Utilise Diversification Effectively to Reduce Risk Proper Definition of Risk: The uncertainty associated with the end of period value of an investment OR the possibility that your realised return will be less than what you expected.  Imagine 2 skydivers leap from a plane at 5,000 feet. One has a parachute, the other does not. Whose outcome is more uncertain? Answer: The skydiver with the parachute. Reason: It is certain that the skydiver without the parachute will fall to his death, but it is uncertain that the skydiver with the parachute will survive (i.e., there is a risk that his parachute may fail to open). Island Economy To better understand the concept of diversification, imagine an island where there are 2 businesses, an umbrella manufacturer and a holiday resort. The weather affects them both. During sunny seasons the holiday resort does a booming business, while umbrella sales plummet. During rainy seasons, the resort owner does very poorly, while the umbrella manufacturer enjoys large sales and high profits. The trick is, although both investments are risky, they are affected differently by the weather. Assuming an investor invests equally in each firm, diversification is achieved as the share prices vary inversely. They have a negative covariance. Covariance Covariance measures the degree to which 2 risky assets move in tandem. A positive covariance indicates that assets move together, and a negative covariance means they vary inversely. As long as there is some lack in unison in the fortunes of the individual companies in the economy, diversification will always reduce risk. Correlation Imagine that a neighbouring island also has 2 businesses. One business exports bananas and the other business imports coffee. The island's economy is very different to its neighbour, and therefore its stockmarket behaves differently to that of the first island. The low correlation (correlation is a statistical measure of the degree to which the movements of 2 variables are related) between the 2 island's stockmarkets smooths out the ride and enhances overall performance, achieving better portfolio consistency. <<Back Find out more about how diversification reduces risk Investment Philisophy Tour: Dissimilar price movement