Page 85 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes
Figure 2.3: Reduction of Risk through Diversification

Project A Project B
Return Return

O O
Time Time

Return Project A and B

O Time

It shows that a portfolio is containing the negatively corrected projects A and B, both having the
same expected return, E, but less risk (i.e. less variability of return) than either of the projects
taken separately. This type of risk is sometimes described as diversifiable or alpha risk. The
creation of a portfolio by combining two perfectly correlated projects cannot reduce the portfolio's
overall risk below the risk of the least risky project, while the creation of a portfolio combining
two projects that are perfectly negatively correlated can reduce the portfolio's total risk to a
level below that of either of the component projects, which in certain situations may be zero.
Benefits of Diversification

The gains in risk reduction from portfolio diversification depend inversely upon the extent to
which the returns on securities in a portfolio are positively correlated. Ideally, the securities
should display negative correlation. This implies that if a pair of securities has a negative
correlation of returns, then in circumstances where one of the securities is performing badly, the
other is likely to be doing well and vice versa in reverse circumstances. Therefore the average
return on holding the two securities is likely to be much 'safer' than investing in one of them
alone.

Utility Function and Risk Taking

Common investors will have three possible attitudes to undertake risky course of action (i) an
aversion to risk (ii) a desire to take risk, and (iii) an indifference to risk. The following example
will clarify the risk attitude of the individual investors.

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