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What is diversification and why is it important?

Diversification is the application of the adage "Do not put all your eggs in one basket." In finance, it means is investing in various financial assets simultaneously to reduce the overall risk of loss of your portfolio. In 1952, Harry Markowitz Nobel prize has shown that a person who invests in two different companies, each with the same return on investment and the same risk, holds a portfolio less risky but with the same performance than a person that invests exclusively in one of these companies. Diversification therefore eliminates some of the financial risk while generating the same return on investment. Markowitz added that stock prices of both companies must be “de-correlated" to observe a reduced risk. To illustrate this concept, consider two listed companies: AirlineCo and FuelCo. AirlineCo is an airline that carries passengers by air from point A to point B. FuelCo is an oil company which provides the fuel needed by AirlineCo to fly its planes.

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What is rebalancing?

Rebalancing is the process of periodically realigning a portfolio to its risk profile when it deviates from its equilibrium. Consider an investor who has a portfolio that initially consists of 50% of equities and 50% of bonds. Over time, it is expected that equities will grow more than bonds. It is therefore likely that at some point the portfolio will hold 60% of equities and 40% of bonds. Our investor is thus exposed to a risk superior to the risk he is willing to accept, as equities are riskier than bonds. To realign a portfolio to a target risk level, one rebalance it, meaning one sells the surplus of stocks and, with the cash generated by the sale, buy bonds to return to the 50%-50% balance. This implies that the investor who rebalances actually sells holdings with the highest prices to increase its holdings with the lowest prices. Buy low and sell high is a basic principle to grow one's wealth.

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