FINM2003 Lecture Notes - Sharpe Ratio, Risk Aversion, Efficient Frontier
Diversification
Diversification is a strategy used by investors to reduce their portfolio risk without
affecting returns (Gupta & Basu, 2011). The main objective for a rational investor is to
achieve an optimal risk-return combination, through maximising their returns for an accepted
level of risk. This can be achieved by choosing a combination of investments to obtain
smoother returns by balancing out movements in the market (Gupta & Basu, 2011), and
reducing volatility (ASIC, 2018). This report will capture the main benefits of diversification,
namely risk reduction and lower volatility, in the 2013-2017 Australian Market through
sectorial performance analysis, financial inferences and statistical conclusions that investors
should be aware of.
Diversification allows investors to reduce portfolio risk and yield reasonably stable average
returns (Fundsupermart, 2014). Each individual investment ‘carries a chance of success,
failure or something in between’ (Lander, n.d.) and by spreading capital across different
investments, limits exposure to unexpected downturns of single investments.
Table 1 suggests that if an investor were to put all their capital in company XRO, they would
obtain an attractive return of 0.2321 but at higher risk due to their highest average S.D of
0.5468 during the period. This investment would ensure high returns if the company
performed well, however due to the high risk, in the case of negative performance in the
market, the investor could suffer from a terrible loss. These cases of uncertainty can be
avoided by an investor choosing to diversify.
Table 2 below has the statistics for different portfolios (EWP, ORP and MVP) all constructed
using the historical data of the ten companies. The portfolios appear to be less risky than the
individual companies as a factor of risk has been now excluded, which is evident in the
varying S.Ds. However, this reduces the potential for higher returns compared to returns
generated by individual investors during successful periods. For example, investors may wish
to invest in SEK due to its attractive returns of 0.25, but must accept a much higher risk at
0.30. Whereas reasonable returns can be guaranteed from the portfolios given their
corresponding level of risk.
Optimal Risky Portfolio (ORP)
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Document Summary
Diversification is a strategy used by investors to reduce their portfolio risk without affecting returns (gupta & basu, 2011). The main objective for a rational investor is to achieve an optimal risk-return combination, through maximising their returns for an accepted level of risk. This can be achieved by choosing a combination of investments to obtain smoother returns by balancing out movements in the market (gupta & basu, 2011), and reducing volatility (asic, 2018). This report will capture the main benefits of diversification, namely risk reduction and lower volatility, in the 2013-2017 australian market through sectorial performance analysis, financial inferences and statistical conclusions that investors should be aware of. Diversification allows investors to reduce portfolio risk and yield reasonably stable average returns (fundsupermart, 2014). Each individual investment carries a chance of success, failure or something in between" (lander, n. d. ) and by spreading capital across different investments, limits exposure to unexpected downturns of single investments.
