Diversification

Definition

Diversification involves spreading investments across various financial assets to reduce risk. It aims to minimize the impact of any single asset's poor performance on an overall investment portfolio.

5 Must Know Facts For Your Next Test

1. Diversification reduces unsystematic risk associated with individual stocks.
2. The principle behind diversification is that different assets often perform differently under various market conditions.
3. A well-diversified portfolio typically includes a mix of asset classes such as stocks, bonds, and real estate.
4. Diversification does not eliminate systematic risk, which affects the entire market.
5. Correlation between assets is a key factor in diversification; lower correlation means better diversification benefits.

Review Questions

• What type of risk does diversification primarily aim to reduce?
• Why is correlation important in a diversified portfolio?
• Can diversification completely eliminate all types of risk?

Related terms

Systematic Risk: The risk inherent to the entire market or market segment, also known as market risk.

Unsystematic Risk: The risk specific to a single company or industry, which can be reduced through diversification.

Asset Allocation: The process of distributing investments among different categories like stocks, bonds, and cash to optimize risk and return.