Risk & Diversified Portfolios

Diversifiying theoretically reduces risk without reducing expected return

By simply diversifying across uncorrelated assets, investment portfolio risk can theoretically be eliminated. The term "risk" refers to variance, or how up and down a portfolio's returns are, and "diversifying" means to not put all your eggs in one basket. To diversify optimally, different asset classes such as stocks, bonds, and commodities should be utilized.

Risk

Risk is best defined as the variance, or standard deviation, of returns. For example, if the return is 10 percent one year but negative 10 percent the next, there is a higher variance (risk) in the returns than if there were returns of 10 percent every single year. Variance can be calculated either by hand or by using a spreadsheet program like Microsoft Excel. Risk can be measured across any recurring time period, but most investors use a yearly measure such as standard deviation of returns per year.

Returns

Returns come in two forms (either dividends or capital gains). When trying to compare two assets, dividends need to be taken into account. For example, if a stock rises 5 percent in a year and pays a dividend of 3 percent, the total return is 8 percent even though the stock charts do not show it because stock charts only show the stock price.

Correlations

An analogy of correlation is understood by looking at two cities' climates. Sacramento and San Francisco are located approximately 80 miles apart. This means their weather should to some extent be similar, although not identical. If their climates were identical, their correlation would equal exactly one. Instead, their climates are highly correlated, but not perfectly correlated. When it rains in San Francisco, it often rains in Sacramento as well, but not always. Many assets have a relationship similar to these two cities.

Asset Correlations in a Portfolio.

According to Nobel Prize winner Harry Markowitz, combining uncorrelated assets reduces portfolio risk toward zero. The most extreme example is a basic two-asset portfolio with negatively correlated assets. Asset A is a typical domestic equity mutual fund and asset B is a U.S. savings bond. They tend to be negatively correlated; stocks rise in value when U.S. savings bonds fall in value. All the while the stocks pay their dividends and the bonds pay their interest payments. In the end, a steady return is earned even though each asset is rather unsteady by itself. Therefore, risk is reduced without reducing return.

References

• "The Father of Portfolio Theory on the Crisis"