Reducing Risk Through Diversification

If a mutual fund invests the funds received from investors in the stocks of a large number of companies, the mutual fund is diversified and its risk is reduced. Diversification means reducing the risk of investing in assets whose returns do not move in the same direction at the same time.

Investors with small amounts to invest find it difficult to achieve diversification like mutual funds as they do not have enough funds to buy shares of a large number of companies. Yet investors can achieve diversification by investing in mutual funds for the same dollar amount invested, thereby reducing risk.

Financial intermediaries perform the financial function of diversification as intermediaries convert riskier assets into less risky assets. Although individual investors with sufficient funds can diversify on their own, they cannot do so as cost-effectively as financial intermediaries. Cost-effective diversification to reduce risk by purchasing the financial assets of a financial intermediary is an important economic advantage for financial systems.

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