3.3 Diversification

Question 1

Diversification diagrammatically

Answer 1

Question 2

What are the benefits of diversification?

Answer 2

• “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

Question 3

What is a limit of diversification?

Answer 3

There exist risks that cannot be diversified known as systematic or market risk.

• Economy slows - financial crash perhaps????

Question 4

Two components of risks in individual asset returns

Answer 4

• Systematic risks - common to most assets
• Non-systematic, idiosyncratic risks - specific to individual assets

Question 5

How is the approach to systematic and non-systematic risks different?

Answer 5

• Non-systematic risks are diversifiable.
• Systematic risks are not.

Question 6

Define portfolio

Answer 6

A portfolio is a collection of assets, characterised by the mean, variance/covariances of their returns.

Question 7

Notation for portfolios

Answer 7

Question 8

Consider investing into swimwear or investing into umbrellas where:

What is the expected return on stock 1?

Answer 8

Question 9

Consider investing into swimwear or investing into umbrellas where:

What is the expected return on stock 2?

Answer 9

Question 10

Consider investing into swimwear or investing into umbrellas where:

What is the expected return of the equally weighted portfolio in the case of sun

Answer 10

Question 11

Consider investing into swimwear or investing into umbrellas where:

Expected return of the equally weighted portfolio in the case of rain

Answer 11

Question 12

Consider investing into swimwear or investing into umbrellas where:

Portfolio return of the equally weighted portfolio

Answer 12

Question 13

Consider investing into swimwear or investing into umbrellas where:

StD of stock 1

Answer 13

Question 14

Consider investing into swimwear or investing into umbrellas where:

StD of stock 2

Answer 14

Question 15

Consider investing into swimwear or investing into umbrellas where:

Covariance between stock 1 and 2

Answer 15

Question 16

Consider investing into swimwear or investing into umbrellas where:

[covariance is -1.44%]

Correlation coefficient between stock 1 and 2

Answer 16

Question 17

Consider investing into swimwear or investing into umbrellas where:

Weighted average risk of the equally weighted portfolio

Answer 17

Question 18

Consider investing into swimwear or investing into umbrellas where:

[covariance = -1.44%]

Portfolio risk of the equally weighted portfolio

Answer 18

Question 19

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

Answer 19

Question 20

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

Answer 20

Question 21

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

Answer 21

Question 22

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

Derivation?

Answer 22

Question 23

Portfolios of multiple assets

What is:

1. The return on the portfolio?
2. The expected return on the portfolio?
3. The variance of the portfolio?
4. The volatility of portfolio return?

Answer 23