4/18/2024

Portfolio Management
Diversification

Objectives

• What is the relationship between diversification and portfolio

risk?
• What is the effect of correlation on portfolio risk?
• What happens to portfolio risk as the number of securities in
portfolio increase?

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Diversification
Diversification and Portfolio Risk

Diversification and Portfolio Risk

• In the real-world, investors own many assets at any given point in

time. Therefore, the risk of any single investment should not be
viewed independently of other assets held by investors.

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Diversification and Portfolio Risk

• New investments must be considered in the light of their impact

on the risk of an investor’s existing portfolio. Therefore, one needs
to ask: What happens to risk of investor’s portfolio, when he
purchases an additional asset?

Diversification and Portfolio Risk

• In order to answer this question, suppose that there are two stocks
(auto and gold) available in the economy and there are three
equally likely outcomes of the economy.
States of the Probability of Each Return on Auto Return on Gold
Economy State Stock Stock
Recession 0.33 – 8% +20%

Normal 0.33 +5% +3%

Boom 0.33 +18% -20%

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Diversification and Portfolio Risk

• Let us start by computing the expected return and standard

deviation of both stocks.

Diversification and Portfolio Risk

• Expected return and standard deviation of auto stock is as follows:

State Return Expected Return Standard Deviation

Recession -8%
√0.33*(-8%-5%)2 + 0.33*(5%-
0.33*(-8%) + 0.33*5% +
Normal +5% 5%)2 + 0.33*(18%-5%)2 =
0.33*18% = 5%
√112.7 = 10.60%
Boom +18%

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Diversification and Portfolio Risk

• Expected return and standard deviation of gold stock is as follows:

State Return Expected Return Standard Deviation
Recession +20%
√0.33*(20%-1%)2 + 0.33*(3%-
0.33*20% + 0.33*3% +
Normal +3% 1%)2 + 0.33*(-20%-1%)2 =
0.33*(-20%) = 1%
√268.7 = 16.40%
Boom -20%

Diversification and Portfolio Risk

• What do our results suggest?

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Diversification and Portfolio Risk

• Our results show that the gold stock offers lower return with
higher standard deviation than the auto stock.
• As a result, one can argue that no investor should be interested in
buying the gold stock.
• Everyone should invest in the auto stock with an expectation of
higher return and lower standard deviation than the gold stock.

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Diversification and Portfolio Risk

• However, some investors do invest in the gold stock.

• WHY?

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Diversification and Portfolio Risk

• For the sake of an argument, let us assume that those investors

that include the gold stock in their portfolio decide to put most of
their money (75%) in the auto stock and some of their money
(25%) in the gold stock.

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Diversification and Portfolio Risk

Divergence…

• Return of a portfolio (rp) is a weighted average of the returns of

the individual assets from which it is formed.

• In the above expression, rj is the return of asset j and wj is the

fraction of wealth invested in asset j.

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Diversification and Portfolio Risk

• Portfolio return in the three states is as follows:

• Portfolio return in recession = [0.75*(-8%)] + [0.25*(20%)]
= -1%
• Portfolio return in normal period = [0.75*(5%)] + [0.25*(3%)]
= 4.5%
• Portfolio return in boom = [0.75*(18%)] + [0.25*(-20%)]
= 8.5%

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Diversification and Portfolio Risk

• The expected return of portfolio can be computed as follows:

• E(r) = 0.33*(-1%) + 0.33*(4.5%) + 0.33*(8.5%) = 4%
• The standard deviation of the portfolio is computed as follows:
0.33 *  1%  4%  0.33 * 4.5%  4% 
2 2

σ
 0.33 * 8.5%  4% 
2

σ  15.2%  3.9%

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Diversification and Portfolio Risk

• Surprising finding of this analysis is that when you shift money

from auto stock to a more volatile gold stock, your portfolio
variability actually decreases. This variability is considerably less
than either gold or auto stock – major benefit of diversification.

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Diversification and Portfolio Risk

• Our previous example has shown that a little diversification can

offer substantial reduction in risk. Does it mean that we can
reduce all of the risk via diversification?

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Diversification and Portfolio Risk

• Practically, the answer is: No

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Diversification and Portfolio Risk

• Next figure shows that as we increase the number of securities in

our portfolio, standard deviation of portfolio can decrease
substantially.

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Diversification and Portfolio Risk

• The figure shows that most of reduction in standard deviation is

observed when we diversify our portfolio by a few stocks.
• The figure also illustrates that no matter how many securities we
add in our portfolio, we cannot diversify all of the risk.

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Diversification and Portfolio Risk

• Next table
reproduces the
empirical findings
that relate
portfolio risk with
number of
securities in a
portfolio.

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Diversification and Portfolio Risk

• The risk that cannot be avoided regardless of how much we

diversify is called market risk (also called as nondiversifiable
risk or systematic risk).
• The risk that can be eliminated by diversification is called unique
risk (also called as diversifiable risk or unsystematic risk).

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Diversification and Portfolio Risk

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Diversification and Portfolio Risk

Example 1

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Diversification and Portfolio Risk

Example 1

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Diversification
Effect of Correlation on Portfolio Risk

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Correlation and Portfolio Risk

• Previous discussion shows that reduction in the risk of a portfolio

is a function of the number of assets included in the portfolio.

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Correlation and Portfolio Risk

• Will portfolio risk always go down as the number of risky

assets in a portfolio increase?

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Correlation and Portfolio Risk

• The answer to this question depends on the correlation between

constituents of portfolio. If constituents of portfolio have less
than perfect positive correlation, the portfolio risk will
decrease with increase in the number of risky assets.

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Correlation and Portfolio Risk

Divergence…

• The correlation can be measured by the correlation coefficient (ρ).

It can be interpreted as follows:
• ρ = +1 means that there is an exact positive relationship between the two
securities. Both move in the same direction.
• ρ = 0 means that there is no relationship between the two variables. Both
move randomly.
• ρ = -1 means that there is an exact negative relationship between the two
securities. Both move in opposite direction.

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Correlation and Portfolio Risk

• In order to understand the effect of correlation on portfolio risk,

consider a portfolio consisting of two risky assets (D and E).

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Correlation and Portfolio Risk

• Both risky assets (D and E) have the following characteristics:

• Expected Return of E = E(rE)
• Expected Return of D = E(rD)
• Standard Deviation of E(rE) = σE
• Standard Deviation of E(rD) = σD
• Correlation Coefficient = ρDE

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Correlation and Portfolio Risk

• If wD is invested in D, and the remainder (1 – wD) [also denoted as

wE] is invested in E, the variance of this two-asset portfolio [(σp)2]
will be expressed as follows:
• (σp)2= (wDσD)2 + (wEσE)2 + 2wDwE ρDEσDσE
• Above equation indicates that the variance of portfolio is not a
weighted average of variances of individual assets.
• It also shows that portfolio variance is higher if ρDE is higher.

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Correlation and Portfolio Risk

• In case of perfect positive correlation (ρDE = +1), variance of a

portfolio is expressed as follows:
• (σp)2 = (wDσD)2 + (wEσE)2 + 2wDwEσDσE
= (wDσD + wEσE)2
• Therefore, in case of perfect positive correlation, standard
deviation is the weighted average of component standard
deviations.
• σp= wDσD + wEσE

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Correlation and Portfolio Risk

• In case of perfect negative correlation (ρDE = -1), variance of a

portfolio is expressed as follows:
• (σp)2 = (wDσD)2 + (wEσE)2 - 2wDwEσDσE
= (wDσD - wEσE)2
• In this case, standard deviation is less than the weighted average
of component standard deviations:
• σp= wDσD - wEσE

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Correlation and Portfolio Risk

Divergence…

• Covariance is a closely related concept to correlation coefficient.

The relationship between covariance [Cov(rD, rE)] and correlation
coefficient (ρDE) between returns of two risky assets (D and E) is
represented as follows:
• Cov(rD, rE) = ρDEσDσE
• In the above expression, σD and σE are standard deviation of
returns of risky assets D and E.

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Correlation and Portfolio Risk

Divergence…

• Covariance between returns of two assets is a measure of how

much two variables change together.
• If the greater (smaller) values of one variable corresponds with
the greater (smaller) values of the other variable, the covariance is
positive.
• When the greater (smaller) values of one variable corresponds to
the smaller (greater) values of the other, the covariance is
negative.

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Correlation and Portfolio Risk

Divergence…

• The magnitude of the covariance is not easy to interpret. The

normalized version of covariance (also known as the correlation
coefficient) is often used to show the strength this relationship
(how much two variables change together).

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Correlation and Portfolio Risk

Example 1

• What is the variance of portfolio comprising of three assets (D, E,

and F)?

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Correlation and Portfolio Risk

Example 1

• Portfolio comprising of three assets will have the following

correlations:
• Correlation between D and E
• Correlation between D and F
• Correlation between E and F

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Correlation and Portfolio Risk

Example 1

• We can modify the formula for variance of a portfolio comprising

of three assets as follow:
• (σp)2 = (wDσD)2 + (wEσE)2 + (wFσF)2
+ 2wDwEρDEσDσE + 2wDwFρDFσDσF
+ 2wEwFρEFσEσF

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Correlation and Portfolio Risk

Example 2

• What is the variance of portfolio comprising of four assets (D, E, F,

and G)?

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Correlation and Portfolio Risk

Example 2

• Portfolio comprising of four assets will have the following

correlations:
• Correlation between D and E
• Correlation between D and F
• Correlation between D and G

• Correlation between E and F

• Correlation between E and G

• Correlation between F and G

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Correlation and Portfolio Risk

Example 2

• We can modify the formula for variance of a portfolio comprising

of four assets as follow:
• (σp)2 = (wDσD)2 + (wEσE)2 + (wFσF)2 + (wGσG)2
+ 2wDwEρDEσDσE + 2wDwFρDFσDσF
+ 2wDwGρDGσDσG
+ 2wEwFρEFσEσF + 2wEwGρEGσEσG
+ 2wFwGρFGσFσG

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Correlation and Portfolio Risk

Example 3

• How many covariance terms are present in the expression for

standard deviation of the portfolio comprising of three assets?
• How will your answer change if the portfolio comprises of four
assets?
• What is the general expression for determining the number of
covariance terms in the portfolio comprising of N assets?

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Correlation and Portfolio Risk

Example 3

• In the expression of standard deviation standard deviation of the

portfolio comprising of three assets, we have SIX covariance terms.
• 2wDwEρDEσDσE (two terms)
• 2wDwFρDFσDσF (two terms)
• 2wEwFρEFσEσF (two terms)

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Correlation and Portfolio Risk

Example 3

• In the expression of standard deviation standard deviation of the

portfolio comprising of four assets, we have TWELVE covariance
terms.
• 2wDwEρDEσDσE (two terms)
• 2wDwFρDFσDσF (two terms)
• 2wDwGρDGσDσG (two terms)
• 2wEwFρEFσEσF (two terms)
• 2wEwGρEGσEσG (two terms)
• 2wFwGρFGσFσG (two terms)

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Correlation and Portfolio Risk

Example 3

• The general expression for determining the number of covariance

terms in the portfolio comprising of N assets is N(N-1).
• For three assets case, the number of covariance terms are 6 [=3(3 – 1)].
• For four assets case, the number of covariance terms are 12 [=4(4 – 1)].

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Correlation and Portfolio Risk

• Next table documents the effect of portfolio weights (and

correlation coefficients) on standard deviation. The data used for
computation is as follows:
• Expected Return of E = E(rE) = 13%
• Expected Return of D = E(rD) = 8%
• Standard Deviation of E(rE) = σE = 20%
• Standard Deviation of E(rD) = σD = 12%

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Correlation and Portfolio Risk

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Correlation and Portfolio Risk

• An interesting observation is that, for perfect positive correlation

coefficient, the standard deviation of portfolio never goes below
the standard deviation of the lowest risk asset (D). It indicates no
advantage of diversification in the presence of perfect positive
correlation.

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Correlation and Portfolio Risk

• However, for lower correlations, the table indicates that we

can construct a portfolio with standard deviation that is less
than standard deviation of both D and E. It indicates that
advantage of diversification can be achieved in the presence of low
correlation.

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Correlation and Portfolio Risk

Example 4

• The correlation coefficients between pairs of stocks are as follows:

Corr(A,B) = 0.85; Corr(A,C) = 0.60; Corr(A,D) = 0.45. Each stock
has an expected return of 8% and a standard deviation of 20%.
• If your entire portfolio is now composed of stock A and you can
add some of only one stock to your portfolio, which stock would
you choose? Would the answer change for more risk-averse or
risk-tolerant investors?

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Correlation and Portfolio Risk

Example 4

• You will choose D because it has the lowest correlation with A and
its risk and return are not different from the others.
• Your choice will not change, even if you are more risk tolerant.

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Correlation and Portfolio Risk

• Our analysis has shown that portfolio risk decreases, if correlation

between assets is less than +1.
• An important question that needs to be asked is: For any given
level of correlation between assets, how can we construct a
portfolio with minimum risk?

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Correlation and Portfolio Risk

• In order to answer this question, rewrite the equation of variance

as follows and differentiate it with respect to portfolio weight.

σ 2  w D σ D   1 - w D σ E   2w D 1 - w D Cov(rD , rE )
2 2

σ 2  w D σ D   σ E   w D σ E 
2 2 2

 2w D σ E   2w D Cov(rD , rE ) - 2w D  Cov(rD , rE )

2 2

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Correlation and Portfolio Risk

• Differentiating with respect to wD gives us the following

expression:

d w D σ D   σ E   w D σ E   2w D σ E  
2 2 2 2
d
dw D
 
σ 
2

dw D  2w D Cov(rD , rE ) - 2w D 2 Cov(rD , rE ) 


d
dw D
 
σ 2  2w D σ D σ D  0  2w D σ E σ E

 2σ E   2Cov(rD , rE ) - 4w D Cov(rD , rE )

2

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Correlation and Portfolio Risk

• Equating the above equation to zero yields the following:

0  2 w D σ D σ D  2 w D σ E σ E - 2 σ E 
2

 2Cov(r D , rE ) - 4w D Cov(r D , rE )

 2 2

0  2 σ D   2 σ E   4 Cov(r D , rE ) w D  2 σ E   2Cov(r D , rE )
2

2σ D 2  2σ E 2  4Cov(r D , rE ) w D  2σ E 2  2Cov(r D , rE )

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Correlation and Portfolio Risk

• Solving the previous equation for wD yields the following:

2 σ E   2Cov(r D , rE )
2
wD 

2 σ D   2 σ E   4 Cov(r D , rE )
2 2

σ E 2  Cov(r D , rE )
wD 
σ D 2  σ E 2  2 Cov(r D , rE ) 

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Correlation and Portfolio Risk

• What happens to previous formula if the correlation

coefficient is -1?

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Correlation and Portfolio Risk

• Replacing covariance term with its constituents (assuming that

ρ=-1) yield the following expression:

wD 
σ E   Cov(rD , rE )
2

σ D 2  σ E 2  2Cov(rD , rE )
wD 
σ E 2  ρσ E σ D 
σ E 2  σ E σ D
σ D 2  σ E 2  2 E D  σ D 2  σ E 2  2σ Eσ D 

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Correlation and Portfolio Risk

• Rearranging the terms yield the following:

wD 
σ E 2   E D 
σ E σ E   D 
σ D 2  σ E 2  2 E D  σ E  σ D 2 
σE
wD 
σ E  σ D 

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Correlation and Portfolio Risk

Example 5

• A pension fund manager is considering two mutual funds. The first

is a stock fund and the second is a corporate bond fund.
• The correlation between the fund returns is 0.10. The probability
distribution of the risky funds is as follows:

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Correlation and Portfolio Risk

Example 5

• What are the investment proportions in the minimum-variance

portfolio of the two risky funds?
• What is the expected value and standard deviation of its rate of
return?

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Correlation and Portfolio Risk

Example 5

• The parameters of the opportunity set are as follows:

• E(rS) = 20%
• E(rB) = 12%
• σS = 30%
• σB = 15%
• ρ = 0.10

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Correlation and Portfolio Risk

Example 5

• The minimum-variance portfolio is computed as follows:

wS 
σ B 2  Covr S , rB   σ B 2  ρσSσ B
σS 2  σ B 2  2Covr S , rB  σS 2  σ B 2  2ρ Sσ B

wS 
0.152  0.10 * 0.30 * 0.15  0.1739
0.302  0.152  20.10 * 0.30 * 0.15

 w B  1  w S  1  0.1739  0.8261

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Correlation and Portfolio Risk

Example 5

• Expected return and standard deviation of this portfolio are as

follows:

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Diversification
Measuring Correlation Coefficient

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Measuring Correlation Coefficient

• The correlation coefficient (ρ) between two assets can be

computed as follows:

 r r 
N

i, t  ri, Avg j, t  r j, Avg

ρ t 1

 N
  ri, t  ri, Avg     r  
N
2 2
j, t  r j, Avg
 t 1   t 1 

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Measuring Correlation Coefficient

Example 1

• Use the following data to compute the correlation between Asset-

A and Asset-B.
Year rA rB
2006 40% 40%
2007 -10% 15%
2008 35% -5%
2009 -5% -10%
2010 15% 35%

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Measuring Correlation Coefficient

Example 1

• As a first step, we should compute the average returns for Asset-A

and Asset-B.
• Average return for Asset-A = (40% -10% +35% -5% +15%)/5 = 15%
• Average return for Asset-B = (40% +15% -5% -10% +35%)/5 = 15%

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Measuring Correlation Coefficient

Example 1

• As a second step, compute the following:

Year rA rB (rA-rA,Avg)*(rB-rB,Avg)
2006 40% 40% 0.0625
2007 -10% 15% 0.0000
2008 35% -5% -0.0400
2009 -5% -10% 0.0500
2010 15% 35% 0.0000

Average 15% 15%

Sum 0.0725

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Measuring Correlation Coefficient

Example 1

• As a next step, do the following:

Year (rA-rA,Avg)2 (rB-rB,Avg)2
2006 0.0625 0.0625
2007 0.0625 0.0000
2008 0.0400 0.0400
2009 0.0400 0.0625
2010 0.0000 0.0400

Sum 0.2050 0.2050

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Measuring Correlation Coefficient

Example 1

• The product of sum of (rA-rA,Avg)2 and sum of (rB-rB,Avg)2 is

0.042025. Square root of this number is 0.2050.
• The correlation coefficient is 0.3536 [=0.0725/0.2050].

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Diversification
Power of Diversification

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Power of Diversification

• In order to further understand the power of diversification,

rewrite the equation of variance as follows:

σ P 2   w i σ i 2   w i w jCovri , rj 
N N N

i 1 i 1 j1
i j

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Power of Diversification

• Make a simplified assumption that wi=1/N for all assets. In this

case, the previous equation takes the following form:

 Covr , r 
N N N
1 1
σ P 2   σi  
2
i j
N2 i 1 N2 i 1 j1
i j

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Power of Diversification

• We can express the previous expression as follows. Multiplying

and dividing the second term with (N-1) will not change anything:
 N 2 
  σ i    
1  N N  N 1
 2   Covri , rj 
1  i 1 
σ P 2 
N  N  N  i 1 j1  N 1
   i j 
 

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Power of Diversification

• Above expression can be simplified as follows:

 N N 
 N 2    Covri , rj  
 σ i  
1   N  1  i 1 ij1j 
σ P 2  i 1
  
N N  N  NN  1 
   
   
 

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Power of Diversification

• Given that there are N variance terms and N(N-1) covariance

terms in the expression for variance, we can define average
variance and covariance of securities as follows:

 21 N
σ   σ i 
N i 1
2

 Covri , rj 
N N
1
Cov 
NN  1 i 1 j1
i j

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Power of Diversification

• Plugging the average values in the equation of variance yields the

following:

σ P 2 
N

1 2 N 1
σ 
N
Cov

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Power of Diversification

• What happens to above equation as N becomes large?

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Power of Diversification

• If N becomes very large, we should expect the following:

1 N -1
 0 and 1
N N
• Therefore, variance of portfolio consisting of very large number of
securities becomes the following:

σ P 2  Cov

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Power of Diversification

• Only the average covariance matters for large portfolios. In other

words, if the average covariance is zero, then the portfolio variance
is close to zero for large portfolios.

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Power of Diversification

• Empirical evidence suggests that the average (annual) covariance

between stocks is around 0.037 for S&P500.
• Since the average covariance is positive, even a very large portfolio
of stocks will be risky. We call the risk that cannot be diversified
away the systematic risk.

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Diversification
Problems

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Problem 2
Question

• Can you construct a portfolio with no risk? What assumption must

hold, if you want to construct a portfolio with no risk?

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Problem 2
Answer

• We can construct a portfolio with no risk, if correlation (ρ)

between assets is -1.

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Problem 3
Question

• Assume that two stock, D and E, have a perfect negative

correlation. What amount should be invested in each of these
stocks to construct a portfolio with no risk?

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Problem 3
Answer

• A zero-risk portfolio can be achieved by choosing the portfolio

proportions as follows:
• (σp)2 = (wDσD)2 + (wEσE)2 + 2wDwEρDEσDσE
0 = (wDσD)2 + (wEσE)2 + 2wDwE(-1)σDσE
0 = (wDσD)2 + (wEσE)2 - 2wDwEσDσE
0 = (wDσD - wEσE)2

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Problem 3
Answer

• Above equation implies that (wDσD - wEσE) = 0. Since wE = 1 - wD,

the solution to above equation is:
w D σ D  w E σ E  w D σ D  1  w D σ E  0
w Dσ D  σ E  w Dσ E  0
w D σ D  σ E   σ E
σE
wD 
σD  σE
 w E  1 w D

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Problem 4
Question

• Suppose that there are many stocks in the market and that the
characteristics of stocks A and B are given as follows:

• Suppose that it is possible to borrow at the risk-free rate. What

must be the value of the risk-free rate?

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Problem 4
Answer

• Since Stock A and Stock B are perfectly negatively correlated, a

zero-risk (risk-free) portfolio can be created and the rate of return
for this portfolio should be the risk-free rate.
• Assume that wA is the proportion of wealth invested in Stock A,
and wB [=(1 – wA)] is the proportion of wealth invested in Stock B.

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Problem 4
Answer

• As was shown earlier, zero-risk portfolio can be created by

investing the following proportion in Stock A:
• wA = σB/(σA + σB) = 0.10/(0.05 + 0.10) = 0.67
• Therefore, wB = 1 – 0.67 = 0.33.
• Expected return of zero-risk portfolio will be as follows. This is
also the risk-free rate.
• E(r) = (0.67*0.10) + (0.33*0.15) = 11.67%

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Diversification
Practice Questions

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Practice Questions
Question 1

• Using the data provided on the next slide to illustrate the effect of
portfolio weights on risk. More specifically, illustrate: What
happens to risk when wD > 1 and wE < 0?
• NOTE: In this case, portfolio strategy is to sell E short and invest the
proceeds of the short sale in D.
• And, what happens to risk when wD < 0 and wE > 1?
• Note: In this case, portfolio strategy is to sell D short and invest the
proceeds of the short sale in E.

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Practice Questions
Question 1

• The assets used to construct a portfolio are as follows:

• E(rE) = Expected return on E = 13%
• E(rD) = Expected return on D = 8%
• σE = Standard deviation of rE = 20%
• σD = Standard deviation of rD = 12%

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Practice Questions
Question 1

• Consider the following cases when (wD = 2 and wE = -1) and (wD =
-1 and wE = 2):
• ρDE = +1
• ρDE = 0
• ρDE = -1
• What happens to standard deviation? Are you able to benefit from
diversification? Why or why not?

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Diversification
References

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References

• Bodie, Z., Kane, A., and Marcus, A.J., (2014). Investments (Chapter
7). 10th Edition, McGraw-Hill/Irwin.

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