasic assets allocation calls for your portfolio to hold several classes of assets with limited
correlation, i.e., assets that do not move in the same direction--for example, stocks, bonds and
commodities. Even if each of those assets is risky, the assets' non-correlated moves can make
your portfolio more stable overall. But many investors go beyond that and diversify within each
class of assets for "further protection." For example, they can hold government bonds, corporate
bonds, short-term bonds, intermediate term bonds and foreign bonds, which provides little
protection, because when interest rates rise, all bonds decline.
3.Below Market ReturnsIf you spread your assets across every conceivable asset class and fund, you effectively invest in
the market as a whole, so your return is going to be the market return minus management fees
and expenses.

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4.ConfusionSome financial advisers use diversification as a selling point, making it sound overly
complicated and academic. Every quarter or so you are supposed to "rebalance" your portfolio by
making sure, for example, that you have precisely 14 percent in investment quality intermediate
term corporate bonds. Those "precise" targets provide no protection or edge and only confuse.
5.Opportunity CostIn any market, some assets or sectors outperform while others lag. For example, Chinese stocks,
commodities or junk bonds can take the lead at different times. The key to superior returns is to
move into the outperforming assets while avoiding laggards. If instead you spread your assets
across the board in the expectation that one day (or one year) you will "capture" those returns,
you incur tremendous opportunity costs by keeping your money in assets that may go nowhere or
even decline for years while limiting your exposure to the leading sectors by maintaining some
"scientific" percentage allocation.

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MEASURING PORTFOLIO DIVERSIFICATION:In the market place, diversification reduces risk and provides protection against extreme events
by ensuring that one is not overly exposed to individual occurrences. We argue that
diversification is best measured by characteristics of the combined portfolio of assets and
introduce a measure based on the information entropy of the probability distribution for the final
portfolio asset value. For Gaussian assets the measure is a logarithmic function of the variance
and combining independent Gaussian assets of equal variance adds an amount to the
diversification. The advantages of this measure include that it naturally extends to any type of
distribution and that it takes all moments into account. Furthermore, it can be used in cases of
undefined weights (zero-cost assets) or moments. We present examples which apply this measure
to derivative overlays.

1. They are not a function of the allocation to the additional investment.


2. The sum of the diversification benefit and the return benefit equals the overall benefit.
3. The return benefit always equals the difference between the expected return of the additional
investment and that of the existing portfolio, which makes common sense.
4. All benefits, including the diversification benefit, are measured in return terms.
Since these are expected returns, they are meaningful only when a risk reference is provided.
(Indeed, all benefits are expressed at the risk level of the existing portfolio.)
5. And lastly, when an infinitesimal amount of the additional investment is included in the
existing portfolio, the marginal benefits can be calculated per unit of allocation, making it
possible to compare the benefits across investments in a consistent fashion.

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Juan, 29, just getting started
Three years out of business school with an MBA, Juan, single and happy in his city condo, is
earning an impressive and growing salary. But because he has been busy paying off loans, he has
just started to build his savings. Juans 401(k) has a current balance of $3,700.
Juan yet another example of why simple formulas dont work! should probably tailor his
portfolio to look something like Jean and Raymonds, despite the obvious differences in age and
wealth. Juan is still many years off from retirement and doesnt see any major expenses on the
horizon. Juans budding 401(k) is meant to sit and grow for a very long time at least three
decades.
History tells us that a portfolio made up of mostly stocks will likely provide superior growth. Of
course, history is history, and we dont know what the future would bring. So it would still be a
good idea to allocate 20 to 25 percent bonds to Juans portfolio.

Before moving any money into stocks or bonds, however, Juan would want to set aside three to
six months worth of living expenses in an emergency cash fund, outside of his 401(k), just in
case he should lose his job, have serious health issues, or become subject to some other
unforeseen crisis.

Miriam, 53, plugging away


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Never married, with no children, Miriam wants to retire from her job as a freelance computer
consultant while still young enough to fulfill her dreams of world travel. Her investments of
$75,000 are growing at a good clip, as she is currently socking away a full 20 percent of her
after-tax earnings about $20,000 a year. But she knows that she has a long way to go.
Miriam is right; she has a long way to go. To fulfill her dreams of world travel, Miriam needs
considerably more than a nest egg of $75,000. In this case, the bond allocation question is a
tough one. Miriam needs substantial growth, but she isnt in a position to risk what she has,
either. Cases like Miriams require delicate balance.
She should most likely opt for a starting portfolio of mostly stocks and about 25 to 30 percent
bonds (see Figure 12-6), but as Miriam gets closer to her financial goal in coming years, she
could up that percentage of bonds and take a more defensive, conservative position.

CONCLUSION:For asset investments, diversification is an effective tool in reducing the risk of investments in
stocks, bonds, and other securities. Utilizing the correlation structure among the assets,
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idiosyncratic risk can be reduced or even eliminated. For businesses, diversification is a strategic
decision. It is vital for a firms long-term value creation to identify and manage growth
opportunities. Diversification is an important way to manage these opportunities well, reducing
risk and ensuring success.
To be more specific, while international investments make systematic risk to lower, other kinds
of risk, such as transaction costs, tax rates, greater resources, foreign exchange risk and possible
information disadvantages, are created. Investors are unable to allocate, fully understand and at
the same time handle these risks and many times are driven to the choice of a regional (noninternational) diversified portfolio.
Portfolio diversification in the stock market consists of not only investing in multiple stocks, but
investing in stocks representing different sectors of the market. A portfolio that focuses only on
one sector, such as technology, is not diversified even if capital is spread over several stocks.
This is because the stocks are subject to the same factors and will likely be highly correlated.
Instead, someone holding technology stocks could diversify by investing in other sectors, such as
pharmaceuticals, real estate and retail.
The truest form of diversification is investment in multiple markets such as stocks, bonds,
commodities and real estate. The percentage of portfolio value dedicated to each market is
entirely up to the investor and varies widely. For example, one investor may have a portfolio
consisting of 80 percent stocks and 20 percent bonds, while another investor may have 50
percent in stocks, 40 percent in commodities and 10 percent in bonds.

BIBLIOGRAPHY:-

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WWW.PORTFOLIOMGT.COM
WWW.INVESTMENTMGTORG.COM
WWW.INVESTOPEDIA.COM
WWW.SCRIBD.COM
WWW.MGT.COM

xecutive Summary
Diversification is a way to reduce risk by investing in a variety of assets or business ventures.
Systematic risk is not diversifiable, while idiosyncratic risk can be reduced or even eliminated.
Portfolio diversification depends on risk-aversion and time horizon, and the portfolio mix must be rebalanced
periodically.

Overdiversification/diworsification can occur under certain conditions. Business diversification relies on


endogenous opportunities, whose value depends on how flexibilities such as timing and expansion options are managed.

Introduction
To diversify is to do things with variety in order to improve well-being. Diversification is thus a common and fundamental
concept in both daily life and business. However, the practice is primarily known as a way of reducing risk by investing in a
variety of assets or business ventures. Buying one utility stock in the East coast and one in the West will minimize local
shocks, while maintaining roughly the same return as buying either of the two alone. A shop at a resort selling both
umbrellas and sunglasses clearly will have a less variable income whether a sunny or a rainy day comes up.
To obtain the optimal strategy of diversification, the risk must be defined and the associated investment opportunities
modeled. In addition, the utility or investors risk tolerance and investment horizon must be specified. In terms of asset
allocation and portfolio choice, the risk is usually defined as the standard deviation of the portfolio return. This measures the
variability of the return relative to the expected value of the return. Given a fixed level of expected return, the strategy that
generates the minimum variance is preferred. To achieve this, the optimal diversification among the assets will usually be
required. The risk tolerance of an investor determines the trade-off between return and risk, as well as the level of risk to
take.
Without a formal framework, naive diversification calls for an allocation of an equal amount of money across N assets, and
thus it is also known as the 1/N rule. This rule goes back to as early as the fourth century, when Rabbi Issac bar Aha
suggested: One should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to
hand. Naive diversification is clearly not optimal in general. For example, when investing in a money market and a stock
index, few investors will allocate 50% to the money market.

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In 1951 Markowitz published his famous portfolio theory, which provides the optimal portfolio weights on a given N risky
assets (stocks) once the expected returns, covariances, and variances of the assets are given, along with the investors risk
tolerance, in a quadratic utility function. The resulting optimal portfolio is a full diversification with money invested in all of the
risky assets. The benefits of diversification depend more on how the assets perform relative to one another than on the
number of assets you want to invest. The more the assets do not behave alikethat is, the lower the correlations among
themthe more the risk can be minimized by holding the right mix of them.
The optimal portfolio is not risk-free. It is simply the one that has the minimum risk among all possible portfolios of the assets
for a given a level of expected return. For any asset, one can decompose its total risk into two components,
systematic/market-wide risk and idiosyncratic risk. The optimal portfolio has only market risk, because idiosyncratic risk is
diversified away. As a result, there is no point in taking any idiosyncratic risk. But market risk is unavoidable. Intuitively, the
return on a suitable portfolio of all stocks in the market has only the market risk, and will not be affected by bad news from
some companies, which is likely be offset by good news from others. However, a war, a national disaster, or a global crisis
will likely affect the entire portfolio in one direction.
With leverage, the optimal portfolio can theoretically be designed to obtain any desired level of expected return by taking
certain necessary risk. The greater the desired expected return on the optimal portfolio, the higher is the risk. Without
borrowing and short selling, the diversified portfolio must have an expected return between the highest and the lowest of the
asset expected returns. However, the risk is often much smaller than the lowest risk of all the assets.
An efficient portfolio is one that offers either the highest expected return for a given level of risk or the lowest level of risk for
a given expected return. The efficient frontier represents that set of portfolios that has the maximum expected return for
every given level of risk. No portfolio on the efficient frontier is any better than another. Depending on the investors risk
tolerance, the investor chooses theoretically one, and only one, efficient portfolio on the frontier.
The investment opportunity set is static in the meanvariance framework underlying the Markowitz portfolio theory. As
investment opportunities change over time, many argue for time diversificationthat the risk of stocks diminishes with the
length of the investment horizon. While this is debatable, the benefit of diversification across assets, and much of the mean
variance theory, carry through into dynamic portfolio choice models with changing investment opportunities. However, due to
incomplete information (such as parameter and model uncertainties), trading costs (such as learning and transaction costs),
labor income, and solvency conditions, it can be optimal theoretically to underdiversifyto not invest in all assets.
Diversification purely for the sake of diversification can cause unnecessary diversification or overdiversification, to end
up diworsificationi.e. worsening off from bad diversification.

Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V., Fundamentals of Investment,
3rd Edition, Pearson Education. Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P.
Investments, 6th Edition, Tata McGraw-Hill. Bhole, L.M., and Mahakud, J. (2009), Financial
institutions and markets.5th Edition, Tata McGraw Hill (India). Fisher D.E. and Jordan R.J.,
Security Analysis and Portfolio Management, 4th Edition., Prentice-Hall. Jones, Charles, P.,
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Investment Analysis and Management, 9th Edition, John Wiley and Sons. Prasanna, C.,
Investment Analysis and Portfolio Management, 3rd Edition, Tata McGraw-Hill. Reilly,
Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition,
Thomson Soth-Western.

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