Diversification

Lesson

Diversification is a portfolio management technique that involves investing in a variety of assets to reduce risk. By spreading investments across different asset classes, industries, and geographic regions, investors can minimize the impact of any single investment's poor performance on the overall portfolio. Diversification helps to protect against market volatility and reduce the potential for significant losses.

Practice Question #1

Which of the following best describes the purpose of diversification in portfolio management?

A) To maximize returns

B) To minimize risk

C) To predict market movements

D) To focus on a single industry

Select an option above to see an explanation here.

A) Diversification does not guarantee maximum returns. B) Diversification aims to minimize risk by spreading investments across various assets. C) Diversification does not involve predicting market movements. D) Focusing on a single industry is the opposite of diversification.

Terms

Diversification:: Spreading investments across various assets to reduce risk.
Correlation:: A statistical measure of how two assets move in relation to each other.
Systematic risk:: Risk affecting the entire or broad market segment.
Unsystematic risk:: Risk specific to a particular company or industry.

Practice Question #2

Which type of risk can be reduced through diversification?

A) Market risk

B) Systematic risk

C) Unsystematic risk

D) Interest rate risk

Select an option above to see an explanation here.

A) Market risk affects the entire market and cannot be reduced through diversification. B) Systematic risk affects the entire or broad market segment and cannot be reduced through diversification. C) Unsystematic risk is specific to a particular company or industry and can be reduced through diversification. D) Interest rate risk is a type of systematic risk and cannot be reduced through diversification.

Do Not Confuse With

Concentration:: The opposite of diversification, where investments focus on a single asset class or industry.

Practice Question #3

Which of the following is NOT a component of a diversified portfolio?

A) Investments in multiple asset classes

B) Investments in different industries

C) Investments in a single geographic region

D) Regular portfolio rebalancing

Select an option above to see an explanation here.

A) Investments in multiple asset classes are a component of a diversified portfolio. B) Investments in different industries are a component of a diversified portfolio. C) Investments in a single geographic region do not provide diversification across different regions. D) Regular portfolio rebalancing is a component of a diversified portfolio.

Real-World Example

An investor with a diversified portfolio might hold a mix of stocks, bonds, cash, and investments in different industries and geographic regions. For example, they might own shares in technology, pharmaceutical, and utility companies, government bonds, and cash.