Mean Variance Analysis - Portfolio Theory and Diversification Assignment

Mean Variance Analysis - Portfolio Theory and Diversification - Assignment Example The most common objective of diversification is â€Å"not to put all eggs in the same basket†. Diversification may have different forms. A well-diversified portfolio is the one in which all the constituents do not have any relationship among each other (Fabozzi et al, 2002). That relationship can be measured by using statistical technique of correlation. Correlation actually measures how much a constituent is associated or linked with the other constituent such that in case if the correlation is equal to or near to 1 among two constituents, then those two constituents would be called as highly associated with each other as having strong relationship between them. On the other hand, if the correlation becomes to 0, it means that there is no relationship between the constituents and they are independent of each other. The third possibility is that the correlation is computed as -1 or near to it which means that the constituents has strong negative relationship among each other a nd they are associated with each other in opposite manner. So according to portfolio theory, the risk of a portfolio can be minimized in case if the portfolio is well-diversified in terms if its constituents such that the constituents either do no have any relationship with each other i.e. correlation = 0 or they have opposite relationship with each other such that correlation = -1 or near to it. ... In case if the constituents do not have any relationship with each other then the constituents would show a unique behavior irrespective of any other constituent. As a result, if the price of any constituent decreases, it will not have any impact on the prices of other constituents and in this way, the overall volatility of the portfolio will remain substantially lower. The negative relationship among the constituents of the portfolio will compensate each other such that if the price of one constituent decreases, than it would be effectively compensated by the other constituent such that its price would be increased, thus it would result in managing the overall risk of the portfolio given that the required return of the portfolio is ensured. This kind of portfolio would be considered as well-diversified and ensure the same return but with the reduced level of risk. The individual return that can be earned on each constituent would be similar to those which are kept in a well-diversif ied portfolio, but the overall risk of the portfolio would be substantially less than every individual constituent. Diversification Principles There are different kinds of diversification strategies which are available for the investors, some of them are discussed as under: Diversification through Different Asset Classes The most famous diversification strategy holds that the constituents of a portfolio must be well spread in different asset class such that investment can be managed in different proportions under stocks, bonds, marketable securities, commodities, property and real estates, currencies etc (Shefrin, 2000). These asset classes provide a large area for diversification and hardly any relationship can be found among these asset classes. Diversification through