Meaning of Diversification

Subject: Risk Management
Pages: 2
Words: 296
Reading time:
< 1 min

This is a risk management practice that combines various asset classes in a portfolio; a portfolio with different types of asset classes will yield higher returns and lower risk when compared to an individual asset class. In such cases, diversification eliminates unsystematic risks. The negative performance of some asset classes is set off against the positive performance of the other assets. But this benefit will hold true when assets classes are not wholly correlated.

Risk can be diversified by investing in a portfolio such as Alpha, Beta, and Gamma since a portfolio eliminates the unsystematic risk within the firm or the industry. One of the assets in a portfolio may do very poorly, and this poor performance is set off by another asset in a portfolio that does very well. Portfolio Alpha has a higher systematic risk of 135.89% and very high returns of 1078.65%; this portfolio combines the most volatile asset classes such as Australian shares, international shares, and property; in this case, the risk in the individual segment is eliminated.

Portfolio Beta has a moderate risk of 81.62% and a very low return of 3.61%; this portfolio includes Australian shares, property, and Australian bonds. In contrast, portfolio Gamma has cash, Australian bonds, and property with a very low risk of 24.41% and a medium return of 513.83%. In all of these portfolios, asset selection and allocation seem to play the part because the selection of poor asset classes that are included in the portfolio leads to low returns. An investor should allocate more of his wealth to those assets that have high risk, and this will lead to high return and less of his wealth to those assets that have low risk.