The Effect of Diversification on Portfolio Risk

Subject: Finance
Pages: 2
Words: 345
Reading time:
< 1 min

There are two types of risk associated with an investment in securities, which include systematic risk and unsystematic risk. The systematic risk is intrinsic to the market and it cannot be avoided through the diversification of the portfolio. The reason is that this type of risk is related to the market where securities are listed and it affects all securities. On the other hand, unsystematic risk is a unique risk that is related to a particular security. It could be avoided or eliminated by not investing in that security. If an investor invests in a single security, then his/her risk exposure increases as he/she would incur a loss if the issuing company fails to generate positive results.

Therefore, it is advisable that the investor places his/her funds in different marketable securities. The diversification of investment assists in reducing the risk exposure as it reduces the weighted risk of the portfolio. Although diversification does not eliminate risk, it can help in reducing the overall risk exposure by investing in different asset classes, including bonds, cash, and securities. It would help to spread risk, maximize return, and reduce the portfolio risk. The effect of diversification could be explained by considering the following example.

Portfolio Diversification

BetaReturnRisk-Adjusted Portfolio Return
ABC Security0.9435%32.90%
Non-diversified Portfolio
Investment ProportionBetaWeighted RiskReturnRisk-Adjusted Weighted Return
ABC Security50%0.940.4735%16.45%
MNO Security25%0.300.0757%0.525%
Diversified Portfolio

Table indicates that a non-diversified portfolio has a high risk and high return condition. On the other hand, the diversified portfolio has a moderate risk and moderate return condition. The risk exposure is reduced but not eliminated.