Question

answer the following

A- When is diversification most beneficial (think correlation)? Provide detailed examples

B- Provide an introduction to portfolio diversification: asset allocation and security selection.

Answer 1

A - Diversification is most beneficial when the correlation between the assets exhibit a negative correlation. When the assets have negative correlation, the diversification benefits leads to risk/standard deviation reduction and maximization of returns. The minimum correlation is -1, in this case assets exhibit perfect negative correlation and this leads to the maximum benefits of diversification. Diversification benefits leads to minimizing standard deviation and maximizing returns.

For example, if the correlation between the assets is -1, this will result in greater diversification benefits as the standard deviation of this portfolio will be reduced to a greater extent  in the portfolio as opposed to the portfolio where the correlation between the assets is 0.3.

B. Within diversification of portfolios, investors may then take the asset allocation decision. Asset allocation adds different types of assets in the portfolio, where they do not exhibit any correlation between them. Then after asset allocation, comes security selection. Security selection is the process of choosing securities from these asset classes. The asset classes such as bonds, stocks, real estate and commodities. These assets are not correlated , so it leads to diversification benefits. The security selection is made keeping in mind the nature of the investor .