What does diversification do to the risk and return characteristics of a portfolio?

Answer 1

Diversifying does little for the return of the portfolio. The portfolio return is the weighted average of the investment returns in the portfolio. However, diversification can do much for reducing the total risk of the portfolio as measured by the standard deviation. By combining assets that perform differently in different economic environments, the overall level of the risk in the portfolio is reduced. In addition, diversifying reduces the firm-specific portion of each asset's total risk.