Is The S P 500 Safer Than A Diversified Portfolio_1

Post on: 23 Июнь, 2015 No Comment

Portfolio diversification is a risk minimization technique where a trader spreads their risk over a wide range of assets and products. The S&P 500 index (SPX), or the Standard & Poor’s 500, is one such asset which one can trade in. The components of this stock market index are determined by the S&P Dow Jones Indices and it comprises of 500 stocks from large cap companies. By market capitalization, the S&P 500 covers about 75% of the American market (equity). Diversifying an investment portfolio is usually associated with numerous advantages but it is also associated with some shortcomings. The million-dollar question is, is it advisable to put all your eggs in one basket?

When an investor diversifies his/her trading portfolio, it means that the risk is spread and a negative effect of one stock, will have a less disastrous result on the investor’s capital. For instance, if an investor owns stocks in let’s say 20 different companies and one stock’s price spirals down consistently, the effect of that one stock on the portfolio won’t be that adverse. Diversifying a trading portfolio generally adds some stability to the investments and it minimizes risk in case a negative event occurs. Diversification does not however protect an investor from the common market slowdowns but instead maintains a portfolio’s stability for a period of time.

When diversifying a portfolio, what an investor is actually doing is increasing the asset choices. Each of the assets included in the portfolio will exhibit different strengths and weaknesses hence an investor can make a choice that favors the trading result. Having a large choice base also increases stability of a given portfolio.

Trading the S&P 500 index is exactly the contrary. An investor cannot choose which stocks to trade or not to trade in the index. The investor can only trade the index as whole and hence his choice is restricted to the index and not the variety of stocks which make up the index.

Diversifying a portfolio is sometimes compared to tying a noose on an investment. That is, it sets a limit on the profits and hence is considered by some investors as a disadvantage in the long run. For instance, if only 5% of the investment spikes, an investor will have a relatively lower income than if he/she would have invested all the funds in one place. Assuming that a trader distributed his investment of $3,000 on ten different stocks and assuming an 80% return and only one company stock appreciates in a given period of time, then after the end of the period, the investor will only make a $240 profit.

On the other hand, focusing an investment in one pool like on the S&P 500 index can translate to huge gains. Assuming the conditions above, an investor will earn an 80% profit on the total $3,000 investment and hence he/she will take away a cool sum of $2,400 as profits.

Conclusion


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