Question

Why we can achieve diversification benefits by including multiple securities in the portfolio? Your discussion must include the underlying drivers of diversification. Your answer can include statistical measures and examples.

Answer 1

Diversification means allocating funds to various financial instruments which have different risk profiles.

Diversification is achieved through adding securities to a portfolio which have different risk profiles. When we keep adding securities of different risk profiles, the portfolio gets diversified.

Drivers of diversification:

1)      Standard deviation or volatility: Each security features different volatility and in combination they throw a different standard deviation for a portfolio

2)      Correlation: The higher correlation among the securities will result in lower diversification benefit and vice-versa

3)      Asset class: Asset class of different nature will have different risk and reward when we add different class of assets to a portfolio then diversification benefit is very high

4)      Risk and reward: High risk securities and low risk security combination helps to achieve a good diversified portfolio

Statistical tool used: Standard deviation, beta, minimum variance portfolio and correlations coefficient are the statistical tools which are used to measure diversification of portfolio.