Read this section that discusses portfolio diversification and weighting, implications for expected returns, and implications for variance.
Portfolio Diversification and Weighting
Weighting is the percent allocation a particular investment type receives within a portfolio.
Describe how weighting a portfolio is important for diversification
- Diversification is the idea of spreading a portfolio across different classes of investments with a target weight attached to each class.
- Modern portfolio theory is the idea that for any investment objective, there is an optimal mix of investments that can maximize expected return subject to a specific risk threshold.
- Systemic risk is the risk that applies to a
particular market or industry. It cannot be diversified away. Specific
risk is the risk that applies to one particular investment within a
market and it can be diversified away.
- systemic risk
Refers to the risk common to all securities which cannot be diversified away.
In finance, there are two types of risk – systemic risk and specific risk. Systemic risk is essentially the risk that the markets will experience in a downturn and all investments within that market will be negatively affected. It is difficult to reduce with diversification. Specific risk is the risk associated with one individual security. It can be diversified away. Let's go back to our Ski/Snowboard example.
Let's say that you pick one resort to invest in, and cross your fingers hoping for a huge snowdrop this winter. It turns out that the winter sets records for snowdrop across the state of Colorado and as an industry, the resorts turn record profits. Unfortunately, your snowboard friend didn't tell you that the resort you picked still hasn't upgraded to the high-speed chairlifts, and they also don't plow their roads very often. It turns out that while all the other mountains were turning huge profits, your investment actually lost 10%. The risk associated with the one mountain is called "specific risk. " The risk of bad weather, in this example, is systemic risk. If you had taken your money and divided it up across all of the ski resorts in Colorado, you would be up 15%, but because you happened to pick the one bad egg, you lost money.
This example explains why investors are often choosing mutual funds and exchange traded funds (ETFs) over individual stocks and bonds. Mutual funds and ETF's invest in underlying pools of investments specific to a particular investment objective. These objectives can range from specific to one particular industry to something that achieves a balanced portfolio of blended assets.
The idea of eliminating risk by spreading investments across pools of underlying stocks and bonds is called "diversification. " A diversified portfolio spreads investments across all asset classes with a weighting system that takes time frame and risk tolerance into account. The "weight" is the proportion of that portfolio assigned to one category. In our example. we talked about diversifying away the risks of slow chair lifts but in reality, there are many more aspects to diversification. Look at the pie chart below. How many pairs of antonyms can you find?
Diversified Portfolio: Asset classes and their weightings for a particular portfolio
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