Efficient Diversification

Bodie, Kane, and Marcus 4

Essentials of Investments,

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 6.1 Diversification and Portfolio Risk
• Suppose your portfolio has only 1 stock, how many sources of risk can
affect your portfolio?
• Uncertainty at the market level (general economic condition)
• Uncertainty at the firm level

• Market risk /Systematic risk /Non-diversifiable Risk

• Risk factors common to whole economy

• Unique/Firm-Specific/Nonsystematic/ Diversifiable Risk

• Risk that can be eliminated by diversification.

• If your portfolio is not diversified, the total risk of portfolio will have
both market risk and specific risk
• If it is diversified, the total risk has only market risk (Dell, Exon-Mobi)
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Figure 6.1 Risk as Function of Number of Stocks in Portfolio

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Figure 6.2 Risk versus Diversification (NYSE)

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 6.2 Asset Allocation with Two Risky Assets
• Covariance and Correlation
• To optimally construct a portfolio from risky assets, we
need to understand how the uncertainties of asset
returns interact.
• Portfolio risk depends on the covariance between the
returns of the assets in the portfolio.
• Covariance describe how the two variable are related:

- Positive covariance means that asset returns move

together.
- Negative covariance means returns move inversely.
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Spreadsheet 6.1 Capital Market Expectations

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Spreadsheet 6.2 Variance of Returns

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6.2 Asset Allocation with Two Risky Assets

• Portfolio risk depends on covariance between

returns of assets
• Expected return on two-security portfolio is the
weighted average of the return on each fund.
•
E ( rp )  W1r1  W2 r2
•
W1  Proportion of funds in security 1
•
W2  Proportion of funds in security 2
•
r1  Expected return on security 1
•
r 2  Expected return on security 2

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 Spreadsheet 6.3 Portfolio Performance
Suppose we form a portfolio with 40 % invested in the stock funds and 60%
invested in the bond funds. Then the return for example in mild recession:
0.40 * (-11%) + 0.60 * 15% = 4.6%

The SD of diversified portfolio is smaller

than that of stock and even than that bonds

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 6.2 Asset Allocation with Two Risky Assets
• Portfolio risk is reduced most when the returns of the
two assets most reliably offset each other.
• The natural question investors should ask, therefore, is
how one can measure the tendency of the returns on
two assets to vary either in tandem or in opposition to
each other.
• The statistics that provide this measure are the
covariance and the correlation coefficient.

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6.2 Asset Allocation with Two Risky Assets

• Covariance Calculations
S
Cov(rS , rB )   p(i )[ rS (i )  E (rS )][ rB (i )  E (rB )]
i 1

• Correlation Coefficient
Cov(rS , rB )
ρ SB (rho ) 
σS  σB

Cov(rS , rB )  ρ SB σ S σ B

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 Spreadsheet 6.4 Return Covariance

- The negative value for the covariance indicates that the two assets, on average,
vary inversely; when one performs well, the other tends to perform poorly.
- For instance, does the covariance of -74.8 (in cell F7) indicate that the
inverse relationship between the returns on stock and bond funds is strong ? It is
hard to say.

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6.2 Asset Allocation with Two Risky Assets
• An easier statistic to interpret is the correlation
coefficient which perform the relationship between
bonds and stock is strong or weak.
• Correlation is a pure number and can range from
values of +1 to -1.
• A correlation of -1 indicates that the securities
would be perfectly negatively correlated.
• A correlation of zero indicates that the returns on
the two assets are unrelated / no correlation.
• A correlation of +1 indicates that the securities
would be perfectly positively correlated.
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6.2 Asset Allocation with Two Risky Assets

• The correlation coefficient of -.49 confirms the

tendency of the returns on the stock and
bond funds to vary inversely.
• When the correlation between the component
securities is small or negative, this will reduce
portfolio risk.

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6.2 Asset Allocation with Two Risky Assets
• Three Rules
• RoR: Weighted average of returns on components, with
investment proportions as weights

• ERR: Weighted average of expected returns on

components, with portfolio proportions as weights

• Variance of RoR on a two risky asset portfolio is:

• SD = 
2
 Portfolio Standard Deviation
p

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6.2 Asset Allocation with Two Risky Assets

• Risk-Return Trade-Off
• Investment opportunity set
• Available portfolio risk-return combinations

• Mean-Variance Criterion
• If E(rA) ≥ E(rB) and σA ≤ σB
• Portfolio A dominates portfolio B

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