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Chapter 8 The Gain From Portfolio Diversification

Chapter 8 The Gain From Portfolio Diversification. Level of Risk. Determine. Optimal Portfolio. Expected Return. Investment Weights. Affect the Portfolio’s Variance Minimize Portfolio’s Risk Determine the Investor’s Risk Exposure 1 Strategy of Weights Will Yield a Portfolio with No Risk.

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Chapter 8 The Gain From Portfolio Diversification

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  1. Chapter 8The Gain From Portfolio Diversification

  2. Level of Risk Determine Optimal Portfolio Expected Return

  3. Investment Weights • Affect the Portfolio’s Variance • Minimize Portfolio’s Risk • Determine the Investor’s Risk Exposure • 1 Strategy of Weights Will Yield a Portfolio with No Risk

  4. Weights For The 2 Asset Portfolio WA + WB = 1 WB = 1 - WA WA + (1 - WA) = 1 or 100% only need to solve for one variable

  5. Gains From Diversification • Lower Correlation • Smaller Portfolio Variance • Larger Gains From Diversification • For a Given Set of Weights

  6. Minimize Portfolio’s Risk • Selecting Assets With Low Correlation • Balancing the Investment Weights • Degree of Correlation • Influences the portfolio’s level of risk • Lower the correlation, the larger the gain from diversification

  7. How Many Stocks Are Required For Adequate Diversification? • The More Stocks, the Better • Increasing Transaction Costs • 10-15 Stocks Sufficient • 90% of Maximum Benefit with 12-18 • Most Benefits Achieved with 10 • Diminishing Benefits with Additional Stocks

  8. “A Little Diversification Goes A Long Way” As the Number of Assets Increases the Incremental Contribution to Variance Reduction Becomes Smaller and Smaller

  9. Mutual Funds • Diminishing Benefits of More Stocks are Still Positive • There is some gain • Low Cost of Data • Large Funds Have to Invest in Many Stocks • Avoid buying and selling affects • Regulation M • Own  5% of any company’s stock

  10. MVP • Minimum Variance Portfolio • Portfolio With the Smallest Variance From the Mean-Variance Frontier • Mean-Variance Frontier • Efficient frontier • Dominate portfolio • Inefficient frontier

  11. What Is The Implication Of Diversification For Portfolio Management? • Not All Diversification Strategies are Desirable • Some Strategies are Inefficient • No Investor Would Select Portfolios From the Segment Below Point MVP see next slide

  12. E(R) • Efficient Frontier MVP Inefficient Frontier Standard Deviation

  13. Two Assets With Different Correlations • The Higher the Correlation, the Smaller the Gain From Diversification • As Correlation Declines, Risk Reduction Increases • Implies larger risk reduction because of diversification

  14. Complicated Portfolio Choices • More Than Two Assets to Choose From • Assets do not Have the Same Mean or Variance • Nonzero correlations prevail • Must Find the Mean-Variance Frontier • Identify the Efficient and Inefficient Sets

  15. Unrelated Industries • Significant Risk Reduction • Achieved by diversifying across different industries • Stocks From Same Industry • Highly positively correlated • Stocks From Different Industries • Negative correlation

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