Diversification

By dispersing the investments over different financial instruments (diversification), a considerable risk decrease can be achieved with regard to the default risk, price rate risk and liquidity risk.


 

The liquidity risk can be reduced quite easily by spreading the investments over as many liquid investments as possible. However, it is important to know to what extent the default risks and price risks of the financial instruments are connected. The scope of the risk decrease depends largely on how the risks between the single investment forms are interrelated. Risk connections arise from common economic dependencies of financial instruments.

 

Hence, an optimum risk structure depends less on whether the investment is in stocks, bonds or other investment forms, but more on the extent to which these financial instruments rely on common economic factors. The more independent they are, the higher the decrease in risk. Thus risk can be reduced more significantly by combining different stocks than by mixing stocks and bonds, if their risk factors are independent of each other.