Diversification
Diversification is the process of reducing the overall risk of the portfolio by
investing in several securities (typically across different asset classes)
instead of investing in a single security.
Benefits of diversification
The main benefit over diversification is the reduction of risk (volatility of
returns).As we discussed in the previous article; risk is the volatility of
returns. Every fund manager would like to have the highest possible return with
the lowest possible risk.
Example of the benefits of
diversification
Suppose there exist two companies, IcecreamLand and BlanketWorld which
manufacture and sell ice-creams and blankets respectively. On hot days,
IcecreamLand has high sales and makes a profit of $1 per share while
BlanketWorld has low sales and no profits. On cold days, BlanketWorld has high
sales and makes a profit of $1 per share while IcecreamLand has very low sales
and no profit.
An investor with $2000 to invest could choose to invest in IcecreamLand and/or
BlanketWorld. Suppose Mark Alphonso invests $2000 and buys 2 shares of
IcecreamLand, George Santino invests $2000 and buys 2 shares of BlanketWorld and
Bill Yang too invests $2000 and buys 1 share of IcecreamLand and 1 share of
BlanketWorld.
Their returns would be as follows:
|
Summer(180 days)
|
|
|
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IceCreamLand
|
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$180 per share
|
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BlanketWorld
|
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$0
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|
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|
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|
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MarkAlphonso
|
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$360
|
|
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George Santino
|
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$0
|
|
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Bill Yang
|
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$180
|
|
|
|
|
|
|
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Winter(180 days)
|
|
|
|
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IceCreamLand
|
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$0
|
|
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BlanketWorld
|
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$180 per share
|
|
|
|
|
|
|
MarkAlphonso
|
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$0
|
|
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George Santino
|
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$360
|
|
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Bill Yang
|
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$180
|
|
|
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Total(360 days)
|
|
|
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IceCreamLand
|
|
$180 per share
|
|
BlanketWorld
|
|
$180 per share
|
|
|
|
|
|
|
MarkAlphonso
|
|
$360
|
|
|
George Santino
|
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$360
|
|
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Bill Yang
|
|
$360
|
|
Note that all three investors earn the same return i.e. $360 over the entire
year, an impressive 18% p.a. However, the important point to note here is that
the variance in the total income is different for different investors. Mark
Alphonso and George Santino experience huge volatility in their incomes, a
semi-annual standard deviation of $255 as opposed to Bill Yang whose semi-annual
standard deviation is 0. All three investors got the same return (18%p.a) but
Bill Yang’s portfolio was far less volatile and thus far less risky. Thus,
Bill’s diversified portfolio outperformed the other two portfolios as it
achieved the same return as the other two portfolios despite being much less
risky.
The lesson to be taken away from here is that diversification reduces the
overall risk of the portfolio. The larger the number of securities, the lower
the variance and thus, the lower the risk of the portfolio (assuming a
correlation of less than 1 between the stocks).
The importance of correlation
Correlation is a statistical measure that characterizes the linear relationship
between two variables. The correlation coefficient measures the strength and
nature of that relationship. From a qualitative perspective, the returns of two
stocks are positively correlated if the return of one stock increases as the
other increases; and are negatively correlated if one increases as the other
decreases.
Illustration
Series A: 1, 3, 4,5,6,8
Series B: 3, 4, 6, 8, 6, 9
Series C: -5,-, 3, 1-, 7-, 12,-14
Series A and Series B are highly correlated (correlation coefficient of 0.9)
while Series A and Series C are negatively correlated (correlation coefficient
of -0.7).
We will cover the quantitative aspects of correlation in a different article.
For now it will suffice to understand that the overall volatility (risk) of the
portfolio decreases as the correlation between the different in the portfolio
decreases.
Next: Taxation Issues