In the context of investments, explain the importance of building a diversified financial portfolio.

Question

What will be an ideal response?

Answer 1

Answers will vary. Not all financial securities are mutually exclusive. It is possible-and usually desirable-to invest in a diversified financial portfolio consisting of a variety of stocks, bonds, certificates of deposits (CDs), government securities, and other assets.The main advantage offered by diversification is that it reduces your risk. If you put a large part of your wealth into one specific investment, you could be wiped out if that investment goes sour. If you invest in several different assets, then losses in some are likely to be offset by gains in others. But diversification also has a downside-it not only reduces risk but also reduces the possibility of earning exceptionally high returns. One widely accepted financial principle is that a tradeoff exists between risk and return; in other words, investments with the potential for generating high returns tend to be riskier than investments that offer lower returns. For example, stock prices sometimes decline sharply, so investing in stocks is considered quite risky. But historically, the long-run average return on stocks has been significantly higher than the average return on bonds, which offer safer, more predictable returns. In general, younger investors are less concerned about risk than older investors. When you are young, you have more time to recover from adverse results, so you may be willing to take more risks and be more aggressive in pursuit of higher returns. If you invest mostly in stocks when you are young, and the stock market crashes, you still have time to recoup your losses and take advantage of future increases in stock prices. But older investors who hold a lot of stock might find that the same crash wiped out much of the wealth just when they were counting on it to supplement their retirement income. Older investors often become more conservative, adjusting their portfolio to include a greater percentage of relatively safe assets such as government securities, bonds of corporations with strong credit ratings, and CDs.