benefits of diversification don't put all your eggs in one basket is a common expression.
In investing terms, it means not risking everything by putting all of your investment assets into any one specific company or security. The goal of diversification is not necessarily to boost performance. It won't ensure gains or guarantee against losses. However, diversification does have the potential to improve returns for the level of risk, you choose to Target in other words improving portfolio efficiency.
diversification can be achieved on many levels Securities sectors asset classes countries portfolio characteristics and even exposure to different types of risk factors can be Diversified the covariance in correlations are the key for diversification. Let's look at an example a major reason that portfolios can effectively reduce risk. Is that combining security whose returns to not move together provides diversification sometimes a subset of assets will go up in value at the same time that another will go down in value the fact that these May offset each other creates the potential diversification benefit. We attribute to portfolios.
Recall that combining Securities whose returns are less than perfectly correlated reduces the standard deviation of the Diversified portfolio below the weighted average of the standard deviations of the individual Investments.
So while we can use a simple weighted average of the expected returns of Assets in the portfolio, when we evaluate risk, we need to measure not just the standard deviation of individual assets, but also their correlation.
The expected return formula is a simple weighted average in this example. We can see the expected return multiplied by the waiting for the asset a added to the same for asset b equals 11.6% the portfolio risk formula calculates the weighted standard deviation, but also considers how the two assets move together their correlation.
It is an imposing formula. So let's take a more detailed. Look at the calculations.
The first two parts of the formula are taking the weighted average standard deviation. The third part of the formula is calculating the correlation of the two assets using our examples figures. We reach a risk of 14.98% Now, let's see how that compares to investing in the assets individually.
Instead of investing 100% asset a the investor combined it with investing in asset B, which is a riskier asset given its higher standard deviation. Therefore the return increases versus 100% in asset a and the risk decreases the combination of the two assets results in a superior risk return trade-off in this example, the investor gets the weighted average return of the assets, but critically they get that return for a lower overall risk than the two assets individually. This is the power of diversification.
The example above illustrates the returns and standard deviations of two assets Home Depot's common stock and Microsoft's common stock individually Home Depot has a standard deviation of 5.6 and Microsoft has 6.0. However combined together in a 50/50 portfolio the standard deviation drops to 5.4 lower than both assets individually using the capital asset pricing model. Home Depot is return is 7.4 percent while Microsoft is 7.85% combined with a 50/50 portfolio. The return is a simple way to average of 7.63 percent therefore by combining these two assets. We are getting the same return but for a lower risk looking back at the ways to achieve diversification these stocks operate in different sectors and operational geographies consumer discretionary for Home Depot versus technology from Microsoft.
North America for Home Depot versus global for Microsoft however, both being large cap us-based stocks. They still have a relatively High positive correlation of 0.75 while the combination is helped to reduce risk. The benefit is in this great compared to a different stock with a lower correlation.
Remember, there are two types of risk systematic and unsystematic, unsystematic risk can be minimized through diversification. Whereas a level of systematic or Market risk will always remain events such as a recession can't be predicted easily and assets risk should be measured in relation to the remaining systematic risk, which should be the only risk that affects the assets price and expected return since investors can minimize on systematic risk by properly diversifying portfolios.
They are not compensated for bearing it as the chart suggests. The incremental benefits derived from diversification begin to decline as more Securities are added.
