Diversification in stock portfolios

Diversification in Stock Portfolios

In this hypothetical scenario one may have the knee-jerk reaction to invest in the economy where all the stock move up or down evenly with the financial trends that occur. However, not only financial trends affect stock prices and we have certainly seen over many decades that psychological/irrational impetus can aversely affect market trends. So while it may seem a safer bet to invest in stocks that average out, this is actually the riskier investment strategy. In weighing risks in a risk averse portfolio a financial advisor must use a mitigating strategy in order to spread that risk over several venues of stock investment, using the best available knowledge to make the safest investments. In an economy where stock prices are fixed and move in total, there is no safe place to harbor funds in that economy. For this analysis Market A will be the economy where all stocks rise and fall together and Market B. will be the diversified stock economy.

As most advisors and investor know putting one's egg all in one basket is perhaps the riskiest move for keeping a safe harbor for ones wealth.

It is unlikely that you would invest all your money in a single asset, as this would be the high risk strategy. Rather, your objective should be to create an efficient portfolio, that is one which will maximise your return for a certain level of risk, or alternatively minimise your risk for a required level of return. (McMenamin, 1999, p. 198)

In Market A, while it may seem that the risk is spread over a wide range, in reality the risk is not shared but actually intensified in this particular economy. Let us say that an investor has used a fundamental analysis of a company to guide his or her purchase of stock. This analyzes past performance in financial statements as well as general economic conditions, as the predictor of future results. While the financial statement may have some insight, the general economic conditions become moot as the stock will rise and fall with all the others. Using a Technical analysis is equally ineffective since this analysis would not necessarily focus on the financial statements of the company, but rely on trends in the economy, price trends and overall market tendencies to predict where a particular type of stock will go. While this strategy is risk aversive in general, the point becomes moot again as the overarching quality of all stock in this economy rise and fall together.