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This assignment examines how the variances of portfolios comprised of randomly selected
stocks are reduced as a result of diversification. The results are reexamined for the special
case of all the stocks are in the same industry, World Steel.
a) Using the file “Returns”, form equal-weight portfolios using the first 5, first 10, first
25, and all 50 stocks on the worksheet labeled random. Calculate the sample mean and
standard deviation of returns for each of the four equal-weight portfolios. Plot
estimated standard deviations as a function of the number of stocks in the equal-
weight portfolio. Comment on the shape of the function.
Answer-The shape of the function is appropriate verifying the theory that for a portfolio
that contains an increase number of stocks, the risk is lesser compared with a portfolio
with lesser stocks .
Are the results consistent with what you would expect theoretically? Eyeballing the graph,
does it look like adding more and more stocks will diversify away all the standard
deviation?
The graph shows that diversification helps until a number of approx. 40 stocks is included
in portfolio,after which the curve becomes almost flat. This indicates that further
diversification will not further decrease the risks associated with investing in this
portfolio.
Why or why not?
b) For all four equal-weight portfolios, decompose the estimated portfolio variance into
its two components (the contributions of variances and covariance’s). Hint: you do not
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C517 Financial Management
d) Do the results in c) differ from those in a) and b) in a manner you expect? Explain
e) The results don’t differ that much. The graphs are pretty much similar .