Day 112 Portfolio Diversification

Portfolio Diversification 

When investors are trading in the financial market, it is not likely they will hold only one or two securities. In the contrary, a sophisticated investor would establish his/her own investment portfolio. It is a combination of several financial assets that carefully picked by investors in order to achieve the expected return. In fact, most rational investment portfolio normally held up to 20 different securities. The most important reason for that is to minimize the risk. 

There are three factors that define the risk on a portfolio: the standard deviation from the expected value, the weight of each financial asset and the correlation between these assets. As mentioned in our previous articles, the standard deviation is introduced to determine the distribution of all possible outcomes. It uses the mean return as the base line, and calculates the return allocated between plus and minus standard deviation sector. Consequently, the larger the standard deviation value is, the more risk will be anticipated to take that investment. Another element we use to evaluate the risk in a portfolio investment is the weight of each investment. Investors would adjust the structure of the assets in accordance with their strategy. For example, people who are risk-averse might want to allocate 60% of their fund on more secured investment such as government bond, and 40% on the share market which is reasonable risky. The nature of every individual investor leads to different portfolio structure. At last, the correlation coefficient is the most critical instrument that we use to assess and reduce the risk of the portfolio. It represents the implicit or explicit relation of two financial assets. Therefore, the positive correlation is the two assets share the same pattern on value variation. And the negative correlation makes the two asset show reflected movement on price. Financial decision makers utilize the characteristic of negative correlation to minimize the risk of portfolio investment. It is quite straight-forward, since if one of the assets incurs a loss, the amount can be covered by the gain of its negative correlated security. This process is called diversification, which means investors spread their fund on various assets in order to decrease the risk. However, there are many issues that is not diversifiable( systematic risk) including national policy changes, international problems, or even natural disasters. Investors cannot reduce the systematical risk since it is beyond their reach. The statistical tool portfolio beta was introduced to investors for measuring the market risk. It identifies the relationship between an investment’s return and the market’s return. 

As a financial decision maker, we must understand the process of diversification, because it is widely used on development of investment portfolios.