Relationship between Diversification and Correlation

All right, now that brings you straight into the age of diversification. We cannot really separate diversification from co-relation. At the heart of diversification is the co-relation. You cannot again think about the risk of a portfolio, without thinking the impact of correlation, and that is the relationship between the behavior of the assets in the portfolio. Now, one or a couple of important things about diversification. Number one, this is one of the bedrocks of finance, investment and corporate finance. Let’s make it very broad. It’s one of the bedrocks of finance. diversification, the fact that a smart investor should have a diversified portfolio, is at the very core, at the very heart of just about everything that we do, in finance. When we talk in sessions three and four about the CAPM, and the way we assess risk about, in that, capital asset pricing model, were going to go back to the fact that remember, beta is a measure of risk after everything has been diversified away. Is the measure of the risk that we cannot really, Escape from that we cannot really diversify, again from. So that means that when we think about the expected require return of an asset that is a function of the race that we cannot diversify away. And the implication of that is that any investor or any model in finance is going to assume that a smart investor is properly diversified. And that’s why, at the very beginning of all the financial theory, you have an investor that has a portfolio that is properly diversified and that a lot of that risk has gone actually away. The only risk that he bears is the risk that he cannot diversify away. The second thing that is important in terms of diversification. Most people, if you ask people, you know, even if they don’t know a whole lot of finance, why would you diversify a portfolio, they would think in terms of protection or risk reduction, and there’s absolutely nothing wrong with that. But we’re going to look at different ways of thinking about why you may want to diversify. Protecting yourself from large fluctuations in your portfolio is a typical one. Not putting all your money in an asset, when that asset actually may disappear, you know, like a company that goes bankrupt, or a bond that actually goes into default, well you know, those, those are obvious reasons for diversifying. So it’s getting away from very large potential losses and it’s also about the diminishing, decreasing volatility or variability of that portfolio. That’s the typical way that most people would justify. Diversifying the portfolio, we’re going to be a little bit more sophisticated than that. Because, there’s a better reason for diversifying, and we’re going to see that the result of diversity, diversifying goes to the heart of why investors actually invest. And how investors invest in different assets. So, the remainder of this section we’re going to spend on three points about diversification. And those three points are point number one. Let us think for a minute about reducing risk, and remember and here is very important that you remember. That positive relationship we talked about before between risk and return. The more risk that you’re ready to bear, the higher is the expected and return on the assets which you invest. All right? Now it’s important that you keep that in mind, because if we say. Look, as an investor I want to minimize risk. Well, you know, that sounds, it sounds okay, but once you think about the implications of minimizing risk then it doesn’t sound so okay. Because I can always know where the risk of my portfolio, but the cost of that is that I’m also lowering the expected return of my portfolio. In the limit, I could put my money safely in the bank and know exactly what I’m going to get at the end of any given period. But of course, a return that I’m going to get is going to be very, very small. But, if I’m willing to bear more risk. If instead of putting my money in the bank, I, I’m willing to put it in the bond. Or even I’m willing to put it in a share of a stock. Then, the more risk I’m ready to bear, then the higher is going to be that expected return. So, now, once you think about it in those terms, minimizing risk it also implies minimizing your expected return. And then it doesn’t sound so good. That’s why most people if you really ask them, is the goal of your portfolio to have the minimum possible risk? Once they realize the implications they would say no, no, no it sounds good but, you know, in principle, but now that I realize that then I would have to expect the lowest possible return, then minimize risk is not a very good idea. So I’m going to say and I hope that I convince you, that most investors and I am saying most because there can always be exceptions, but most investors do not really want to minimize risk. Second thing and this sounds shall even a little bit better, which is well, you know most investors want to get their returns as high as possible. But again, here’s when you have to remember that positive relationship between risk and return. If you want to maximize the expected return of the portfolio, that means that you’re going to have to expose your portfolio to a very large amount of risk. And exposing your portfolio to a very large amount of risk might mean that over time you can make a lot of money or you might lose a lot of money. That’s why we call it the risk. Nothing is guaranteed. So a lot of risks might expose you to very large gain or to very large losses. Of course, the longer you remain invested, then the more likely is that risk is going to translate into the return. But at the end of the day, once you think, and once you realize that maximizing expected return or maximizing return goes with maximizing risk, then, as in the first case, it doesn’t sound nearly as good. So if I try to minimize risk, my expected return is going to be very low. If I try to maximize return, my expected risk is going to be very high, and neither of these two things sounds very appealing to investors. What is very appealing to investors, is to actually get the best possible combination of risk and return. That is, to get one, one of the many ways to think about this is, to get the highest possible return for a given level of risk. And that is what we call in finance, risk-adjusted return. Taking into account, the return of the assets in which I invest, and the risk of the assets in which I invest by putting them together in a measure of risk-adjusted return. Now we are going to see one quick and dirty way, oh, of assessing those risk-adjusted returns that are much more fancy and technical ways in finance but for the purposes that we have in this course, our quick and dirty combination of risk and return is going to be good enough. But what I want to highlight. And the first point to highlight is that investors do not really want to minimize return. Investors do not really want to maximize risk. What investors want to do, is to maximize to get the best possible combination of return and risk. And that is what we technically call in finance maximizing risk adjust and returns. And guess what, that is exactly what you can achieve by diversification. You can never maximize the risk-adjust return of the portfolio if you don’t diversify the portfolio. The portfolio that maximizes the risk-adjusted return is going to be a diversified portfolio.

Relationship between Diversification and CorrelationAdminCapital Budgeting TechniquesRelationship between Diversification and Correlation All right, now that brings you straight into the age of diversification. We cannot really separate diversification from co-relation. At the heart of diversification is the co-relation. You cannot again think about the risk of a portfolio, without thinking the impact of correlation, and that is the relationship between the behavior...Investment analysis basics