what is the relationship between diversification and portfolio risk?
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A company spreads its risks by selling a varied product range, operating in different markets, or selling in many countries. Investors create a diversified portfolio of assets, so specific risk associated with one asset is offset by the specific risk associated with another asset.
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Covariance helps investors reduce risk and diversify their portfolios. Covariance is used in portfolio theory to determine what assets to include in the portfolio. Covariance is a statistical measure of the directional relationship between two asset prices.
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However, because the risk is low, the rate of return is also lower than other types of investments. If the estimated rate of return on the investment is less than the risk-free rate, then the result is a negative risk premium.
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The correlation between the hazards one runs in investing and the performance of investments is known as the risk-return tradeoff. The risk-return tradeoff states the higher the risk, the higher the reward—and vice versa.
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What is the difference between common risk and independent risk? Common risk is the risk that is perfectly correlated across assets. On the other hand, independent risk is the risk that is uncorrelated and independent across assets. ... Diversification is the average from independent risks in a large portfolio.
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Price risk, or interest rate risk, is the decrease (or increase) in bond prices caused by a rise (fall) in interest rates. ... Reinvestment risk refers to the increase (decrease) in cash flow or investment income caused by a rise (fall) in interest rates.
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Like most investments, mutual funds have risk — you could lose money on your investment. The value of most mutual funds will change as the value of their investments goes up and down. The level of risk in a mutual fund. ... Usually, the higher the potential returns, the higher the risk will be.
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The tumbling of stocks and the alarm sounding of a recession have many investors fleeing to safer ground — bonds. ... However, while having bonds may reduce stock market risk, bonds have interest rate risk, Cheng said.
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Systematic risk is the risk associated with entire class of assets. However, unsystematic risk is unique to the particular investment. ... Diversifiable risk can be eliminated by diversification in the portfolio. Non-diversifiable risk is the risk common to the entire class of assets or liabilities.
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Stocks offer an opportunity for higher long-term returns compared with bonds but come with greater risk. Bonds are generally more stable than stocks but have provided lower long-term returns. By owning a mix of different investments, you're diversifying your portfolio.
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Diversifiable risk is the risk of price change due to the unique features of the particular security and it is not dependent on the overall market conditions. Diversifiable risk can be eliminated by diversification in the portfolio. Non-diversifiable risk is the risk common to the entire class of assets or liabilities.
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['Interest Rate Risk and Bond Prices. ... ', 'Reinvestment Risk and Callable Bonds. ... ', 'Inflation Risk and Bond Duration. ... ', 'Credit/Default Risk of Bonds. ... ', 'Rating Downgrades of Bonds. ... ', 'Liquidity Risk of Bonds.']
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Key Takeaways Volatility and risk are normal parts of investing. Volatility is a measure of an investment's price changes. Highly volatile investments can carry greater risk and be detrimental to short-term goals.
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An investor opts for international portfolio investment because international diversification of portfolio of assets helps achieve a higher risk adjusted return. This means that an investor is able to reduce risk and raise return through international investment.
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Systematic risk is the probability of a loss associated with the entire market or the segment whereas Unsystematic risk is associated with a specific industry, segment or security. ... Conversely, unsystematic risk can be eliminated through diversification of a portfolio.
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A lower risk always means a higher return. A higher risk often means a lower return. A lower risk will always mean a lower return.
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Conventional wisdom has it that when stock prices go up, bond prices go down. In other words, bonds and stocks have an inverse relationship. The logic behind this is simple. Investors have to choose between the safety, but relatively low return, of bonds, or the risky nature, but relatively high return, of stocks.