Diversification

Question 1

Systematic and unsystematic risk

Answer 1

-Unsystematic risk refers to diversifiable risk and refers to industry/market specific risk affecting a small number of assets. Eg) Union Action, specific supply change shortages.

-Systematic risk refers to overall market risk that affects all assets within a market. Eg) inflation, GDP etc.

-Unsystematic risk can be eliminate by increasing number of assets, systematic cant. Always be risk associated with holdin an asset.

Question 2

Portfolio variance formula

Answer 2

on flashcard

Question 3

Diversification and correlation of assets assets

Answer 3

-The variance of a portfolio is a function of the variance of the each individual asset plus the covariance/correlation between between them.

-Diversification through negatively correlated assets is a good strategy to reduce risk in a portfolio eg) If one asset performs poorly, the other asset’s positive performance can offset the loss, stabilising the portfolio’s overall returns.

-In order to achieve benefits of diversification, examples/formula shows investing in assets with low/negative correlation is beneficial.

Question 4

Problems with diversification

Answer 4

-Measurement issue: literature shows its emprically difficult to measure diversification. Example measurement survets dont contains individual asset level, households speciifcally rich dont like discolosing info.

-Many studies adopt different methods of measuring diversification, focusining on different parts of portgolio. As diversifaction evolves over time, market constantly changing, measuring it at one point may not caputre housegolds investment decisions.

-Financial literact significantly important for diversification however most households low literacy.

Question 5

Benefits of diversification

Answer 5

-Risk reduction reducing unsysteamtic), reducing portfolio volitity (negatively correlated asset holding)

-Access to foregin growth markets and differnt asset classes

-Diversified asset class can act as hedge against inflation
-Reduced anxiety

-Potential for higher average returns Diversifying across asset classes can capture a broader range of opportunities and enhance overall returns.

Question 6

Determinants of diversification

Answer 6

-Similar factors to stock holding
-Risk tolerance
◦ Education/Financial Literacy
◦ Demographic characteristics – e.g. age and gender
◦ Income and Wealth