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19 Feb 2019

How does diversification allow risky assets to be combined so that the risk of the portfolio is less than the risk of the individual assets in it?

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Deanna Hettinger
Deanna HettingerLv2
19 Feb 2019

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As part of our portfolio management chapter, we discussed diversification benefits. We said that when two stocks are combined into a portfolio, we end up with a portfolio that has a better return and better risk than the best of the two stocks. Any reasonable person would expect to have an average return and average risk when two securities are combined into a portfolio. How is it even possible to have a portfolio that has lower risk than the best of the two securities included into the portfolio?

What is the portfolio of assets?

What is well-diversified portfolio?

What happens to the risk of single investments when it is held as part of a portfolio of assets?

Explain the differences between stand-alone risk, diversifiable risk ,and portfolio risk.

Why should all investors hold well-diversified portfolios rather than individual assets?

Is standard deviation the appropriate risk measure for an individual asset?

Is standard deviation the appropriate risk measure for investor’s portfolio of assets? Explain your answer.

A project in a non-profit business is held as part of what two portfolios?

Hi guys could someone help me and explain in detail the two fundamental principles of investments – the risk/return tradeoff and diversification. Also, describe how asset allocation and the correlation of various securities within asset classes impact the riskiness of an investor’s portfolio.

I found an answer but it seems to me very long and not sure about it so can you help me out guys

ANS:

Risk /Return Tradeoff

Risk, return and liquidity are three dimensions of investment decision. Risk/Return trade off considers two dimension ie risk and return. As risk of an investment increases , its expected return will decrease. Risk is measured by volatility of return which can be statistically obtained by standard deviation of return. Higher the standard deviation, higher will be volatility of return and higher the risk

Risk can be also measured as a relative risk compared to the market. This is measured by stock beta with reference to a market index. Higher the beta, higher the value of stock Beta, higher will be the risk .

Investors seeking higher return will need to take higher risks.

Treasury bonds are almost risk free assets. This has the lowest rate of return. Stocks have higher risk , hence have higher expected return. High beta stocks will have higher risk and higher returns.

An investor should understand his risk taking ability and will have to make a trade off between risk and return depending on his risk apetite.

Diversification:

There is a saying, do not put all your eggs in one basket. The reason is that it has higher risk if all eggs are in one basket. If the eggs are distributed in different basket, risk of loss decreases.

Same principle is applied in investment. Diversification reduces risk.

If one invests in different classes of assets like bonds, stock, commodities and properties –his risk is likely to reduce. Reduction in return in one asset is likely to be compensated by return in other asset.

Within one class of asset also, there should be diversification to reduce risk.

For example one stock “A “may have expected return of 10% and standard deviation of 5%.This risk can be reduced by diversification in number of assets and the ratio of Risk/return can be decreased.

If we diversify and instead of investing 100% in stock A, we invest 60% in “A” and 40% in another stock “B” having expected return15% and standard deviation of 8%.assume the correlation between the two assets are 0.5

Portfolio return=wa*Ra+wb*Rb

Wa=Weight of asset A=0.6

Wb=Weight of asset B=0.4

Ra=Return of A=10%

Rb=Return of B=15%

Sa=Standard deviation of A=5%

Sb=Standard deviation of B=8%

Corr(a,b)=Correlation of A & B=0.2

Portfolio return=0.6*10+0.4*15=12%

Portfolio Variance=(wa^2)*(Sa^2)+(wb^2)*(Sb^2)+2wa*wb*Cov(a,b)

Cov(a,b)=Corr(a,b)*Sa*Sb=0.1*5*8=4

Portfolio Variance=(0.6^2)*(5^2)+(0.4^2)*(8^2)+2*0.6*0.8*4=23.08

Portfolio standard deviation=Square root of Variance=(23.08^0.5)=4.8%

The diversification has increased return and reduced risk

Stock A was giving 10% return with 5% standard deviation. With diversification of portfolio we have 12% return and 4.8% standard deviation. Risk return ratio is decreased.

It may be noted that, higher the correlation between assets in the portfolio, higher will be risk in terms of standard deviation. Hence it is better to diversify with uncorrelated assets.

Diversification reduces unsystematic risk,but it cannot reduce systematic risk of overall market or economy

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