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Mean Variance Analysis - Portfolio Theory and Diversification

The most common objective of diversification is “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 and 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. ...Show more

Author : jaylenmcculloug

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