In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and oftn less risk than the least risky of its constituents.[1]. Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors.
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Diversification is one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive. Hedging relies on negative correlation among assets, or shorting assets with positive correlation.
Diversification can lower the volatility (risk) of a portfolio because not all asset categories, industries, or stock, move together. Holding a variety of non-correlated assets can nearly eliminate unsystematic risk. In other words, by owning a large number of investments in different industries and companies, industry and company specific risk is minimized by diversification. In addition, diversification can reduce portfolio losses in bear markets, preserving capital for investment in bull markets.
Diversification advantages include reducing portfolio risk and simultaneously increasing portfolio returns through portfolio optimization. Holding a variety of assets enables the portfolio manager to invest in more aggressive assets without increasing the risk of the overall portfolio. Optimization can be achieved because proper diversification lowers portfolio risk, allowing an investment manager to invest in higher risk, higher reward assets, and still maintain a desired target amount of total portfolio risk.
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