Question

2. How can you diversify your investments to spread the risk of losing return on investment?

Answer 1

A mix of diverse assets will significantly reduce the overall risk of a portfolio. Assets that are unrelated (i.e lack of corelation) will have unrelated risk. The lack of corelation is what helps a diversified portfolio of assets to have a lower total risk , measured by the Standard deviation of each asset. A portfolio, having corelation of the assets lower than 1, (i.e negative correlation) will have a lower total risk..

Diversification is the process, which combines assets that are less than positively corelated in order to reduce the portfolio risk, without sacrificing any portfolio returns. The lack of corelation is what helps a diversified portfolio of assets to have a lower total risk, which is measured by the standard deviation. The risk of losing return on the investment can be reduced by creating a diversified portfolio of unrelated assets.

Illustration:-

For example, there are two securities –A and Security –B, that offer returns of 15% p.a. The Standard deviation of return of each of these two securities is 0.20 each.

Hence the two securities have the same level of risk and offer same level of return. However, when these two securities are combined, the combination will have a different risk pattern based on the correlation of returns between these securities.

Correlation Coefficient of Security A and Security B	Standard deviation of the Portfolio having Security A and B in equal weights
1	0.20
0.5	0.1732
0	0.1414
-0.50	0.10
-1	0.00

The Standard deviation of the Portfolio (Risk) is calculated as:-

σ_P²= w_A²σ_A² + w_B² σ_B² + 2 w_Aw_Bσ_Aσ_Bρ_AB

Thus, for the portfolio having negative correlation between the assets, the overall risk is the least for such portfolio. Whereas for a portfolio having positive correlation between the assets, the risk increases.