Assignment No 6
Diversification in Stock Portfolios
Diversification is one of the key components of a successful investment portfolio. Almost all
experts advise the avoidance of concentrating all of your investments in one type. However,
many investors forget about diversification once they see a financially attractive stock and
concentrate all of their assets in it. Other investors make a similar mistake and being influenced
by their emotions fail to listen to their common sense whispering "Diversify".
Many companies have attracted their employees to investing in company stock as part of their
retirement plan through the provided matching of contributions. As a result most investors end
up concentrating their assets in company stock and forgetting about the importance of
diversification. Investing in your company's stock is not something bad. However, you should
own not only your company's stock, because if something bad happens with your company you
risk not only losing your job but all of your assets. Through diversifying your stocks among
different industries you decrease to a great extent the risk of losing your money..
You can use index funds or exchange traded funds to track a broader market index. This gives
you exposure to many different types of companies, without your individual research required.
Furthermore, your money is allocated between many sectors, so if financial companies hit a
rough patch, perhaps your oil companies will be doing well.
. The most diversified funds will have exposure to the largest sectors of the US economy, and are
generally linked to a broad market index (like the Dow Jones or S&P). For diversification, stick
with the index funds, as they will incorporate a variety of company types.
Managing overall portfolio risk
The most general definition of investment risk is "return volatility through time." Asset
allocation is your most important decision when managing overall portfolio volatility. For
example, a measured blend of stocks (domestic and international), bonds and cash tends to
provide a higher level of return per unit of risk exposure than an all-stock portfolio.
Consequently, it's better to reduce the overall risk of an all-stock portfolio by allocating part of
the portfolio to bonds rather than by trying to invest only in less-volatile stocks.
Managing equity portfolio risk
After targeting your overall portfolio risk level via asset allocation, you can turn to managing
risk within your individual stock portfolio. The primary objective is to manage volatility relative
to your benchmark so that your stock portfolio generally moves with or "tracks" the stock
In the previous article, we showed that a randomly selected portfolio of 40 stocks historically has
tracked the market with an annual standard deviation (a statistical measure of relative volatility)
of only 5.3%. Conversely, a five-stock portfolio historically tracked the market with a shocking
annual standard deviation of 23.8%!
To reduce relative risk, we suggest aligning your portfolio with your benchmark along the two
most critical dimensions of relative risk: company size and company sector.
You should be cautious when selecting your stocks because you may have chosen different
stocks and still have not achieved diversification. For example, you may select stocks of
companies that are highly related to one another and as a result a change in one of the industries
may affect the rest of them. In such a case it is said that the companies have a high degree of
correlation. Therefore, you should select companies not only from different industries, but also
companies that are influenced by different economic influences. An example of a...
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