Updated July 11, 2023
Definition of Portfolio Diversification
Portfolio Diversification (PD) is defined as a process of contributing the investment of money in diversified securities. An individual’s portfolio should comprise different securities because the risk factor associated with these securities will also differ.
PD is important to consider while planning or making any investment strategies. It is also a process of distributing capital to reduce the chance of risk to a minimum.
Explanation
Some wise men say, “Never put all eggs in the same basket” This means that the investor should not put all his money in the same security. Because the risk associated with this security can be very high and damage the entire investment return expected from the particular security. Every security is combined with risk and then returned. Investor should use their knowledge and prudence to understand the methods of investing. This practical-oriented concept of PD requires detailed knowledge of the securities in which one invests. The portfolio diversification will also provide safety to the investors from the unsystematic risk. Investors must acquire knowledge of investment strategies as portfolio diversification is also complex.
Purpose of Portfolio Diversification
- It helps the investors to reduce the risk associated with the investment.
- The investors will be able to plan their securities much better than the investment, wherein they can earn income or return on their investment.
- The growth can also be assessed in this type of security because, in a diversified portfolio, the concept of different securities is there. Thus, it will help to grow the returns from different securities.
- The investors must analyze to get the exact idea associated with PD. The investor will have to identify the investable security and thus make prudent decisions on the same.
- It considers a balanced investment strategy where the investment is strategically maintained.
- It also helps to get the opportunity because there are many different security levels with risks and rewards.
- The ideal PD will help reduce the tax implication for individuals.
- PD is somewhat complicated, and the investors must gain knowledge of the investment strategies before investment.
Characteristics of Portfolio Diversification
- It can be a mix of equity and bonds, mutual funds, etc.
- It should be very transparent and logical.
- This has different securities whose risk and return are different.
- It is such that the volatility of the stock will maintain.
- It comprises different types of stocks and securities.
- This has a limited scope; therefore, investors should be cautious while investing their money.
Examples of Portfolio Diversification
In the basket of securities, there are four securities A, B, C, and D. If we consider the portfolio as 100%, then the weights of the securities are as follows. The weights of the securities are A- 0.10, B- 0.25, C-0.30, and D- 0.35. The return from the security is-12, B-15, C-20, and D-25. Therefore find the expected return of the portfolio.
Solution:
| Securities | Returns of The Securities (A) | Weight of The Securities(B) | Expected Return ( A*B) |
| A | 12 | 0.1 | 1.2 |
| B | 15 | 0.25 | 3.75 |
| C | 20 | 0.3 | 6 |
| D | 25 | 0.35 | 8.75 |
| Expected Return | 19.7 |
Why is Portfolio Diversification Important?
- It is important because this gives securities a balance of return and risk.
- It minimizes the risk from the return of the portfolio.
- Portfolio diversification also helps in even distribution for the investors because if the price of any security falls, the whole portfolio will not lose.
- It is always a great idea because it will help the investor to make a good decision.
- The portfolio diversification will be able to maintain the individual’s tax status.
Advantages
- It reduces the impact of market volatility.
- It also reduces the risk when the stock price rises or falls.
- The advantage of portfolio diversification is that the investor will expos to different securities which will help them make profitable returns.
- This also helps in systematic as well as unsystematic risk of the stocks.
- Investors can invest in long-term securities when they have their investments in a varied portfolio.
Disadvantages
- Portfolio diversification is an important tool, but it can be risky also.
- The investors must gain proper knowledge of the portfolio because if the portfolio is not selected wisely, the investor will suffer losses.
- It has been seen that the investors may not be able to focus on the different portfolios because the investors will find it difficult to maintain the investment strategies.
- Portfolio diversification has its limitations, and thus it can be risky for investors.
- Portfolio diversification can be a bit complicated for investors.
- The portfolio diversification will require the indexing to be done at the time of purchase, which may attract a bit higher tax liability.
Conclusion
Portfolio diversification is a very helpful strategy for any investors to invest their money. This process helps to reduce the risk associated with the securities. Investors are required to gain proper knowledge of portfolio diversification. Investors should choose the proper portfolio mix to make more returns than regular ones. Portfolio diversification can be complicated for some individuals because it may take time to maintain a portfolio where the returns are high and the risk is lower. The market conditions are also a concern for the individuals to look after. Thus, it will help them establish a good portfolio investment.
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