Executive Summary
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Diversification is a way to reduce risk by investing in a variety of assets or business ventures.
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Systematic risk is not diversifiable, while idiosyncratic risk can be reduced or even eliminated.
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Portfolio diversification depends on risk-aversion and time horizon, and the portfolio mix must be rebalanced periodically.
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Overdiversification/“diworsification” can occur under certain conditions. Business diversification relies on endogenous opportunities, whose value depends on how flexibilities such as timing and expansion options are managed.
Introduction
To diversify is to do things with variety in order to improve well-being. Diversification is thus a common and fundamental concept in both daily life and business. However, the practice is primarily known as a way of reducing risk by investing in a variety of assets or business ventures. Buying one utility stock in the East coast and one in the West will minimize local shocks, while maintaining roughly the same return as buying either of the two alone. A shop at a resort selling both umbrellas and sunglasses clearly will have a less variable income whether a sunny or a rainy day comes up.
To obtain the optimal strategy of diversification, the risk must be defined and the associated investment opportunities modeled. In addition, the utility or investor’s risk tolerance and investment horizon must be specified. In terms of asset allocation and portfolio choice, the risk is usually defined as the standard deviation of the portfolio return. This measures the variability of the return relative to the expected value of the return. Given a fixed level of expected return, the strategy that generates the minimum variance is preferred. To achieve this, the optimal diversification among the assets will usually be required. The risk tolerance of an investor determines the trade-off between return and risk, as well as the level of risk to take.
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