The Pros and Cons of Diversification

Diversification helps reduce risk from an investment portfolio by eliminating unsystematic risk from the portfolio. By choosing securities of different companies in different industries, you can minimize the risks associated with a particular company's "bad luck." By diversifying among asset classes that are negatively or weakly correlated, you further reduce the volatility of your portfolio.

However, diversification can reduce the return of your portfolio as well. By selecting several assets, the overall return on your portfolio will be the weighted average of the returns of those assets. For example, let us look at a portfolio made up 50/50 of a single stock and a single bond. In one year, the stock has a total return of 30 percent, the bond 6 percent. The portfolio return will be only 18 percent (36 divided by 2). However, if the entire portfolio were invested in the stock, the return would have been 30 percent.

Many investors feel that settling for a lower average return is a small price to pay for eliminating risks for which they cannot be rewarded (unsystematic risk) from their portfolio. They might argue that if the stock in the example above tanked, then 3% would look pretty good. Of course, in practice these extremes, while possible, are rare.

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