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What Is Portfolio Diversification and Why Is It Important?
A Quick Guide by
Hello Readers,
A key component of investment strategy is portfolio diversity, which aims to minimize risk and maximize returns. Investors may create robust portfolios that survive market volatility and support long term financial objectives by distributing capital across a plethora of asset classes like industries and geographical areas. The mechanics, advantages and useful tactics of diversification are inspected in this article.
The Basics of Portfolio Diversification
Diversification involves allocating investments across different assets — stocks, bonds, cash equivalents, and more — to minimize the impact of any single investment’s poor performance. The principle hinges on assets responding differently to economic events, reducing overall portfolio risk.
Modern Portfolio Theory (MPT), pioneered by Harry Markowitz, mathematically supports this. It shows that combining assets with low correlation (ρ, ranging from -1 to +1) reduces portfolio volatility. For instance, a portfolio with two assets (correlation ρ = 0.2) has lower risk than either asset alone, as their price movements partially offset each other. The portfolio variance formula illustrates…
