Thursday, January 22, 2009

How does Diversification help us ?

Diversification help us when ?
1) Combining two securities with positive correlation with each other provides no reduction in portfolio risk. as more securities are added the risk remain weighted average. There is no risk reduction.
2)Combining two securities with zero correlation
(each is independent of other)with each other reduces the risk of the portfolio. If more securities are added the uncorrelated returns are added to the portfolio and significant risk reduction can be achieved.
3) Combining two securities with negative correlation with each other could eliminate risk altogether. This is the principle used in hedging strategies.

4) In real world this extreme cases are rare, most of the securities typically have positive correlation with each other. So risk can be reduced but it cannot be eliminated. Other things being equal investor should find securities with least positive correlation possible. Ideally they should look for negative of low positive correlation.

Three factors determine the risk of portfolio.
1) The variance of each security.
2) The Co-variance between securities.
3) The portfolio weights for each security.

Every investor should try for an efficient portfolio defined by Markowitz's as the one that has smallest portfolio risk for given level of expected return or the largest expected return for the given level of risk.

Rupee cost averaging
The systematic investment plans in mutual funds, along with consistent periodic new purchases of shares, creates risk reduction by creating lower cost per share owned over time. This is known as rupee cost averaging.

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