Diversifying Investment

Diversifying investment is a risk management technique that is used to minimize the risk of individual securities by investing in a portfolio of securities. That is, if investors reduce their reliance on particular assets, they can more easily bear a downturn on an individual security. Diversification is the cornerstone of modern portfolio theory that has seen wide applications in financial decision making. Both firms and individuals diversify investments. The former diversify by investing in individual activities, while the latter diversify by investing in portfolios rather than in individual assets.

In portfolio theory, investors are assumed to be risk averse, that is, they prefer lower to higher risk for a given return and will accept a higher risk only if they are compensated with a higher return. This creates indifference curves, lines on which risk and return combinations are offered to investors and as long as investors are on this line, they are indifferent on where to invest. Namely, as risk increases, return increases as well, so that investors are compensated for the increased risk they take on. The expected return of an investment in a single asset is the sum of the returns on that investment conditional on the probability of every return occurring. For example, if there is 60 percent probability that an investment earns a 5 percent return and 40 percent probability that it will earn 15 percent, the expected return on this investment is 9 percent, which is the weighted average of the probability of each event occurring. Furthermore, the expected return on an investment portfolio, i.e., on a combination of investments, is the sum of the weighted average of the returns of the individual holdings of the portfolio.

On the other hand, variance measures the variability of returns and is used as a benchmark for the risk of individual assets. In a single asset, the variance is the square root of the difference between the realized and the expected return on the asset. However, the variance of a portfolio of assets is proportional to the weights that are invested on each asset, to the variance of individual assets, and also to the degree of correlation between the individual assets.

Correlation

Correlation is a measure of interrelationship between assets and measures the extent to which the returns from two investments move together. If the correlation coefficient is +1 this means that the returns of the two investments always change proportionately in the same direction (perfect positive correlation). A correlation coefficient of −1 means that the returns always move proportionately in the opposite directions (perfect negative correlation). When the correlation coefficient is zero, this means that the returns have no correlation whatsoever and their returns are independent from one another.

The essence of diversification lies on the correlation coefficient of securities. Since the variance of a portfolio has two components, the individual securities' variance component and the correlation coefficient component, when two assets are negatively correlated, i.e., when the second component is negative, the portfolio variance is greater than portfolio variance. In other words, by investing in securities with negative correlation, the overall risk of the portfolio is reduced. If the correlation is zero, the second term of the portfolio variance is zero, so the variance of the [Page 522]portfolio is simply the sum of the individual variances of each stock included in the portfolio. The benefit of diversification is eliminated when the correlation coefficient is +1. Thus, other things equal, the smaller the correlation between two assets, the smaller the variance (risk) of the portfolio of the two assets. One can create the same risk level and higher expected returns by diversifying one's investments across a wide range of stocks. The only assumption is that as long as the individual stocks are not perfectly correlated, the risk-return combination of the portfolio will be better than the risk-return combinations of all individual stocks. The benefit of diversification increases as the degree of correlation decreases. This creates the efficient frontier, which represents the set of portfolios that give the highest return at each level of risk, or alternatively, the lowest risk at each level of return.

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