Saturday, December 25, 2010

Diversification

Diversification refers to a strategy which aims to reduce risk by holding a small amount of a large number of assets (i.e. if one asset goes bad then the overall impact wont be as noticeable). Diversification can be as simple as holding a wider range of assets or a higher number of shares or bonds; or as sophisticated as an advanced multi-asset mean-variance optimisation exercise (see modern portfolio theory and portfolio optimisation). More scientific diversification strategies will analyse correlations, and aim to put together a portfolio of assets that tend on average not to move in the same direction (i.e. low or even negative correlations). Diversification is a key rationale for investing in managed funds, e.g. large bond funds, equity funds, and particularly balanced funds which hold a variety of asset classes.

Synonyms: Risk spreading, Risk optimisation, Risk and return, Efficient portfolio, Mean-variance optimisation
 
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