BU283 Chapter Notes - Chapter 6: Performance Metric, Risk Premium, Market Portfolio

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Diversification: act of giving something variety; in context of investing, diversification manages the risk of a portfolio by including a variety of assets. A low-risk portfolio is constructed by selecting low-risk stocks false. To build low risk portfolio, we should collect stocks that are negatively correlated. Diversification reduces risk and that reduction in risk depends on correlation between assets. When correlation coefficient = 1, there"s no bonus from diversification. Effectiveness of diversification depends on correlation of returns. Perfectly positively correlated forming portfolio doesn"t reduce risk much. When returns are less than perfectly correlated portfolio can substantially reduce risk. Standard deviation of a portfolio with many assets. As number of stocks gets large (assuming equal weight), risk of each stock matters less and variance of portfolio converges toward average of pair-wise covariances risk is driven by average degree of covariance. If you want to build a low risk portfolio, then pick stocks with low covariances (correlations)

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