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Diversification & risk - Coggle Diagram
Diversification & risk
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A portfolio which is constructed of a number of different asset classes such as equities, bonds, cash, property and commodities will blend low risk cash deposits and bonds with higher risk equities and commodities for instance
The asset class can be diversified further with different managers, industry sectors and geographies selected
The proportions allocated will depend upon the investor's risk preference and the prevailing market conditions
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A specific risk is diversifiable by adding other diverse holdings to the portfolio, provided that the risks of the other holdings are not directly correlated
Systematic risk is that of the portfolio or market and cannot be diversified away though the addition of other assets and is due to outside factors such as the economy performing poorly or international tensions
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MPT is interested in the amount that this return deviates from the average return and quantifies this risk accordingly measuring it as standard deviation
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MPT assesses the likely profitability of investments from a basis of weighting the expected returns on a normal distribution, bell shaped curve when drawn graphically
Risk is measured by the standard deviation of returns and the expected portfolio return is measured by the weighted average of individual investments within it
Correlation
In considering risk, it is the effect that an investment will have on the overall risk of the portfolio that is important not the risk of the investment in isolation
the amount of diversification of risk available will depend upon the degree to which returns from different investments move in line with each other the degree to which they are correlated
An investor can reduce the risk within a portfolio by holding investments that are not perfectly (positively correlated)
Highly correlated shares for instance may occur from companies in the same industry or sector, if the oil price moves, oil companies' shares will tend to move in the same direction
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If no discernible relationship can be observed with prices bearing no relationship to each other, there is no correlation between the assets
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A correlation coefficient of 1 between two assets (perfect) means whatever one asset does will predict the movement of the other, one assets gain of 10% will be matched by the other assets gain of 10%
Minus one is perfect inverse and is equally predictable but opposite. This means that if asset a increased by 10%, asset b will decrease by 10%
The greater the number, the greater the strength of the relationship between the two
A correlation of zero means returns are completely independent and no relationship exists between the two
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Proportionate reduction of risk, relative to return is therefore available in almost all portfolios with two or more investments
The correlation between investments varies over time and reassessment of data leading to rebalancing of the investments in the portfolio may be necessary. This is a criticism levelled at MPT