Diversification in Stock Portfolio

Topics: Modern portfolio theory, Investment, Risk Pages: 3 (758 words) Published: September 8, 2013
Financial Management: FIN 534
Diversification in Stock Portfolio

Diversification in Stock Portfolio

As a risk averse investor, I am considering investing in one of two economies. The expected return with volatility of all stocks in both economies is the same. In the first economy, all stocks move together, in good times all prices rise together and in bad times they all fall together. In the second economy, stock returns are independent; one stock increasing in price has no effect on the prices of other stocks. Diversified Portfolio

There are certain guidelines I need to consider when investing and creating a diversified portfolio. First, I must be cognitive of my risk capabilities in order to manage risk within my portfolio. Secondly, Systematic and Nonsystematic are two types of risks that I need to be knowledgeable of also. Systematic or market risk: This risk pertains to each capital market, which can be volatile. For example, a significant political event could affect several of the assets in my portfolio. It is virtually impossible to protect myself against this type of risk. When the stock market averages fall, most individual stocks fall and when interest rates rise nearly all-individual bonds and preferred shares fall in value. Systematic risk cannot be diversified away; the more a portfolio becomes diversified, the more it ends up mirroring the market. Nonsystematic or security specific risk: This risk pertains to the risk that the price of a specific security or a specific group of securities will change in price to a different degree or in a different direction from the market as a whole. This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect myself from nonsystematic risk. Both of these types of risk can be avoided if I correctly evaluate the risk guidelines and determine the maximum amount of risk...

References: Berk, J., & DeMarzo, P. (2007). FIN534: Corporate finance: 2008 custom edition. Boston: Pearson
H. M. Markowitz, “Portfolio Selection,” Journal of Finance 7 (1952): 77-91.
Investing Lessons From Across The Pond by Ryan C. Fuhrmann,CFA. Retrieved from
The Importance Of Diversification by Investopedia Staff. Retrieved from http://www.investopedia.com/university/risk/risk2.asp
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