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Diversication Example
Lecture 2.3: Diversication
Investment Analysis
Fall, 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 8, 2012
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Diversication Example
Diversication
The risk on a portfolio is more complex than a simple average of the risk
of individual assets - it depends on whether the returns on individual
assets tend to move together or whether some assets give good returns
when others give bad returns.
Benets of Diversication
There is risk reduction from holding a portfolio of assets if the assets do
not move in perfect unison.
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Diversication Example
Diversication
The risk on a portfolio is more complex than a simple average of the risk
of individual assets - it depends on whether the returns on individual
assets tend to move together or whether some assets give good returns
when others give bad returns.
Benets of Diversication
There is risk reduction from holding a portfolio of assets if the assets do
not move in perfect unison.
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Diversication Example
Benets of Diversication
The variance of a portfolio of N assets is

2
p
=
N

i =1
X
2
i

2
i
+
N

i =1
N

k=1
i =k
X
i
X
k

ik
In the case where all the assets are independent, the covariance
between them is zero, and the formula for the variance becomes

2
p
=
N

i =1
X
2
i

2
i
Furthermore, when equal amounts are invested in each asset,

2
p
=
N

i =1

1
N

2
i
=
1
N
N

i =1

2
i
N
0 as N
if we have enough independent assets, the variance of a portfolio of
these assets approaches zero.
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Diversication Example
Benets of Diversication
The variance of a portfolio of N assets is

2
p
=
N

i =1
X
2
i

2
i
+
N

i =1
N

k=1
i =k
X
i
X
k

ik
In the case where all the assets are independent, the covariance
between them is zero, and the formula for the variance becomes

2
p
=
N

i =1
X
2
i

2
i
Furthermore, when equal amounts are invested in each asset,

2
p
=
N

i =1

1
N

2
i
=
1
N
N

i =1

2
i
N
0 as N
if we have enough independent assets, the variance of a portfolio of
these assets approaches zero.
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Diversication Example
Benets of Diversication
The variance of a portfolio of N assets is

2
p
=
N

i =1
X
2
i

2
i
+
N

i =1
N

k=1
i =k
X
i
X
k

ik
In the case where all the assets are independent, the covariance
between them is zero, and the formula for the variance becomes

2
p
=
N

i =1
X
2
i

2
i
Furthermore, when equal amounts are invested in each asset,

2
p
=
N

i =1

1
N

2
i
=
1
N
N

i =1

2
i
N
0 as N
if we have enough independent assets, the variance of a portfolio of
these assets approaches zero.
CMU-logo
Diversication Example
Benets of Diversication
The variance of a portfolio of N assets is

2
p
=
N

i =1
X
2
i

2
i
+
N

i =1
N

k=1
i =k
X
i
X
k

ik
In the case where all the assets are independent, the covariance
between them is zero, and the formula for the variance becomes

2
p
=
N

i =1
X
2
i

2
i
Furthermore, when equal amounts are invested in each asset,

2
p
=
N

i =1

1
N

2
i
=
1
N
N

i =1

2
i
N
0 as N
if we have enough independent assets, the variance of a portfolio of
these assets approaches zero.
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Diversication Example
Benets of Diversication contd.
In most markets, the covariance between assets is positive the risk
on the portfolio cannot be made to go to zero but can be much less than
the variance of an individual asset.
The variance of a portfolio of N assets is

2
p
=
N

i =1
X
2
i

2
i
+
N

i =1
N

k=1
i =k
X
1
X
2

ik
=
N

i =1

1
N

2
i
+
N

i =1
N

k=1
i =k
1
N
1
N

ik
=
1
N
N

i =1

2
i
N
+
N 1
N
N

i =1
N

k=1
i =k

ik
N (N 1)

1
N

2
i
+
N 1
N

ik

ik
as N
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Diversication Example
Benets of Diversication contd.
In most markets, the covariance between assets is positive the risk
on the portfolio cannot be made to go to zero but can be much less than
the variance of an individual asset.
The variance of a portfolio of N assets is

2
p
=
N

i =1
X
2
i

2
i
+
N

i =1
N

k=1
i =k
X
1
X
2

ik
=
N

i =1

1
N

2
i
+
N

i =1
N

k=1
i =k
1
N
1
N

ik
=
1
N
N

i =1

2
i
N
+
N 1
N
N

i =1
N

k=1
i =k

ik
N (N 1)

1
N

2
i
+
N 1
N

ik

ik
as N
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Diversication Example
Systematic vs Nonsystematic Risk
Systematic Risk
The risk that remains even after extensive diversication is called
market risk, (also called systematic risk or nondiversiable risk) risk
that is attributable to market-wide risk sources.
Nonsystematic Risk
The risk that can be eliminated by diversication is called unique risk,
(also called rm-specic risk, or diversiable risk, or nonsystematic
risk).
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Diversication Example
Example: Portfolio Risk as a Function of the Number
of Stocks in the Portfolio
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Diversication Example
Portfolio Diversication