Question

6. Explain to me the benefits of diversification using the model of the variance of portfolio returns that we explained in class.

Answer 1

ANSWER DOWN BELOW. FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

Diversification means a reduction in the overall risk of the portfolio when 2 or more stocks are present in the portfolio. The overall risk of the portfolio is less than its weighted average risk of Individual stocks in the portfolio.

how can an investor have a diversified portfolio?

As per modern portfolio theory. There is a Benefit of diversification of risk when non-perfectly correlated stocks are added in the portfolio.

The benefit of diversification is when non perfectly correlated stocks are added then if the stock return of stock falls then it's offset by a rise in the stock return of another stock.

In simple words "Overall risk of the portfolio decreases" when we add more stocks to it.

The variance of the portfolio is not the weighted average variance of individual stocks. it is due to the benefit of diversification due to non-perfect relationship between the stocks.

It is usually less than the weighted average.  

If there is a perfect correlation between stocks in the portfolio then it is the weighted average standard deviation. Although, this is not the case in almost any scenario.

The Variance of the portfolio of two stocks is:
[(Weight*Sd)^2+(Weight*Sd)^2+2*(Weight*Weight)*Sd*Sd*correlation]

When Sd= standard deviation.