A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate.
Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments would allow an investor to have a small cushion of protection against losses due to an American economic downturn.
Most non-institutional investors have a limited investment budget, and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification.
An investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon.
Modern Portfolio Theory - MPT
A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.
An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.
Risk
The chance that an investment's actual return will be different than expected.
The risk inherent to the entire market or entire market segment.
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