Question

Explain why it is commonly accepted that diversification reduce risk?

Answer 1

Diversification means adding assets in the portfolio that are not perfectly positively correlated with other assets in the portfolio. As the risk comprises of market risk and unique firm-specific risk, every asset has different firm-specific risks and hence move differently from other assets. Also, the impact of market movements is also not the same for every asset as each asset reacts differently to market movements. As the correlation is not +1, the assets will not move together hence the adverse movements in one asset might be offset by favorable movements in other. Therefore, diversification reduces risk. Also, from the formula of standard deviation we see that standard deviation of a portfolio is less than weighted average of individual risks/standard deviations when correlation is less than +1. Lower the correlation, higher the risk reduction is achieved.