Page 90 - DCOM507_STOCK_MARKET_OPERATIONS
P. 90
Unit 4: Risk and Return
4.8 Portfolio Diversification and Risk Notes
In an efficient capital market, the significant principle to consider is that, investors should not
hold all their eggs in one basket; investor should hold a well-diversified portfolio. In order to
comprehend the nature or meaning of portfolio diversification, one must understand correlation.
Correlation is a statistical measure that shows the relationship, if any, between series of numbers
representing anything from cash flows to test data. If the two series move together, they are
positively correlated; if the series move in opposite directions, they are negatively correlated.
The existence of perfectly correlated particularly negatively correlated-projects is quite
uncommon. In order to diversify project risk and thus reduce the firm’s overall risk, the projects
that are best combined or added to the existing portfolio of projects are those that have a
negative (or low positive) correlation with active projects. By combining negatively correlated
projects, the total variability of returns or risk can be reduced. The figure demonstrates the
result of diversifying to reduce risk.
Figure 4.3: Reduction of Risk through Diversification
Project A Project
B
Return Return
O Time O 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 (that is, less variability of return) than either of the projects
taken alone. This type of risk is at times described as diversifiable or alpha risk. The creation of
a portfolio by combining two absolutely correlated projects cannot lessen the portfolio’s overall
risk below the risk of the least risky project, whilst the creation of a portfolio combining two
projects that are perfectly negatively correlated can decrease the portfolio’s total risk to a level
below that of either of the component projects, which in some particular situations may be zero.
Task Pen down your views on Portfolio and Security Returns.
LOVELY PROFESSIONAL UNIVERSITY 85
