THE PROS AND CONS OF DIFFERENT DIVERSIFICATION STRATEGIES

As you have seen, diversification helps reduce risk by eliminating unsystematic risk from a portfolio. By choosing securities of different companies in different industries, you can minimize the risks associated with a particular company's "bad luck." By diversifying among asset classes that are negatively or weakly correlated, you further reduce the volatility of your portfolio.

However, diversification can reduce the return of your portfolio as well. By selecting several assets, the overall return on your portfolio will be the weighted average of the returns of those assets. For example, let us look at a portfolio made up 50/50 of a single stock and a single bond. In one year, the stock has a total return of 30 percent, the bond 6 percent. The portfolio return will be only 18 percent (36 divided by 2). However, if the entire portfolio were invested in the stock, the return would have been 30 percent.

In our last tutorial section, let's sum up what you have learned about diversification.