Diversification of Investment
Diversification is a practice in finance to reduce risk of exposure of portfolio to any asset category or industry. The diversification can be achieved by investing in different financial instruments and industries which are not correlated mutually and are weighted according to the volatility of the asset class. For example- you can reduce the risk by splitting investment among the stocks from different companies. You can also reduce portfolio risk by including bonds and cash.
What are the Risks associated with investment?
Investors face two types of risk in investment portfolio, which should be considered while diversifying the portfolio.
- Systematic or market risk- Also known as un-diversifiable risk. Causes due to exchange rates, inflation rates, and interest rates. Systematic risk is not specific to any particular company or industry. And can’t be reduced or eliminated through diversification of investment.
- Unsystematic risk - This risk is also known as diversifiable risk and it is specific to market, industry, company, economy or for a country. The common sources of diversifiable risk are business risk and financial risk. The diversification can be achieved by properly putting the assets in weights proportional to their relative correlation
Conclusion
Diversification can help to manage risk related to investment by minimizing the effect of volatile price movements of individual asset. The key is to find a medium between risk and return. This helps to achieve your financial goals in a safely manner.
