Diversification of investment portfolio

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Portfolio diversification - diversification of the investment portfolio resulting in a reduction in the specific (non-systematic) risk of individual assets and, consequently, a decrease in the risk of the entire portfolio. The essence of diversification is reduced to the purchase of diversified assets in the hope that any fall in the value of some of these will be compensated by increases in the value of others.

The effectiveness of portfolio diversification depends, therefore, on the degree of correlation between the prices of the underlying assets (their correlation). The smaller it is, the better the effects of diversification. The strongest diversification is achieved when the correlation of asset price volatility is negative, ie when the increase in the price of one asset is accompanied by a decrease in the second price.

Precisely defining the correlation of future asset price changes in a portfolio is difficult mainly because historical changes do not necessarily repeat in the future. For this reason, simplified diversification techniques are often used to purchase assets from various sectors of the economy (eg shares of banks, telecoms, construction companies, mines, etc.), assets from different market segments (eg shares and bonds), geographically diversified assets (eg shares from different countries) or assets of small and large companies.

The issue of diversification of the investment portfolio has been formally described in the framework of the so- Markovitz's portfolio theory. Higher returns on investment portfolios tend to involve higher risks. Markovitz's theory shows how to design effective portfolios from the viewpoint of the expected return to risk ratio. Bibliography

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