Portfolio Theory & Diversification, Slides of Security Analysis

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Portfolio Theory and Diversification are

fundamental concepts in the field of security

analysis and investment management.

They play a crucial role in helping investors

optimize their investment strategies to achieve

better returns while managing risk.

RISK AND RETURN Investors aim to balance the trade-off between risk and return. Higher potential returns are typically associated with higher risk. EFFICIENT FRONTIER OPTIMAL PORTFOLIO This is a curve that represents the set of portfolios that offer the highest expected return for a given level of risk. According to Portfolio Theory, the optimal portfolio lies on the efficient frontier and is aligned with the investor’s risk tolerance.

• A risk that an expected return will not be realized.
• Investors must think about return distributions, not just a single return.
• Use probability distributions.
  • A probability should be assigned to each possible outcome to create a distribution.

• Random Diversification
  1. Diversifying without looking at relevant investment characteristics.
  2. Marginal risk reduction gets smaller and smaller as more securities are added.
• A large number of securities is not required for significant risk reduction.
• International diversification is beneficial.

Example 1 : Assets:

• Asset A: Stock in Company X with an expected return of 10 % and a standard deviation of 5 %.
• Asset B: Bond in Company Y with an expected return of 5 % and a standard deviation of 3 %.
• Asset C: Real Estate investment with an expected return of 8 % and a standard deviation of 4 %.

Example 2 : Assets:

• Asset A: Stock in Company X with an expected return of 12 % and a standard deviation of 7 %.
• Asset B: Gold with an expected return of 4 % and a standard deviation of 2 %.

Example 1 : Correlations:

• 1. 1 (Very weak positive correlation) Portfolio Weights: 70 % in Asset A, and 30 % in Asset B. Expected Return: ( 0. 7 x 12 %) + ( 0. 3 x 4 %) = 9. 6 %

NON-CORRELATED ASSETS

• Diversification works best when the assets in the portfolio are not perfectly correlated, meaning they do not move in the same direction at the same time. RISK REDUCTION
• By holding a diverse set of assets, the overall risk of the portfolio is reduced, as the impact of a poor- performing asset is mitigated by the better performance of other assets.

Portfolio Diversification is one of the most important functions for every portfolio of stocks and assets under investment management. The idea is to create a portfolio that includes different investments in order to reduce the overall risk of the portfolio.

When investing or managing a diversified portfolio

with different asset-classes, these asset-class when

diversified, could include stocks, commodities,

precious metals, bonds, and different currencies.

Diversification is a very important tool on the

hands of those managing assets, investing in

stock markets or other industry markets and is

the cornerstone of modern portfolio theory in

financial economics.