gen-define-diversification-and-portfolio-risk-and-give-one-short-4668

Define diversification and portfolio risk and give one short worked example.

# Diversification and Portfolio Risk ## Definitions **Diversification** is an investment strategy of spreading investments across different assets to reduce overall risk. The principle is "don't put all your eggs in one basket." **Portfolio Risk** is the total variability of returns for a combination of investments. It's measured by standard deviation or variance and depends on both individual asset risks and how they move together (correlation). ## Worked Example ### Scenario You have $10,000 to invest and are considering two stocks: - **Stock A** (Tech): Expected return = 12%, Standard deviation = 25% - **Stock B** (Utilities): Expected return = 8%, Standard deviation = 15% - **Correlation** between A and B = 0.3 ### Option 1: No Diversification (100% in Stock A) - Portfolio return = 12% - Portfolio risk = 25% ### Option 2: Diversified Portfolio (50% A, 50% B) - **Portfolio return** = (0.5 × 12%) + (0.5 × 8%) = **10%** - **Portfolio risk** = √[(0.5² × 25²) + (0.5² × 15²) + (2 × 0.5 × 0.5 × 0.3 × 25 × 15)] - Portfolio risk = √[156.25 + 56.25 + 56.25] = **16.5%** ### Result By diversifying, you reduced risk from 25% to 16.5% while only giving up 2% in expected return. The portfolio is less volatile because the stocks don't move perfectly together.