Question

There is a common concept in the financial industry, both for personal and institutional investing, that a balanced, diversified portfolio is the smartest way to shield oneself from the risks of investing. Using probabilities and risk example calculations, explain why market diversification is a myth. Use specific examples from 2008 in which the entire market declined when only a small number of companies were at high risk.

Answer 1

Diversification in a Portfolio will be helping the investor in order to eliminate the unsystematic risk in the portfolio. Investor would be trying to diversify his portfolio in a better manner so that he can have a better exposing her assets so that he can manage the downfall in the stocks.

But market diversification is also a myth because when there would be a very high macro risk into the economy & stock prices are going to get down as it can be seen in the case of of global recession and even though a small number of company has defaulted there was a high risk of contagion in the overall market and that led to sharp decline across all the sectors as they were discounting the futuristic events in advance and that were reflected in the share prices and it can be said that there were an intense macro risk that this contagion can cripple various sectors of the economy and they were trying to discount these in the stock prices so the overall stock prices crashed and diversification would not have helped the investor in order to prevent these risks so it can be said the diversification is only managed in case of stable economic situation & where there is a high level of volatility across all the sectors and when there would be a high level of uncertainty across all sectors, then these diversification techniques go for a toss.