Finance Principles Essay Example | Topics and Well Written Essays - 2000 words

Finance Principles - Essay Example It can be explained as, if one of the asset in the portfolio is giving negative return, then it would not have a significant impact on the overall return of the portfolio because the other assets might be performing well and thus making up for the asset which is not performing well. Diversification helps an investor to have consistent return on its portfolio over a period of time. An investor who is risk-averse in nature would always strive to have a completely diversified portfolio in order to minimize risks associated with it. Quantitative measure of portfolio is possible with the advent of several portfolio selection theories. Using those quantitative measures one can have the benefits of diversification to the maximum amount possible. The diversification strategy proposed by Markowitz is based on the covariance between the returns generated by the assets included in a portfolio. The diversification theory proposed by Markowitz is related to the risks associated with the portfolio as a whole and not the risk associated with any asset in isolation. Markowitz used variance as a measure of risk. Markowitz tried to develop a diversified portfolio by including those assets in the portfolio which are not perfectly positively correlated with each other, so that the variance in return of the portfolio is minimized without affecting much on the return of the portfolio.1 Mean – Variance Diversification Mean – Variance diversification portfolio theory utilizes marginal analysis as a means of achieving optimal level of diversified portfolio. It is based on the fact that diversification should be enhanced until and unless marginal cost is less than the marginal benefit. The advantage of this theory is the minimization of risk. The costs that are considered in this theory are holding costs and transaction costs. The standard deviation of the returns generated through the combination of assets is used as the risk measure in case of this theory of diversificat ion. Marginal benefits associated with diversification of portfolio get increased with decrease in correlation between asset returns. On diversification of the portfolio the expected value of standard deviation goes on decreasing. Optimal diversification depends on the expected correlations between each pair of assets in the portfolio, the buying costs of each of the assets, the holding costs of the assets and expected premium on equity used as asset in the portfolio.2 Risks associated with any portfolio can either be unsystematic risks or systematic risks. As discussed earlier risk gets reduced with diversification. However, diversification reduce risk only to a certain level, beyond which it is not possible to reduce risk because changes in the market conditions as a whole affects in variation of prices of all the assets included in the portfolio and it is not possible to reduce or eliminate this variability beyond a certain level. Hence it is necessary to divide risk into two par ts, namely systematic risk and unsystematic risk. The risk which represents that portion of the variability in asset caused by the market movements are known as systematic risk. This type of risk is unavoidable in nature and is sometimes termed as beta as mentioned in the Capital Asset Pricing