Diversification

Investors can reduce risk, and improve the level of risk relative to return, by diversifying their portfolios. Diversifying portfolios moves them closer to the efficient frontier

The key to diversification is to choose investments whose prices are not strongly correlated. Although some financial institutions use sophisticated financial models to calculate and control risks, a private investor can achieve good diversification with little more than reasonable common sense.

Firstly, investing in different sectors, geographical regions and classes of security improves diversification: the values of shares, bonds and pieces of real estate will be more correlated with each other than with investments of the other types.

In a globalised economy investors in shares will find it hard not to have geographically diverse exposure, as so many listed companies have substantial sales or operations around the world.

Within an equity portfolio an investor does not need to buy lots of different shares to be well diversified: eight or ten is enough provided their returns are not too highly correlated.

Because idiversification affects risk, it means that it also affects value (because divserifying away risk reduces the risk premium an investor requires. Valuation models such as CAPM usually assume that risk is measured in the context of a diversified portfolio.

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