Under what circumstance will portfolio diversification minimise risk?
Understand the Problem
The question is asking about the conditions under which portfolio diversification can effectively reduce investment risk. It seeks to understand the relationship between diversification and risk management in finance.
Answer
Diversification minimizes risk by spreading investments across asset classes, regions, and sectors.
Portfolio diversification minimizes risk by spreading investments across different asset classes, geographic regions, and sectors. This reduces the impact of poor performance of any single investment, balances economic fluctuations, and mitigates sector-specific risks.
Answer for screen readers
Portfolio diversification minimizes risk by spreading investments across different asset classes, geographic regions, and sectors. This reduces the impact of poor performance of any single investment, balances economic fluctuations, and mitigates sector-specific risks.
More Information
Diversification can reduce unsystematic risk, which is specific to a particular company or industry. This risk can be mitigated by holding a diverse portfolio, while systematic risk, which affects the entire market, cannot be eliminated through diversification alone.
Tips
A common mistake is assuming diversification eliminates all types of risk. It primarily reduces unsystematic risk, but market-wide (systematic) risks still persist.
Sources
- The Importance of Diversification - Investopedia - investopedia.com
- Portfolio diversification: What it is and how it works | Vanguard - investor.vanguard.com
- Diversification in Investing May Reduce Risk | U.S. Bank - usbank.com
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