Portfolio

Management and
Wealth Planning
DIVERSIFICATION
Diversification

 Don’t put all of your eggs in one basket !

Diversification and Portfolio
Risk
 In a naive diversification strategy, you include additional
securities in your portfolio.

 If we diversify, we spread out our exposure to the firm

spesific factors, and portfolio volatility should continue
to fall.

 However, even with a large number of stocks we can not

avoid risk altogether. Securities are affected by the
common macroecomic factors.
 The risk that remains after diversification is

 market risk = systematic risk = nondiversifiable risk

 The risk that can be eliminated by diversification is

 Unique risk = firm-spesific risk = nonsystematic risk =

diversifiable risk
Portfolio Risk and
Diversification
Hedge Asset

 A hedge asset has negative correlation with the other

assets in the portfolio.

 Hedge assets are effective in reducing total risk.

 Therefore, other things are equal, we will always prefer

to add to our portfolio assets with low or negative
correlation with our existing position.
 The portfolio’s expected return is the weighted average
of its component expected returns,
 whereas its standard deviation is less than the weighted
average of the component standard deviations.


Portfolios of Two Risky
Assets
 D = bond portfolio
 E= stock portfolio
 P = portfolio
 r = return
 w = weight
 E ( r ) = expected return
Return on the portfolio

  
 Expected return on the portfolio is weighted average of
expected returns:
 E(
Variance of the portfolio

  Variance of the portfolio:

+ + 2 Cov (, )

 Cov (, ) = - E]^2 =

Cov (, ) + Cov (, ) + 2 Cov (, )

Portfolio with three funds

  
 Consider three funds as X, Y, Z
 + + + 2 Cov (, ) + 2 Cov (, ) + 2 Cov (, )
Correlation

 Correlation is a statistical measure of the relationship

between two series of numbers representing data
 Positively Correlated items tend to move in the same
direction
 Negatively Correlated items tend to move in opposite
directions
 Correlation Coefficient is a measure of the degree of
correlation between two series of numbers representing
data
Correlation Coefficients

 Perfectly Positively Correlated describes two positively

correlated series having a correlation coefficient of +1
 Perfectly Negatively Correlated describes two negatively
correlated series having a correlation coefficient of -1
 Uncorrelated describes two series that lack any
relationship and have a correlation coefficient of nearly
zero
Correlation is Important for
Diversification
 Assets that are less than perfectly positively correlated
tend to offset each others movements, thus reducing the
overall risk in a portfolio
 The lower the correlation the more the overall risk in a
portfolio is reduced
 Assets with +1 correlation eliminate no risk
 Assets with less than +1 correlation eliminate some risk
 Assets with less than 0 correlation eliminate more risk
 Assets with -1 correlation eliminate all risk
Correlation and Variance

  Cov (, ) =

 Other things are equal,

 If is higher, portfolio variance is higher:


 + +2
Portfolios of less than
perfectly correlated assets
always offer better risk-
return opportunities than
the individual component
securities on their own.
Example

Debt equity
Expected return 8% 13%
Standard 12% 20%
deviation
covariance 72
correlation 0.30
  E(

 + +2
EXAMPLE

Expecte Standard deviation

d return
X stock 10% 20%
(weight 20%)
Y stock 30% 60%
(weight 30%)
Z - bond 5% 0
(weight 50%)
Correlation between X and Y is -0,2
  
+ + + 2 Cov (, ) + 2 Cov (, ) + 2 Cov (, )

+ + +2 +2 +2

+ + + 2 * Cov (, ) + 2 * Cov (, ) + 2 Cov (, )

  Cov (, ) =

 Cov (, ) = *

 Cov (, ) = 0.024
   + + 2 *0.024

 = 0.03688
 Reference
 Bodie, Z., Kane, A., & Marcus, A. J. Essentials of
Investments 8th Edition. McGraw-Hill.