Investing

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Diversification

In 'Asset Allocation', we saw that equity investment has (historically) provided the highest long term returns of any asset class. But we also saw that it exposes an investor to higher intermediate risk. This risk is investment risk - the uncertainty of future returns; and it can be measured by the variability (or volatility) of a share price.

Diversification is about reducing the volatility of returns. To see how this works, let's begin by looking at two hypothetical shares. Which is the riskier investment, Dinocorp or NewTech?

The movement in NewTech's share price is, on any one day, likely to be far greater than Dinocorps, so the chance of large losses or large gains is much greater. NewTech is far more volatile, and that is the measure of risk in financial markets - the greater the price volatility, the riskier (the more uncertain) the investment.

This definition is not restricted to share prices. Any investment with a known market price can be measured in terms of the volatility of its price.

Highly volatile investments offer the potential for the greatest gains, but also for the greatest losses; whilst low volatility investments offer more certain future returns, but these returns will be lower. A sensible investor will aim to optimise the balance between risk and return.

Let's see how this might be achieved.

This material has been prepared by FT Knowledge and is for information purposes only. It has not been independently verified by Standard Chartered Bank and makes no recommendation and accepts no responsibility or liability with respect to the accuracy or correctness of information contained in the material. It has not been prepared to be suitable for any particular person or class of persons and should not be relied on as a basis for investment decisions. The material in this document is not intended as an offer or solicitation of an offer to buy or sell any financial products. It does not constitute a prediction of likely future movements in rates or prices or any representation that such future movements will not exceed those shown in this document. Past performance is not necessarily indicative of future performance; the value, price or income from investments that may fall as well as rise. Before making any investment, you should seek your own professional advice.