Portfolio Effect: How Diversification Reduces Investment Risk

The portfolio effect is a way to reduce risk when investing.

The portfolio effect is an investment term. When you add more diversity to your investment portfolio, you take on less risk. Risks that could greatly affect your portfolio if you had only one or two investments in it have much less effect when your portfolio contains several more investments.

Principle

The portfolio effect principle is adding more assets to a portfolio to make the total investment less risky. Generally, this is true, as long as you have more profitable investments than losing investments and you diversify them properly.

Considerations

The portfolio effect shows the value of diversifying your investments. If you invest in two direct competitors, their stock value will rise and fall depending on many factors: politics, weather, market conditions and simple market share. However, investing across a variety of industries lessens your risk, since economic conditions affect industries differently.

Other Uses

Conservation officials use the portfolio effect when breeding salmon. Basically, adding several different populations to breeding stocks help stabilize the population growth. This means there are fewer population booms and busts.