Question

Suppose you invest 50% of your money into the stock of oil and gas, and the other 50% into the stock of apparel (clothing) retail firm. Explain in words how diversification will reduce your total risk exposure.

Answer 1

Diversification is the process of allocating funds in a number of securities which reduces the overall risk. diversification spread the total risk among the number of securities and overall risk of the portfolio reduces. due to diversification company reduces the chance of losing money and it also helps in averaging the returns of the portfolio.

Suppose if all the funds are invested into a single security, then if that security underperform, the value of the invested fund would be reduced and investment would be subject to high degree of risk and chances of losing money would be high while if such funds are invested into more than one stock chances of losing money would be low as risk would be averaged and returns would also be averaged. Thus we can say that diversification is a process through risk can be allocated among the different securities for investment.