- Hedging (through derivatives).
Diversification is guided by the principle that “Do not put all your eggs in one basket”. In other words, diversification implies that any investor should not limit their exposure to one business or invest all funds into one particular asset class. The funds and exposure should be apportioned amongst different asset classes which display low correlation between their returns. This would help to minimize the aggregate risk exposure of the portfolio and the business subject to the constraints. As an example, in investment theory, an aggressive stock (with beta greater than one) can be combined with a defensive stock (with beta less than one) to create a two asset portfolio whose cash flow variability is less than that of the individual securities. Diversification helps to eliminate the unsystematic risk of the investment and leads to the total risk of the portfolio to the systematic risk that is non diversifiable. As the number of stocks in the portfolio increases, which exhibit low correlation between their returns, the beta of the portfolio (which is the weighted beta of the individual assets and their respective percentage weights in the portfolio) approaches unity and the expected return of the portfolio becomes the expected market return as the beta of both tend to be equal to unity.