Diversifying risk is a method applied to an investment portfolio that minimizes the risk through the allocation of investments across several instruments. Diversification is done to maximize the returns by dividing the initial investment into several areas. By adding risk-free security, investors can perform better than the efficient frontier. Investors, therefore, choose assets without risk or a minimal risk allowing for diversification of the assets and subsequently the risk. By applying the modern portfolio theory, investors select assets that balance by calculating the expected returns using statistical methods. The efficient frontier allows a diverse portfolio of assets each with a different level of risk. The aim of applying the efficient frontier is to attain the highest level of return for investments for various levels of risk ( Lioudis, 2020 ).
If investors select risk-free assets to the portfolio, they can do better as it serves as an upgrade on the efficient frontier. The efficient frontier allows various levels of risk, which is not as efficient as selecting risk-free investments. Investors can, therefore, balance their portfolio during diversification to accommodate a balance between risk-free assets and assets with a moderate level of risk. However, balancing the modern portfolio by selecting more assets with a low level of risk does not guarantee the highest return. Experienced investors create a balanced portfolio with the same level of risk as the efficient portfolio through diverse assets with a higher return to attain a better modern portfolio ( Lioudis, 2020 ).
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The market risk premium is the return that an investor receives, in addition to holding a risky market portfolio. The market risk premium has a significant impact on stock prices. An increase in the market risk premium causes an increase in the percentage or return of a stock. The rise in market premiums, therefore, influences investors to buy stocks that have the potential to bring maximized returns ( Boyte-White, 2020 ).
References
Boyte-White, C. (2020, February 10). How does market risk affect the cost of capital? Retrieved from https://www.investopedia.com/ask/answers/043015/how-does-market-risk-affect-cost-capital.asp
Lioudis, N. K. (2020, January 29). The Importance Of Diversification. Retrieved from https://www.investopedia.com/investing/importance-diversification/
