Outline the risk-reduction benefits of diversification of an investment portfolio. In your answer, briefly discuss how portfolio diversification works in principle to minimise overall investment risk.

Answer:

The purpose of portfolio diversification is portfolio risk reduction. Risk cannot be eliminated completely but it can be reduced. Portfolio diversification means investing in multiple assets to reduce risks.

The risk is spread out when investing in different assets. If one asset generates losses, then another one could be a success resulting in great returns. So, it limits the exposure to big losses when investing only in one asset class.

Another benefit of diversification is low volatility of returns. Assets that have low correlations should be picked to achieve this. For example, investing in a stocks and bonds.

It enables an investor to achieve a positive return in one asset or market while generating negative returns in another. It can help in preserving capital.

When investing in equity, investing in stocks from different industries will diversify risks. In short, you need to select stocks that do not move together.