Diversification and portfolio construction

Managing risk with diversification

An explanation of how diversification can manage your investment risk is as follows:

You have $100,000 and you have the choice of purchasing $100,000 worth of shares in one company (let’s call this Portfolio One), or the choice of buying shares in 100 different companies – i.e. $1,000 worth of shares in each company (we’ll call this Portfolio Two).

So the two portfolios have the same value initially; however, Portfolio One has shares in one company and Portfolio Two has shares in 100 different companies.

In both portfolios assume you bought HIH Insurance shares (the company which went insolvent in 2003).

In Portfolio One you would have lost 100% of your money.

However, in Portfolio Two you would have lost only 1% of your money, as the other 99 shares would still be there (assuming the remaining shares do not change in value).