3.3 Diversification Flashcards
Diversification diagrammatically

What are the benefits of diversification?
- “Don’t put all your eggs in one basket”
- By holding many stocks - risk is diversified, idiosyncratic or specific risk
- Factory burns down
- Competitor builds better product
What is a limit of diversification?
There exist risks that cannot be diversified known as systematic or market risk.
- Economy slows - financial crash perhaps????
Two components of risks in individual asset returns
- Systematic risks - common to most assets
- Non-systematic, idiosyncratic risks - specific to individual assets
How is the approach to systematic and non-systematic risks different?
- Non-systematic risks are diversifiable.
- Systematic risks are not.
Define portfolio
A portfolio is a collection of assets, characterised by the mean, variance/covariances of their returns.
Notation for portfolios

Consider investing into swimwear or investing into umbrellas where:
What is the expected return on stock 1?


Consider investing into swimwear or investing into umbrellas where:
What is the expected return on stock 2?


Consider investing into swimwear or investing into umbrellas where:
What is the expected return of the equally weighted portfolio in the case of sun


Consider investing into swimwear or investing into umbrellas where:
Expected return of the equally weighted portfolio in the case of rain


Consider investing into swimwear or investing into umbrellas where:
Portfolio return of the equally weighted portfolio


Consider investing into swimwear or investing into umbrellas where:
StD of stock 1


Consider investing into swimwear or investing into umbrellas where:
StD of stock 2


Consider investing into swimwear or investing into umbrellas where:
Covariance between stock 1 and 2


Consider investing into swimwear or investing into umbrellas where:
[covariance is -1.44%]
Correlation coefficient between stock 1 and 2


Consider investing into swimwear or investing into umbrellas where:
Weighted average risk of the equally weighted portfolio


Consider investing into swimwear or investing into umbrellas where:
[covariance = -1.44%]
Portfolio risk of the equally weighted portfolio


Equation for the expected and unexpected return on a portfolio with two assets

Equation for the variance of return on a portfolio with two assets

How is the variance of the return for a portfolio with two assets derived?

Equation for the variance of return on a portfolio with three assets.
Derivation?

Portfolios of multiple assets
What is:
- The return on the portfolio?
- The expected return on the portfolio?
- The variance of the portfolio?
- The volatility of portfolio return?
