>> Diversification is the process of reducing risk
by allocating investment dollars among various financial instruments.
A portfolio is a collection of various financial instruments.
There are two types of risk that can affect the portfolios.
The first is Systemic Risk or sometimes called Market Risk.
This risk affects all firms in the market.
Examples include; economic recession, inflation,
changes in tax rates or interest rates,
or trade wars and actual wars.
The other is Unsystematic Risk or sometimes called Business Specific Risk.
This risk affects only a specific company.
Examples include; labor strikes,
CEO changes, various regulations, etc.
Only unsystematic risk can be reduced or eliminated through effective diversification.
The graph shows how unsystematic risk is reduced by adding stocks to a portfolio.
The gold section is
systemic risk which cannot be eliminated by adding stocks to the portfolio.
This is why the risk amount remains the same as
we add stocks and move left to right across the graft.
The blue section is the unsystematic risk.
Notice how that is reduced as stocks are added to the portfolio as we move left to right.
The degree to which diversification works in
a portfolio depends on how correlated the investments are.
If stocks are perfectly positively correlated,
then adding them to our portfolio has no effect on risk.
If for example, Walmart, Target,
and Amazon were all perfectly positively correlated,
they would all move up and down in the market the exact same
way when impacted by similar market events.
So firms in the same industries are often positively correlated.
Diversification occurs when stocks are negatively correlated.
As one goes up, another goes down.
So we should pick securities and assets that have
negative or low positive correlation to realize diversification benefits.
This is how unsystematic risk can be reduced.
Beta is an important concept.
It is a measure of a company's systemic risk or market risk.
Beta is calculated by comparing the historical returns of
a stock with the historical returns of the market as a whole.
Then a regression line is added to determine the line of best fit.
This is called the characteristic line and the slope of this line is Beta.
Beta is the risk that remains for a company even after we have diversified our portfolio.
A stock with a Beta of zero has no systemic risk.
A stock with a Beta of one has
systemic risk equal to the typical stock in the marketplace.
A stock with a Beta exceeding one has systemic risk greater than a typical stock.
Most stocks have Betas between 0.6 and 1.60.
Portfolio Beta indicates the percentage change on
average of the portfolio for every one percent change in the general market.
It is calculated by multiplying the stock weight in a portfolio by it's Beta.
This is done for all stocks in the portfolio.
The total becomes the portfolio's Beta.
Let's do an example.
We have four stocks in a portfolio.
The stock weight in the portfolio and it's Beta are shown on the slide.
We multiply the stock weight by the Beta to get a factor.
After doing this for all four stocks,
we total the factors to get a portfolio Beta of 1.35.
So where for every one percent change in the market,
our portfolio will change 1.35 percent.
Let's summarize diversification.
Through effective diversification,
we can lower risk without sacrificing expected returns,
and we can increase expected returns without having to assume more risk.
Of course, we do this through asset allocation
which refers to diversifying the types of assets in a portfolio.
Asset allocation is considered the most important decision
investors make while managing a portfolio.