DIVERSIFICATION AND RISK

In order to diversify risk for creation of an efficient portfolio, the concept of correlation
must be understood. Correlation is statistical measure that indicates the relationship, if
any, between series of number representing anything from cash flow to test data. If the
two series move in opposite direction, they are negatively correlated. The existence of
perfectly correlated especially negatively correlated project is quite rate.

In order to diversify project risk and thereby reduce firms overall risk, the project that are
best combined or added to the existing portfolio of project are those that have negative
correlation with existing projects. By combining negatively correlated projects, the over
all variability of returns or risk can be reduced.

Measurement of portfolio risk

In order to measure the risk in investment analyses, we may express estimates of the
result of a project as probability distribution by giving a list of possible cash flow with
an estimates of the relative like hood of occurrence of each one. This leads to a
characterization of the result of project in two measures:

• The expected value the weight average of the present value of the various possible
outcomes using probabilities as weight.
• A measure of the dispersion of possible outcome, conveniently summarize in a
statistical quality, the variance or standard deviation.

Benefits of diversification

The gain in risk reduction from portfolio diversification depends inversely upon the
extent to which the return on securities in portfolio is positively correlated. Ideally the
securities should display negative correlation. This implies that if a pair of securities as a
negative correlation of return, then in circumstances where on of the securities is
performing badly the other is likely to be doing well, and vice-versa in reverse
circumstance. Therefore the average return on holding the securities is likely to be much
‘safer’ then investing in one of the two alone.