Answer to Question #233922 in Macroeconomics for Lisa

Question

What are the benefits of portfolio diversification? Would an investor be better off with an over diversified portfolio? Explain. (7marks)

Answer 1

Portfolio diversification have the following benefits;

1) Portfolio diversification reduces the risk of loosing money. For instance in cases where one investment performs poorly, other investment may be performing better during that time reducing potential loses.

2) it serves as a way of preserving capital.

Diversification can help one to protect his or her saving especially people whom are close to retirement.

3) It's also a way of generating return in terms of income.

An investor will not be better off with over diversified portfolio. This is because

over-diversification reduces portfolio returns without meaningfully reducing its risk. Each new investment added to a portfolio results into reduction of its overall risk profile. Simultaneously, these incremental additions also lowers the portfolio's expected return.