Return and Risk of a Portfolio

A portfolio is a collection of assets.

It is always better to spread one's investment over a group of assets in order to minimize risk. This is called diversification. How does the risk reduce by doing so? The risk reduces because the loss in one asset can be offset by the gain in another.

It is important to keep in mind that risk reduction will happen if the returns from the assets that comprise the portfolio are not positively correlated. For instance, it does not make sense to have a 2 - asset portfolio, where both assets are of the same category and nature. Then, rather than reducing the risk, we would be doubling it.

Also, the risk of a portfolio responds to the weights of individual assets. Therefore, the amount of money invested in each asset is important in reducing risk. Through portfolio optimization techniques (for example, Markowitz's mean  - variance model), one can decide exactly what proportion of the portfolio should be invested in each asset to arrive at minimum risk.

We should not get carried away by the idea of not keeping all our eggs in one basket. If we have too many baskets, it becomes progressively difficult to monitor each one of them. There is always an optimum number of assets that should form a portfolio. More than that will lead to superfluous diversification, meaning that the cost and effort to track the portfolio will be more than the benefit from it.

The following video demonstrates the computation of return and risk for a portfolio of assets: