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Does diversification reduce the risk in investment?
Diversification in Investment
If the market conditions are normal, diversification is an efficient way to reduce risk. Holding just one type of investment can potentially pose a threat to your investment if the securities of your industry fail. In such conditions, you could lose all of your money. A well-diversified portfolio with a variety of different investments will save you when one investment performs badly in the market. As it is unlikely that all of the investments will perform badly at the same time, the profits you earn on the investments of other assets that perform well will offset the losses on the investments that perform poorly.
For example, the movement of bonds and stocks is often in opposite directions. The economies weaken and corporate profits drop, stock prices fall down. However, in such conditions, the central banks cut interest rates to diminish borrowing costs and stimulate spending. This lets bond prices go up. If the portfolio contains both stocks and bonds, the increase in the value of one kind of security may help offset the decrease in the value of the other. However. the reason for continuing bonds in a portfolio is not to generate more returns but to reduce the risk.
In theory, diversification allows the reduction of risk without having to sacrifice the potential returns of the portfolio. An effective portfolio usually has the least possible risk for a given return. After building a fully diversified portfolio, you should take on additional risks to earn an increased return on your portfolio.
All types of investments do not perform well simultaneously.
Different instruments are affected differently by various events and concerns, such as world events and changes in economic factors such as changes in exchange, interest, and inflation rates.
Diversification allows you to build a portfolio the risk of which is smaller than the total risks of each of the individual securities.
Without diversification, your portfolio will be unnecessarily risky and there will be no returns for taking such risks.
Why Diversification Works
Diversification allows you to go for different stocks at the same time. If one security fails, others will most probably not be affected by the downturn if there is no specific emergency in the markets. Your specific investments will not be subject to the same risk at the same time. So, you can potentially reduce your overall risk by diversifying your portfolio.
Bonds with strong credit ratings and those with weak credit ratings respond differently to different changes in the economy. Bond values also respond differently to various changes in interest rates depending on the duration. So having different types of bonds in the portfolio may help reduce risk too.
The Limits of Diversification
Diversification becomes less effective and efficient in extreme market conditions. Market conditions usually become extreme when an unexpected event occurs. Examples include a market crash or government default. In such conditions, markets become illiquid and the prices of most investments drop. Diversification does not help in such conditions.
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