Chapter 11 - Slides 01-27 - Diversification and Risky Asset AllocationWe have come full circle. We are back to Risk versus Return, the Eternal Struggle of Investing! You now have a strong foundation in the most popular financial investments, stocks, bonds, “cash” (a.k.a. short-term investments), and mutual funds. It is time to reflect and “tie them all together,” so to speak. In this chapter, we analyze the age-old and still most important and, in my humble opinion, effective method for reducing risk, diversification. Diversification has been shown to be able to reduce our risk, as measured by variance and standard deviation. (Do you remember those two statistics from way back in chapter 1?) But can diversification eliminate risk? The answer is no. We will take a look at why there are limits to how diversification can reduce our risk and why a combination of stocks and bonds actually demonstrated a lower amount of risk than a portfolio consistently entirely of bonds, even though bonds in general are less volatile than stocks.
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