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Investments Chapter 9: Portfolio Diversification

Diversification: The ‘Free Lunch ’ of Finance ,[object Object],[object Object]

Three Ways to Diversify ,[object Object],[object Object],[object Object]

Three Ways to Diversify – Illustration Exhibit 9.1 Correlation matrix for regions, sectors and asset classes (1994 –2003) Source: mba.tck.dartmouth.edu/pages/faculty/ken.french/

Systemic Risk vs. Nonsystemic Risk ,[object Object],[object Object],[object Object],[object Object]

International Diversification: I ,[object Object],[object Object]

International Diversification: II ,[object Object],[object Object],[object Object],[object Object],[object Object]

‘ A Little Diversification Goes a Long Way’ ,[object Object]

‘ A Little Diversification Goes a Long Way’ – Illustration ,[object Object],Exhibit 9.4(b) Effect of the number of assets and the correlation coefficient on a portfolio’s variance (individual assets are identical)

Barriers to Diversification ,[object Object],[object Object],[object Object],[object Object],[object Object]

Estimation Error: I ,[object Object],[object Object],[object Object]

Estimation Error: II ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Human Capital and Property Holdings ,[object Object],[object Object],[object Object]

Actual Diversification by Households ,[object Object]

Portfolio Risk as a Function of the Number of Stocks in the Portfolio Nondiversifiable risk; Systematic Risk; Market Risk Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk n  In a large portfolio the variance terms are effectively diversified away, but the covariance terms are not. Thus diversification can eliminate some, but not all of the risk of individual securities. Portfolio risk

The Efficient Set for Many Securities ,[object Object],return  P Individual Assets

The Efficient Set for Many Securities ,[object Object],return  P minimum variance portfolio Individual Assets

The Efficient Set for Many Securities ,[object Object],return  P minimum variance portfolio efficient frontier Individual Assets

Optimal Risky Portfolio with a Risk-Free Asset ,[object Object],100% bonds 100% stocks r f return 

Riskless Borrowing and Lending ,[object Object],100% bonds 100% stocks r f return  Balanced fund CML

Riskless Borrowing and Lending ,[object Object],return  P efficient frontier r f CML

Market Equilibrium ,[object Object],return  P efficient frontier r f M CML

The Separation Property ,[object Object],return  P efficient frontier r f M CML

Optimal Risky Portfolio with a Risk-Free Asset ,[object Object],100% bonds 100% stocks return  First Optimal Risky Portfolio Second Optimal Risky Portfolio CML 0 CML 1

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