Diversification and portfolio construction

Managing risk with diversification

This also works in reverse.

If the HIH Insurance share doubled in value, Portfolio One would have doubled in value.

However, Portfolio Two would have risen by only 1% (again, assuming the other 99 shares did not change in value).

So by investing in one company’s shares rather than the shares of 100 different companies, you are increasing the risk of your portfolio because you are reliant on the performance of just one company. Whereas with Portfolio Two, your investment outcome is based on the performance of 100 companies. Accordingly, the return on the one-share portfolio could be radically different from the 100-share portfolio.

You could still have a lack of diversity with 100 different companies. You could invest in 100 companies in one sector (for example, banks or transport) and therefore even though you have shares in 100 companies in your portfolio, your diversity is still limited.

To increase the diversity of this portfolio you would need to diversify amongst other sectors and even other countries.