Chapter: 11 Principles of Portfolio Management

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:


  • A and B as individual stocks are risky as the returns are fluctuating over time
  • When they both are held in a portfolio, the average return is stable and higher than the individual return