Portfolio diversification and the relationship to risk return

portfolio diversification and the relationship to risk return

Also effort has been made to find out the extent of correlation between portfolio return and risk i.e. the relationship between portfolio's beta. You get to know the impact on portfolio risk and returns due to correlated assets. It's the cheapest way to reduce the firm-related portfolio risk. The risk-return tradeoff could easily be called the iron stomach test. The Risk- Reward Tradeoff; Risk and Diversification: Diversifying Your Portfolio · Risk and.

Risk is defined in different ways: It defines risk as measurable uncertainty. The other approach created correlates risks to the financial aspects; here, risk is defined as the volatility of expected results on the value of assets and liabilities of interest.

Portfolio risk can be described as the variance of portfolio that refers to the possibility of loss or the percentage in which investor tolerates to compensate for their higher return.

In the purpose of diversification, the risk of portfolio is significantly taken into consideration. Additionally, it is the only factor used currently to explain the superior benefit of portfolio compared to individual stock [ 2 ].

Investment portfolio is a set of financial or physical assets, which belongs to an investor. The main aim of setting or building portfolio is reducing risk through covering the risk of an instrument or an asset by returns of another. Portfolio theory was advanced by Harry Markowitz in He defines portfolio is a collection of securities.

As most securities are available, investments have uncertain returns and thus risky, one needs to establish which portfolio to own. Markowitz asserts investors should base their portfolio decisions solely on expected returns and standard deviations.

Investors should estimate the expected return and standard deviation of each portfolio and then choose the best one on the basis of these two parameters.

portfolio diversification and the relationship to risk return

Expected return can be viewed as a measure of potential reward associated with any portfolio over the holding period and standard deviation can be viewed as a measure of the risk associated with the portfolio [ 3 ]. Since an infinite number of portfolios can be constructed from a set of securities, the problem is to determine the most desirable portfolio.

The Efficient Set Theorem states that an investor will choose his or her optimal portfolio from the set of portfolios that; i Offer maximum expected return for varying degrees of risk; and ii Offer minimum risk for varying levels of expected return.

The set of portfolios meeting these two conditions is known as the efficient set also known as efficient frontier. The process will first involve identification of the feasible set which represents all portfolios that can be formed from a given number of securities.

The investor will then select an optimal portfolio by plotting his or her indifference curve on the same figure as the efficient set and then proceed to choose the portfolio that is on the indifference curve that is farthest northwest. This portfolio will correspond to the point at which an indifference curve is just tangent to the efficient set. Diversification is defined as a technique that reduces risk by allocating investments among a multitude of asset types.

When you diversify, you try to ensure that at any given time, the value of some of your holdings might be down, and some might be up, but overall you are doing fine. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

Conducted a study entitled the impact of stock diversity for reducing investments risks. It aimed to identify the different types of stocks, and the role of Khartoum market in conveying information o investors to make the right decision, and to identify the risks that exposed to the financial investment, in order to reach the role of stock diversity in reducing risks. And the researcher has concluded that there is negative relation between diversification and risks.

Examined naive equal weight diversification is efficient. However, an addition of 80 stocks i. This result depends neither on the investment horizons, sampling periods nor the markets involved.

portfolio diversification and the relationship to risk return

But the number of stocks required in portfolio in order to eliminate the same percentage of diversifiable risk differs according to the size of population.

A closer look at risk reveals that some are uncontrollable systematic risk and some are controllable unsystematic risk.

portfolio diversification and the relationship to risk return

Risk can be categorized into two types: The risk that cannot be diversified away like interest rate risk and recession is known as systematic risk.

Unsystematic risk is stock specific and can be diversified away. Scarcities in raw material supply, labour strike, and management inefficiency are all problems specific to a company and are internal in nature.

Effect of Diversification on Portfolio Risk Management at Rwanda Social Security Board

These negative factors can make the share price fall sharply but can be avoided if well thought. An investment in the shares of certain other companies with sound management can help minimize this risk. Therefore diversification is the mantra for any prudent investor. Diversification is done in many ways. These may beat the benchmark during bullish phases. But during bear runs, they would erode the portfolio returns uncontrollably. A small capital base prevents these from absorbing massive shocks.

  • Role of Correlation in Portfolio Diversification

Conversely, a portfolio which is overweight on large caps is also terrible. Investing in a geographical region like Emerging Markets means diversification.

portfolio diversification and the relationship to risk return

Geographically concentrating your investments is a risky proposition. Investing in companies of different market capitalization results in diversification. Here also, your investments are concentrated in only single asset class i.

Diversification involves investments across different asset classes. Investing in 10 to 20 different types of mutual funds is diversification. It aids in smooth tracking and management.

portfolio diversification and the relationship to risk return

It also prevents overlapping of portfolio holdings. Investing in different asset classes leads to diversification.

Effect of Diversification on Portfolio Risk Management at Rwanda Social Security Board

Although you have invested in different asset classes, your portfolio is still not diversified. Get your financial plan done by a Registered Investment Advisor. Correlation and Portfolio Diversification: The interconnection Correlation relates to movement of two or more asset returns in particular direction.

It indicates the relationship between various asset classes in a portfolio. Two asset classes can be positively or negatively related. They can also be unrelated i. It means that when one asset price goes up, the other asset price goes down. It means that both the asset prices move in the same direction.

Portfolio Diversification No.2 - Over-diversification?

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