Diversification
Diversification is an investment strategy that spreads investments across various assets, sectors, or geographic regions to reduce risk without necessarily sacrificing returns.
🎬 Video Explanation
Exam Tip
Diversification reduces UNSYSTEMATIC (company) risk, NOT systematic (market) risk.
What is Diversification?
Diversification is the practice of spreading investments across different assets to reduce exposure to any single investment's risk. The principle is "don't put all your eggs in one basket."
Types of Diversification
| Type | Description | Example |
|---|---|---|
| Asset Class | Different types of investments | Stocks, bonds, real estate |
| Sector | Different industries | Tech, healthcare, energy |
| Geographic | Different regions | US, Europe, Emerging markets |
| Company Size | Different market caps | Large, mid, small cap |
| Style | Growth vs. value | Growth stocks, value stocks |
How Diversification Reduces Risk
When assets are not perfectly correlated:
- Some go up while others go down
- Portfolio volatility is reduced
- Smoother returns over time
Key Concept: Correlation
- Correlation of +1: Assets move together
- Correlation of -1: Assets move opposite
- Correlation of 0: No relationship
Systematic vs. Unsystematic Risk
| Risk Type | Diversifiable? | Examples |
|---|---|---|
| Unsystematic (Company) | Yes | Management issues, product recalls |
| Systematic (Market) | No | Recession, inflation, interest rates |
Modern Portfolio Theory (MPT)
Developed by Harry Markowitz, MPT shows that diversification can:
- Reduce risk without reducing expected returns
- Create an "efficient frontier" of optimal portfolios
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