Question

Define the following terms:

A- portfolio
B- Diversification
C- Correlation
D- Beta

Answer 1

A) Portfolio - A portfolio is a group of different financial assets like mutual funds, stocks, bonds, derivatives, etc. that are held by investors. Portfolios are constructed with an objective to manage risks as putting all the money on a single stock can be very risky.

B) Diversification - When a portfolio consists of financial assets such that their returns are not correlated or have very less correlation with each other then the portfolio is known as a diversified Portfolio. This strategy to manage the risk is called Diversification. An example of a diversified portfolio can be an investment in a portfolio consisting of Bonds, stocks of different industries (pharma, manufacturing), mutual funds. So when there is a situation that the stock market is down while the bonds market is flourishing then we are protected against the risk because of investing in a diversified portfolio.

C) Correlation - A statistical measure that shows how a given pair is related to each other. The correlation coefficient is used to measure the correlation between the returns of two stocks or financial assets. Correlation coefficient lies between +1 to -1. Correlation of -1 means that there is a strong negative correlation between the pairs, a correlation coefficient of 0 means that the pairs are uncorrelated and correlation coefficient of +1 means that there is a strong positive correlation between the pairs.

D) Beta - Beta of a stock measures its volatility with respect to the market. The formula to calculate the beta of a stock is given by:

where Cov(i,M) is the covariance between the return of stock i and the market and σ_M is the volatility of the market's return.

The beta of a market is 1. If a stock has beta more than 1 it means that it deviates more compared to the market or it is more volatile compared to the market while a beta less than 1 means that it deviates less compared to that of market or it is less volatile compared to that of market.