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The Function of Investment Portfolio Diversification

To better understand the role of diversification in mutual funds, imagine you are a player in the Wheel of Fortune Show and you have two wheels with different potential outcomes in front of you. Each portion of the wheel represents a different return on the investment you have chosen.

The first wheel represents the option of purchasing one stock, meaning no diversification. On the other hand, the second wheel provides you the opportunity of buying a mutual fund with many stocks.

If you choose to play with the first wheel (no diversification), there is a 50 % probability of either winning or losing the invested money. A broad range of potential outcomes is provided due to the many possibilities between the winning and losing pie pieces. The best outcome may be a 50% gain, whereas the worst thing that can happen to you in this investment game is a 50% loss.

On the other hand, the second wheel (diversification) provides a higher probability of earning money, since only two portions include the possibility of incurring a loss. The scope is sufficiently reduced to an 11% potential loss and a 35% potential gain.

After a close examination of the provided options, which wheel would you spin? The prudent investor will straight away choose the second wheel that includes diversification. The purchase of many stocks sufficiently increases the possibility of making money and reduces the likelihood of incurring substantial losses of your hard earned cash! Mutual funds represent a favorable way of diversification, which can be moved to a higher level by your participation in mutual funds with various objectives.

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