FIN 420 - Notes - Lesson M2L2.docx - FIN 420 Notes Lesson M2L2 Diversification and Portfolio Risk There are two high-level types of risk that are

FIN 420 - Notes - Lesson M2L2.docx - FIN 420 Notes Lesson...

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FIN 420 - Notes - Lesson M2L2 Diversification and Portfolio Risk There are two high-level types of risk that are important for investors to understand. The first is called systematic risk , which is the risk that is common to the entire economy. Systematic risk is something that you cannot diversify away. An investor should expect to be compensated for whatever level of systematic risk they remain exposed to. The other major type of risk is called nonsystematic risk , which is company-specific risk that can be eliminated through effective diversification. Source: Bodie, Zvi, Alex Kane, and Alan J. Marcus, Essentials of Investments, 9th edition, McGraw- Hill, 2013 How many stocks are necessary to properly diversify the nonsystematic risk inherent in a portfolio? This question is like politics…everyone has their own opinion. Some academic research suggests exactly 32 stocks. Other research suggests the number is closer to 60. You will notice from this graph that the incremental reduction in portfolio standard deviation begins to diminish after 8 stocks and the reduction becomes almost unnoticeable somewhere between 20- 30 stocks, which is a reasonable number of stock holdings for adequate diversification. The more stocks an investor owns, the more active research is required to maintain those positions, and active research is costly both in terms of time involved and financial resources. If an investor chooses to own a few mutual funds or ETFs in their portfolio, then they can be adequately diversified with far fewer holdings because the funds provide instant diversification. Let’s consider constructing a portfolio using 40% stocks and 60% bonds. One question on every investor's mind is: how much could I potentially expect to earn from my portfolio? To calculate the portfolio's expected return, we use a simple weighting technique where each weight (W 1 ) is equal to the weight of one asset (stock A, stock B, bond A, an ETF, etc.) in the portfolio and W 2 is the weight on the other asset. A basic version of this concept is shown in the formula below.
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Let's consider this formula applied to the information in the table below. Notice that the stocks and bonds react differently to alternative states of the economy (scenarios). During a mild recession, stocks are down while bonds are up. For each investment, you multiply the weight for the category (stock or bond) by the expected return for the given scenario. The value of -14.80% is derived in the "severe recession" scenario by multiplying 40% by -37%. The portfolio's expected return (-20.2%) for the "severe recession" scenario is therefore the weight-adjusted return for stocks (-14.8%) PLUS the weight-adjusted return for bonds (-5.4%). The expected return in the severe recession scenario is much worse than a bond alone, but much better than stocks alone. The reverse is true for the boom scenario. In this simplistic example you can see how diversifying between only these two asset categories could reduce the level of portfolio risk as measured by dispersion of returns.
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