Optional exercise: Diversification

Open the Excel file Diversification.xls. In this exercise we will study the diver-
sification effect. Your input data are the average standard deviation among stocks
and the average correlation among them. You also find the standard deviation for a
portfolio of 30 stocks, and the percent risk reduction such a portfolio gives compared
to a portfolio of a single stock. The two graphs are based on the table “Portfolio data”
and should be self-explanatory.

Questions

1. Start with an average standard deviation of 50% and an average correlation of

0.50. Study the top graph. If you increase the number of stocks from one to 30,
how much does the standard deviation change (in absolute and relative terms)?

2. Study the bottom graph. How much of the total portfolio variance comes from
stock variances, and how much from covariances, in a one-stock, five-stock and
30-stock portfolio, respectively?

3. Change the average correlation to zero, and answer Questions 1 and 2 again.
Discuss the differences between the two correlation cases.

4. Change the correlation to one (all stocks are then perfectly positively correlated).
How does this change the answers to Questions 1 and 2?

5. Let the average correlation be –0.20. Study the graph and table. The analysis
breaks down. What is peculiar in this case? Can you explain why we get this
result (Hint: What does an average negative correlation mean? For simplicity,
think of a three-asset case with perfectly negative correlations.)

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Answers

1. The standard deviation of a one-stock portfolio is 50%. The standard deviation

of a 30-stock portfolio is 35.9%. The risk is therefore reduced by more than 14
percentage points in absolute terms. Put differently, the risk level in a 30-stock
portfolio is only 3/4 of the risk in a one-stock portfolio.

2. In a one-stock portfolio all risk comes from variances. In a five-stock portfolio,

only 33% of total portfolio variance comes from individual stock variances; the
rest is the risk contribution of covariances. Hence, it only takes a few stocks
in a portfolio to drastically reduce the impact of each stock’s own volatility on
portfolio risk. When we have a 30-stock portfolio, 94% of the total portfolio
variance is covariance risk. Almost all individual stock risk is diversified away.

3. When the average correlation is zero (as if stock returns move independently of
each other), the benefits of diversification are much more pronounced. In a 30-
stock portfolio, the risk level is only 12% of the individual stock risk (a standard
deviation of 9.1% compared to 50%). However, all risk is now variance risk as
all covariances are zero when all correlations are zero. The main conclusion is
that the lower the correlations are, the more risk can be diversified away in a
portfolio.

4. This is the polar opposite case. The portfolio risk is always 50%, independent
of the number of stocks in the portfolio. The impact of each stock’s standard
deviation decreases quickly, as the lower graph shows. Covariances dominate the
portfolios.

5. When the average correlation is negative, something funny happens with the
graphs, and, in particular, in the table that shows portfolio risk levels. This is no
Excel peculiarity, but instead the result of us breaking one restriction regarding
correlations. When you think about it, can stocks be on average negatively
correlated? The short answer is no. [There is a longer (technical) answer to
what a well-defined correlation matrix is, but it is not important here.] Take
an extreme case. Assume three stocks (A, B and C), all perfectly negatively
correlated with each other. What happens? If A goes up, then B has to go
down. At the same time, since A and C are also perfectly negatively correlated,
C also has to go down. But then both B and C go down at the same time.

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Hence, B and C are perfectly positively correlated, which is a contradiction to
our original assumption. This is not possible. The same reasoning is valid in
the general case, with several assets and negative, but not necessarily perfectly
negative, correlations.

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