Explain how diversification can reduce the risk of a portfolio of assets to below the weighted average of the risk of the individual assets.
Explain how diversification can reduce the risk of a portfolio of assets to below the weighted average of the risk of the individual assets
Portfolio of assets forms after a grouping or combination of different types of financial assets like cash equivalents, bonds, stocks, currencies, and commodities. It might also be other types of securities like houses, private investment, and so many other things (Zakamulin, 2015). Different people/business have a different preference when it comes to the management of it, some choose to have a financial professional look after it while some manage it by themselves. Regardless of what the choice is, one should always look out for personal objective and risk tolerance. Diversification helps in the reduction of risk.
Diversification doesn’t just mean that you own a lot of assets of multiple businesses and hold onto it. But rather with the use of diversification, all the unsystematic risk associated with the asset should and can be eliminated. These unsystematic risks can be something which is unique to that business like the protest, miss-management, shortages of things for manufacturing and so many more.
Consider that you have a secured saving of $400,000. Now, as you build your portfolio, it’s crucial to consider the effect on portfolio performance and volatility due to diversification. The statement of not putting all your eggs in one single basket proves significant for having a successful investment and return from it. Proper allocation plan ensures that the portfolio is diversified with a mix of investment. All this contributes towards better return and reduced risk. Scattering out the cash you’ve at hand on stocks from Nepal, and other international market helps in the diversification process. For bonds, different level of government from different parts can be sought while cash can be held not just in one financial institution but split into multiple.
All those help in the reduction of risk and keep the weighted average below the two extreme ends (highest and lowest). An example to justify this further would be:
Consider a total of $10,000 wealth is split in the following way in portfolio:
Company A: $5,000 (50% of total wealth)
Company B: $2,500 (25% of total wealth)
Company C: $2,500 (25% of total wealth)
Considering that the expected return of Company A is 20%, B is 3% while for C it’s at 10%. Weighted Average would then be:
0.520 + 0.253 + 0.25*10 = 10 + 0.75 + 2.5 = 13.25
The weighted average calculated is lesser than the two extreme points (high of 20% and the lowest at 3%). However, we can note that the one with the most investment in dominate the weighted average. Further calculation can be done to calculate the risk involved in the same as well. With the investment diversified the risk of losing out everything in the extreme case is removed as well as there will be other investment in other different entities (Witt, 1978). It is worth noting that diversification helps in removing unsystematic risk associated with the project. The other risk type being the systematic risk is something that impacts the entire industrial sector and something that can’t be dealt with (Goetzmann & Kumar, 2008). But identifying the unsystematic risk and diversifying the investment such that to avoid that risk adds a lot of value and decreases the risk involved as well. All the reasons above are how diversification can reduce the risk of a portfolio of assets to below the weighted average of the risk of the individual assets.
Goetzmann, W., & Kumar, A. (2008). Equity Portfolio Diversification. Review Of Finance , 12 (3), 433-445.
Witt, S. (1978). International Portfolio Diversification. Managerial Finance , 4 (2), 198-203.
Zakamulin, V. (2015). Optimal Dynamic Portfolio Diversification Across Assets and Over Time. SSRN Electronic Journal , 1-3. doi: 10.2139/ssrn.2604420
Portfolio is a combination of two or more types of security having different various returns and risks. A good portfolio diversification looks at the best collective return with lowest risk. "When analyzing the risk associated with a capital expenditure, it is important to distinguish
between the total project risk and the portfolio or beta risk of that investment.” (Moyer, McGuigan, Rao, & Kretlow, 2012) One of the most famous investors, Warren Buffet, has said, "Do not put all your eggs in one basket.” This mean to diversify the type of securities you invest in so even if one does not give you return another will which will try and maintain equilibrium to your investment.
There are two types of risks, systematic risk and unsystematic risk. Systematic risk are those risks that are out of a company’s hands like, recession, natural calamity, war etc. which affects the stock of a company. On the other hand an unsystematic risk are those risks that can be reduced or managed by a company such as employee strike, new competitor etc. A good portfolio diversification will have unsystematic risk equal to zero or should be able to minimize to the lowest possible variable.
In a portfolio more than two securities will be invested in. Their weight of investment and average return are different and so are their individual risk. Risk is most likely higher when the return is also high. But mixing these higher risk with those with lower risk minimizes the chances of loss.
Well diversified risk may have higher risk but the beta of the security may show that most of risk are unsystematic risk which can be reduced. Beta also show the sensitivity of the stock to the market. One stock may be very sensitive while the other may not. Investing in stock that have Beta which are both sensitive and less sensitive will be a good diversification of risk as these stock will have negative correlation. "Correlation shows how the return of one asset moves in relationship to that of another. Positive correlation indicates that when the return for one asset is up (or down), the return for the other asset also will tend to be up (or down). (Peavy III & Vaughn-Rauscher, 1994)”
While diversifying therefore it is wise to look at the standard deviation as well as the beta to choose those securities which have good return and higher level of unsystematic risk and less systematic risk. Therefore diversification of portfolio reduces the individual security risk as a result of combined average weighted risk that gives the portfolio an average weighted risk less than individual security risk.
Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.
Peavy III, J., & Vaughn-Rauscher, M. (1994, September). Risk management through diversification. Trusts & Estates; New York , p. 42.
The portfolio can be defined as a group of more than one investment or asserts, that is, collection of more than one investment is called a portfolio. The portfolio theory helps to diversify the investment amount in different assets, which reduces the investment risk. The main objective of portfolio theory is to maximize the investment return at the given level of return or minimize the investment risk at the given level of return. The modern portfolio theory originally, was proposed by Harry M. Markowitz, (1952). Harry M. Markowitz received the Nobel memory Price in 1990 for portfolio theory from economy science. The portfolio theory deals with how a risk average investor chooses optimal portfolio which minimizes the risk and maximize the investment return.
The portfolio return is weighted average rate of return of individual securities which are included in the portfolio and it is denoted by E (Rp). The weight being the proportion of rupees amount of portfolio is invested in individual securities divided by the total amount of portfolio. Note that, the sum of weight is always equal to one. Like the expected return of portfolio, the portfolio risk is not weighted average risk of individual assets which are included in the portfolio. The portfolio risk is the function of risk and relative weight of individual assets as well as covariance or correlation co - efficient between return of individual assets of the portfolio. The total risk of a portfolio is measured by either variance or standard deviation of the portfolio. The portfolio risk is maximum if the correlation co - efficient between return of these assets is perfectly positive and the portfolio risk is minimum if correlation coefficient is perfectly negative. Note that, it is possible to create a zero risk portfolio from two assets if the correlation coefficient between these assets is perfectly negative (r = -1). Thus, higher the correlation co - efficient between return of portfolio’s assets, the greater will be portfolio will be portfolio risk and vice versa.
An investor may invest in one or more assets. When he/she invests more than one assets the combination of asset is a portfolio. If I am a business person and I invest the capital in Butwal power Company, Other commercial Banks, Educational Institute and Medical center and others business is portfolio of investment. If I have loss in any sector but other sector almost recover the loss in portfolio so it is less risky investment procedure. We have different types of risk associate in business. Suppose one is overall risk which affect all business at a time like natural disaster, and County economy crisis or political instability but other is within organizational risk. Like employees sticks for their demand and they closed the organization for few days due to this we have risk. But Portfolio refers to the collection of securities. The investor invest in a portfolio of asserts in order to reduce the risk of his/her investment. Risk of a portfolio is reduced when all eggs in one basket’ is a bit of time tested folk wisdom. The basis rational behind making portfolio is derived from the folk wisdom (Landsman & Makov, 2018).
Reducing the risk by means of portfolio is known as diversification Harry M. Markowitz, (1952) has highlighted the need of analysis of correlation between the return of the assets in order to reduce the risk. Analysis of correlation between securities for making portfolio is known as Markowitz’s diversification. If the correlation between two securities is perfectly positive, there will be no benefits of making portfolio of such securities. It is just like putting eggs in two baskets tied together - the fall of one basket id accompanied by the fall of another. The benefit of diversification is achieved when the correlation between two assets is less than +1. If the correlation between two securities is -1, the risk can be reduced to zero at a particular combination of the two asserts.
Landsman, Z., & Makov, U. (2018). A Generalized Measure for the Optimal Portfolio Selection Problem and its Explicit Solution. European Journal of Operational Research .
Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, Vol. 7, No. 1. , 77 - 91.
Diversification is a risk management system that blends a wide assortment of investments inside a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio (Staff, 2018). It is also defined as the process of investing in various assets or sectors, to reduce the non-symmetric risk. Whereas rick can be defined as the changes which can occur in the actual return from the expected return. Any kind of investments are associated to risk. "There are two types of risk, Unsystematic and systematic risk. Systematic Risks are those risks that affect the entire market. Whereas Unsystematic risk are those risks that are unique to the company. Diversification can help investors in reducing their Unsystematic Risk” (Bakri, 2014).
Diversification reduces the risk factor. This is likewise upheld by Portfolio Theory by Harry Markowitz, which expressed that financial specialists can build portfolios to optimize or maximize return at a given market risk (Markowitz, 1952). When we diverse, the normal return may diminish yet the risk factor additionally decreases altogether. Diversification of risk in the asset determination process enables the investors to decrease risk by combining negative corresponded resources with the goal that the risk of the portfolio is not as much as the risk of the individual asset. Regardless of whether resources are not adversely associated, the lower the positive connection between them, the lower the subsequent dangers. It also reduces the risk associated with the portfolio of the assets. The risk decreases below the weighted average risk of the individual asset, since when resources are consolidated together in a gathering or portfolio, extraordinary returns in a single course from one asset might be balanced by outrageous returns the other way from another asset.
Let’s make an assumption, to portfolio A and B having different assets along with different expected risk with same amount of cash
|particular||Portfolio A||Portfolio B|
|Standard Deviation (Sd)||14.32||13.51|
Calculating the expected portfolio, E(rp)= WaE(Ra) + WbE(Rb)
Standard deviation = Wa* SD of A +Wb * SD of B
= 0.514.32 + 0.5 13.51
Variance of the portfolio = √13.91
11% is the expected return from the portfolio and 13.91% is the standard deviation which implies the risk of the portfolio. Whereas the variance is 3.63, which the portfolio doesn’t consist of large asset and security.
Staff, I. (2018). Diversification . Retrieved from Investopedia: https://www.investopedia.com/terms/d/diversification.asp
Bakri, A. A. (2014). Portfolio Diversification Strategy and the Impacts on the Middle East Real Estate Investment Decision. International Journal of Economics and Finance Vol.6, No.2, 62-74.
Markowitz, H. (1952). Portfolio Selection. The Journal of Finance,Vol.7,No.1 , 77-91.