Notes On The Value Of Diversification

1352 Words Sep 24th, 2014 6 Pages
The value of diversification
Introduction
Every finance students have learnt diversification is to reduce total risk by investing a basket of assets in portfolios. But what contributes to the success of portfolio diversification? A large number of assets? A variety types of asset allocation? Adding international investment? Numerous of risk factors? They are all indicators of a well-diversified portfolio. In this case, we will discuss about the advantages and disadvantages of diversification in portfolio management with related indicators. On one hand, some mention dynamic and numerous assets allocation in the portfolio will reduce both risks. While some also state the benefit of introduce multi-factor portfolio pricing models. On the other hand, arguments arise demonstrating adding international investment may disappoint investors because foreign market could be correlated and moved together. Another disadvantage could be the correlated assets collected weaken the effect of diversification. At the end, a balanced conclusion will be drawn to support the useful diversification.
Dynamic and numerous asset allocation benefits
Since there are two types of risk we need to account for: systematic risk and idiosyncratic risk, the easiest one to be diversified away is the idiosyncratic risk. It is known that an optimal portfolio could gain on diversification by investing a large basket of stocks. This is a good way to offset firm-specific risk. According to Bodie, Kane and Marcus…
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