How Diversification Reduces Risk In Short

Author: Kenneth ([email protected])

Published: Monday March 22, 2021

Diversification is an important technique for reducing risk in your investments. You have surely heard the phrase “Don’t put all of your eggs in one basket.” In the financial world, that sage advice points to diversification. From what I recall in my finance classes, diversification reduces the variance of a portfolio of stocks. If you combine your assets with a risk-free asset, you would reach the efficient frontier.

The CAPM and the Efficient Frontier

The CAPM assumes that the risk-return profile of a portfolio can be optimized—an optimal portfolio displays the lowest possible level of risk for its level of return. Using the CAPM to build a portfolio is supposed to help an investor manage their risk. If an investor were able to use the CAPM to perfectly optimize a portfolio’s return relative to risk, it would exist on a curve called the efficient frontier, as shown on the following graph.