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Section: 3 Portfolio Diversification and Risk
Diversification refers to building a portfolio, which includes different classes of derivatives or investments. In a portfolio consisting of various classes of investments, when there is a drop in value of one class of asset, another class of asset value may go up and thus the portfolio as a whole is stable and minimizes the risk.
The above can be illustrated graphically as follows:
Assume that we have two stocks A and B, A’s performance graph is as shown below:
B' performance graph is shown below:
If stock A and B are in one portfolio, the performance of the combined investment would be:
The above graph clearly depicts the following: