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 be comprised of different securities because the risk factor associated with these securities will also differ. PD is an important aspect that should be kept in mind 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 that “Never put all eggs in the same basket” this means that the investor should not put all his money in the same security. This is because the risk associated with this security can be very high and can damage the entire investment return expected from the particular security. Each and every security is combined with risk and then return. Investor should use their knowledge and prudence to understand the methods of investing. This concept of PD is very practical oriented and it requires detailed knowledge of the securities in which the investment is to be made. The portfolio diversification will also provide safety to the investors from the unsystematic risk. Portfolio diversification is also complicated so the investors are required to gain knowledge of the investment strategies.
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 in a much better way 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 and thus it will help to grow the returns from different securities.
- The investors will have to make an analysis to get the exact idea associated with PD. The investor will have to identify the investable security and thus will have to make prudent decisions on the same.
- It is considered a balanced investment strategy where the investment is strategically maintained.
- It also helps to get the opportunity because there are lots of different security with different levels of risk and rewards.
- The ideal PD will help reduce the tax implication for the individuals.
- PD is somewhat complicated and the investors are required to 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.
- It has different securities whose risk and return are different.
- It is known to be such that the volatility of the stock will be maintained.
- It is comprised of different types of stocks and securities.
- It has 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.
- The portfolio diversification also helps in even distribution for the investors because in case the price of any security will fall then the portfolio as a whole 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 tax status of the individual.
Advantages
- It reduces the impact of market volatility.
- It also reduces the risk when the price of the stock rises or falls.
- The advantage of portfolio diversification is that the investor will be exposed to different securities which will help them make profitable returns.
- Portfolio diversification also helps in systematic as well as unsystematic risk of the stocks.
- The investors will be able to invest in long-term securities when they will have their investments in a varied portfolio.
Disadvantages
- Portfolio diversification is an important tool but it can be risky also.
- The investors are required to gain proper knowledge of the portfolio because if the portfolio is not selected wisely then the investor will have to 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 own 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 therefore it 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 associated with it is lower. The market conditions are also a matter of concern for the individuals to look after. Thus, it will help them establish a good portfolio investment.
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This is a guide to Portfolio Diversification. Here we discuss the definition and purpose of portfolio diversification along with its advantages and disadvantages. You may also have a look at the following articles to learn more –
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