Diversification in Stock Portfolios Table of Contents Problem 20 A risk-averse investor is one who, when given a choice of two investment options with similar expected return, would have a preference for the option which has comparative lower risk. In this case, a risk-averse investor is given two completely different economies as options and has a choice of investing in either of the two economies. The two economies have identical expected return and similar volatility of all the stocks. But in the first economy, each and every one stock move in the same trend, i.e.
in good times the price of every stock rises simultaneously and in bad times the price of every stock descend together. On the contrary, in the second economy the price of one stock has no effect on the price of the other and hence the stock returns are independent. Diversification in stock portfolios represents reduction of risk by investing in a variety of stocks. It is a common approach based on the old saying that ‘one should not put all his eggs in a single basket’.
An investor who diversifies her assets among numerous investments or stocks can lessen the instability of her portfolio, proviso the stocks are imperfectly correlated (Campbell, 2000). Correlation is an evaluation of how two stocks move in comparison to each other, they are said to be correlated if both of them move in a similar trend. If all the stocks in a particular portfolio shift in a similar direction i. e. when markets are favorable all the stocks show an upward movement and when markets are not favorable all of them show a downward slide; then such a portfolio cannot be considered to be properly diversified.
Thus, the mere investment in various stocks does not diversify one’s portfolio; one has to also consider the correlation between the stocks where one’s asset has been invested. An association between two stocks can be positively correlated, negatively correlated or non-correlated. In some instances, these positive correlations are easily visible, for example in the cases of gasoline and crude oil or silver and gold (Tanous, 2008, p. 48). In such cases, as one market moves, the other has a tendency to move in the same trend. Therefore, diversification would not be accomplished by buying both gold and silver, or gasoline and crude oil.
Negatively correlated stocks tend to progress in entirely opposite track, when one moves up, the other moves down. While negative correlations do offer diversification opportunities, they might not be the best strategy to employ as they tend to neutralize the returns achieved. When looking for diversification prospects, it is significant to focus on stocks that are non-correlated to one another. Such stocks are independent of each other and it is best to hold the stocks that will profit independently (Patel, 2004). The returns on two or more completely correlated stocks would shift toward positive and negative direction together and a portfolio of such stocks would be precisely as risky as the individual specific stocks (Besley &Et.
Al, 2007, p. 320). Thus, investing in the first economy, where the stocks in the portfolio are inclined to shift in the same way, is not advisable. Investing in stocks that have no correlation to one another can help to reduce risk without compromising on the returns (Patel, 2004, p.
78). Thus, it is advisable to invest in stocks in the second economy. References Besley, S. & Et. Al. (2007). Essentials of managerial finance. Cengage Learning. Campbell. J.Y. (2000). Diversification: A Bigger Free Lunch. Harvard University. Retrieved Online on August 03, 2011 from http: //kuznets. fas. harvard. edu/~campbell/papers/diversification. pdf Patel, A. B., (2004). Alpesh B. Patel on Stock Futures: Strategies for Profiting from Stock Futures. Harriman House Limited. Tanous, P., (2008). Kiplingers Build a Winning Portfolio: Investment Strategies for Reaching Your Financial Goals. Kaplan Publishing