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Finance Principles

Diversification A technique of risk management that takes into account a broad selection of investments within a portfolio is called diversification. (Lakshmanan and Amer-Yahia, n.d.). 1The rationale that guides this technique argues that a portfolio consisting of different kinds of investment on an average will give higher returns as well as pose a lower risk compared to any other individual investment that is found within the portfolio. As a result the positive performance of some investments will rule out the not so positive or negative performance of the other investments. The benefits from the process of diversification can only be accrued if the securities within the portfolio are perfectly uncorrelated. The first form of diversification takes place when the company has the potential to develop beyond the existing product market. The related form of diversification can be further categorized into backward diversification, forward diversification and horizontal diversification. Unrelated diversification takes place when an organization has the potential to develop interests that is complementary to its existing activities. When a company involved in media services can think of diversification in financial services, such kind of diversification is called unrelated diversification (Chatterjee and Wernerfelt, 1991). ...
The diversification speed of the value at risk is regarded as the rate at which the value at risk changes because the number of assets included in the portfolio increases. (Ansoff n.d. p. 113). 3The criteria of value at risk are evaluated at a probability level that is fixed. One can also launch the converse analysis where the level of the value at risk is kept fixed and the level of the probability changes with increase in the number of assets. A majority of the theoretical literature in finance assumes that returns are distributed normally. The speed of diversification is different in cases of normal and other distributions. The diversification speed is higher for the finite variance classes relative to the speed of normal distribution. The speed is lower relative to the speed of the diversification of the risk level (Hyung and Vries, 2004, p. 3). 4 Suppose there are two stocks one with return 0f 8% and another with 15%. The expected range of return of the investor is 8% to 15%. The standard deviation of the former stock is .05 while that of the later is 2. The investor will quantity the associated risk of the two assets and diversifies the investments accordingly. Country wise diversification can also arrive in the scenario (Marineilli, 2011, p. 2). 5 Measurement of the benefits of Diversification Suppose A and B are two portfolios. The former portfolio has an expected return and return volatility of 7.5% with equal weighing of both types of assets. But the later portfolio is leveraged in such a way that the weighing of the risk free asset is -50% while that of the risky asset is 150%. The expected return of the later portfolio is 12.5% and the return volatility is 22.5%. The behavior of the investors should be indifferent between the portfolios as one can convert ...Show more

Summary

Finance principles Contents Risk 3 Diversification 3 Theoretical concepts underpinning portfolio diversification 4 Measurement of the benefits of Diversification 5 Limitations 6 Risk The potential that a particular activity or a certain type of action will lead to an outcome that is undesirable is called risk…
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