Portfolio Diversification
Portfolio diversification is the strategy of spreading investment across a range of assets to reduce risk without proportionally reducing expected return. Diversification is a central principle of investment management.
The Principle
The principle of diversification is based on the observation that the risk of a portfolio depends not only on the risk of the individual assets but also on the relationship among them. When assets are not perfectly correlated, the risk of the portfolio is less than the weighted average of the risks of the assets.
The benefit of diversification increases as the correlation among the assets decreases. When assets are perfectly positively correlated, there is no benefit. When they are negatively correlated, the benefit is greatest, and the risk of the portfolio can be less than the risk of the least risky asset.
The principle implies that investors should hold a portfolio of assets rather than a single asset, and that the composition of the portfolio should reflect the correlations among the assets.
Systematic and Unsystematic Risk
The analysis of diversification distinguishes between systematic risk, which is the risk that affects all assets and cannot be eliminated by diversification, and unsystematic risk, which is specific to individual assets and can be eliminated.
The capital asset pricing model holds that investors are compensated only for systematic risk, since unsystematic risk can be diversified away. The expected return of an asset therefore depends on its beta, which measures its sensitivity to the systematic risk.
The implication is that the relevant measure of risk for the pricing of an asset is its contribution to the risk of a well-diversified portfolio, not its total risk. The analysis of diversification is therefore central to the theory of asset pricing.
Portfolio Construction
The construction of a diversified portfolio involves the selection of the assets, the determination of the weights, and the management of the risk. The analysis is based on the expected returns of the assets, on their variances, and on their correlations.
The efficient frontier is the set of portfolios that offer the highest expected return for each level of risk. The investor chooses the portfolio on the frontier that matches their preferences for risk and return.
The construction of the portfolio also involves consideration of the constraints, including the liquidity of the assets, the transaction costs, and the investment policy. The practical implementation of diversification must take account of these constraints.
Limitations
Diversification has limitations. It cannot eliminate systematic risk, which affects all assets, and it may not protect against the losses that occur during periods of stress, when the correlations among assets increase.
Diversification also requires information about the expected returns and the correlations of the assets, which are difficult to estimate. The estimates are subject to uncertainty, and the optimal portfolio may be sensitive to the errors in the estimates.
The Efficient Frontier
The efficient frontier is the set of portfolios that offer the highest expected return for each level of risk. The frontier is derived from the expected returns, the variances, and the covariances of the available assets.
The investor chooses the portfolio on the frontier that matches their preferences for risk and return. The choice depends on the risk aversion of the investor, and it determines the composition of the portfolio.
The frontier demonstrates the benefit of diversification, since the frontier for a portfolio of assets lies above the frontier for a single asset. The analysis of the frontier is central to the theory of portfolio choice.
The Capital Asset Pricing Model
The capital asset pricing model extends the analysis of the frontier to the market as a whole. The model holds that the market portfolio, which comprises all the risky assets, is on the efficient frontier, and that the expected return of an asset depends on its beta.
The beta measures the sensitivity of the asset's return to the return of the market. An asset with a beta greater than one is more volatile than the market, and it requires a higher expected return. An asset with a beta less than one is less volatile, and it requires a lower expected return.
The model has been influential in finance and in practice, and it is used in the estimation of the cost of equity. The model has been criticised for its empirical performance and for the difficulty of measuring the market portfolio.
The Limits of Diversification
The limits of diversification are central to the analysis of risk. Diversification cannot eliminate the systematic risk, which affects all the assets, and it may not protect against the losses during periods of stress.
The correlation among the assets tends to increase during periods of stress, which reduces the benefit of diversification precisely when it is most needed. The phenomenon is a source of concern for the investors and for the regulators.
The analysis of the limits of diversification informs the design of the portfolios and the assessment of the risk. The investors must consider the behaviour of the correlations during the stress and the exposure to the systematic risk.
Summary
Portfolio diversification reduces the risk by spreading the investment across the assets. The analysis of the efficient frontier, of the capital asset pricing model, and of the limits of diversification informs the understanding of the portfolio choice and of the pricing of the assets.