The process of diversification of stocks, sometimes referred to as diversification of stocks, is based on the idea of allocating capital in a manner that the correlation of the assets’ price movements equals less than 1. In a simple example of a portfolio with two assets, a correlation of 1 (perfectly correlated) would mean asset A and asset B rise and fall together 100% of the time. In this example, a correlation of 0 (no correlation) would mean there is no relationship between the returns on the two assets. They could rise together, fall together, or go in opposite directions; however, the return on asset A is not related to the return on B. A -1 correlation (perfect inverse correlation), would indicate the returns on the assets are inversely related; when asset A rises, asset B declines or vice versa.
The goal of stock diversification is to reduce the volatility of a portfolio. Volatility is often calculated as the standard deviation of portfolio returns vs. the mean return of the market. In this way, to diversify stocks is to diversify a portfolio – ultimately a process of risk management.
Modern Portfolio Theory states that a properly diversified portfolio would have higher returns with lower risk by having the positive returns outweigh the negative performance of some assets and through this process unsystematic risk is reduced. In simple terms, the process is best explained by the cliché of not putting all your eggs in one basket.
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