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Diversification Definition and Quiz

Diversification is about improving the reward-to-risk ratio. Decreasing the denominator improves the ratio.

Define - Define Diversification for investments.
Context - Use Diversification in a sentence.
Quiz - Test yourself.

by Paul Alan Davis, CFA

Published: August 02, 2016

Updated: February 17, 2021

It wasn't until the 1960s that investors had the computing power necessary to quantifiy the benefit of diversification.

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Diversification for investment portfolios

Beginner

Diversification is the concept of lowered risk when securities are held in a portfolio. Securities with low correlation, or co-movements, offer greater diversification benefits. The quantification of this lowered risk can be forecast by using portfolio weights and the risk measures found in a covariance matrix.

Synonym: Risk Spreading

For context, to quantify the free risk-reduction benefit of diversification requires the creation of a stock-by-stock or factor-based covariance matrix. These matrices are computed using large samples of past values of assets to see if they co-vary, or move in tandem over time. The mathematical computing power needed to pull of such an estimate over thousands of securities explains why advancements in Modern Portfolio Theory (MPT) took time to be implemented.

In a Sentence

Guy: How do you measure diversification when executing your daily trade lists?
Rex: By instinct. How much did you spend at lunch today Guy? $6.73 or $6.74?

Video

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Quiz

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Two sectors offering diversification include healthcare and industrials because of their high correlation. | True or False?

False. The first part is true, the second is false

MPT utilizes expectations for risk and return for the future, and many investors incorrectly utilize past observations. | True or False?

True

Questions or Comments?

Still unclear on the term Diversification? Check out the Quant 101 Series with a deep-dive in Excel where we walk through examples of diversifying portfolio risk.

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