Diversification of finance means to invest in a variety of different assets so as to reduce the risk of loss. If the values of the assets do not rise and fall synchronously, then the weighted average risk of the individual assets will be more than the risk of a diversified portfolio. Any investor, who wants to avoid risks as much as he can would definitely diversify to some extent. Diversification can possibly increase the performance of the investments. This process requires very active management that can ratchet up the different and uncorrelated variances which constitute the portfolio.
The following proverb provides a perfect example of diversification:
“Don’t put all your eggs in one basket”
If you place all of your eggs in a single basket, and that basket falls, then all eggs may break. To reduce the risk of this loss, you can place eggs in different baskets.
Now let’s come back to finance. An undiversified portfolio will have a single stock only. This proves very risky as a single stock may fall in value by fifty percent over the course of a year. This is not an unusual performance. Now, if a portfolio was to have twenty stocks, then the probability of that portfolio going down by such a large percentage is lesser, especially ifall the stocks were selected at random.
If prior return expectations are identical, then in a diversified portfolio the expected returns would be the same as that of an undiversified portfolio. Some stocks may perform better than others. The returns of a diversified portfolio will be higher than the returns of the stock that performs the worst. Also, a diversified portfolio’s returns will be lower than those of the best-performing stock. So in this way, by diversifying a portfolio, you are avoiding coming out either the best or the worst by investing in single stock.
There are also concepts of diversifiable and non-diversifiable risks. If someone buys a particular stock in a company then the stock is exposed to index movements and stock movements of the company. This risk can be diversified or reduced if the buyer diversifies among several different stocks. However, if the buyer buys all stocks of a company, then he is only exposed to the movements in that index. This is non-diversifiable risk and it will remain the sameno matter how many stocks of the company are bought. However, the buyer must keep in mind that there is always a risk of overdiversifying. This may lead to a severe loss, your performance may suffer, and you may end up paying for fees.
Diversification is either vertical or horizontal in corporate portfolio models. Horizontal diversification means that related companies are being acquired or that product line is being expanded. Vertical diversification means that distribution channels are being amalgamated. Non-incremental diversification is a strategy that is mostly employed by corporate empires. In this strategy, the individual businesses have very little in common and still the company manages to achieve diversification from external risk factors to stabilize.
Playing in the stock exchange market is not easy. There are a lot of risks and you may have to face losses. However, there are certain risks that you have to take order to achieve what you desire. Finance is a field in which you take risks regardless of how good you are. however, if there is a strategy that you can implement in order to reduce the risk then you would be smart to adopt it. Diversification is a strategy that can improve overall stock performance. If a portfolio has more than one stock, then not all those stocks will fall in their performance. Despite the falls that some stocks will face, the overall performance of your stock will still be higher than that.
Diversification has its disadvantage in that the overall performance will always be lower than the highest performance among all the stocks.This is a trade-off that you will have to deal with because coming up with only the worst-performing stock of the year in your portfolio will not generate a healthy impression.
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