BUS202: Principles of Finance

A diversified portfolio containing investments with small or negative correlation coefficients will have a lower variance than a single asset portfolio.

TERM

• Correlation Matrix

  A matrix that shows a set of correlations between two random variables over a number of observations.

A primary reason for a diversified asset allocation is the fact that markets often sway away from each other, and it can be beneficial to have a portion of your holdings invested in bonds in years when stocks do badly. As you can see from the graphic below, there is still considerable risk to an investor who is heavily invested in stocks, even with a blended portfolio.

Remember that in 2000, the Nasdaq lost 39.28% of its value (4,069.31 to 2,470.52) and in 2001, the Nasdaq lost 21.05% of its value (2,470.52 to 1,950.40). Had your portfolio consisted of a set of stocks that approximated the Nasdaq index, you would have lost roughly 52% of your portfolio's value (from 4069.31 to 1950.40).

In actuality, as mentioned before, there are more than two basic asset classes. Here are some examples of the the types of assets that may be included in a diversified strategy:

• cash and cash equivalents (e.g., deposit account, money market fund )
• fixed interest securities, such as bonds: investment-grade or junk (high yield); government or corporate; short-term, intermediate, long-term; domestic, foreign, or emerging markets; or convertible security
• stocks: value, dividend, growth, sector specific, or preferred (or a "blend" of any two or more of the preceding); large-cap versus mid-cap, small-cap or micro-cap; public equities versus private equities, domestic, foreign (developed), emerging or frontier markets
• commodities: precious metals, broad basket, agriculture, energy, etc.
• commercial or residential real estate (also REITs )
• collectibles, such as art, coins, or stamps
• insurance products (an annuity, a life settlement, a catastrophe bond , personal life insurance products, etc.)
• derivatives, such as long-short or market neutral strategies, options , collateralized debt, and futures
• foreign currency
• venture capital, leveraged buyout, merger arbitrage, or distressed security funds

A fundamental justification for asset allocation (or Modern Portfolio Theory) is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Asset diversification has been described as "the only free lunch you will find in the investment game". Academic research has painstakingly explained the importance of asset allocation and the problems of active management (see academic studies section below). Although risk is reduced as long as correlations are not perfect, it is typically forecast (wholly or in part) based on statistical relationships (like correlation and variance) that existed over some past period. Expectations for return are often derived in the same way.

A diversified portfolio containing investments with small or negative correlation coefficients will have a lower variance than a similar portfolio of one asset type. This is why it's possible to reduce variance without compromising expected return by diversifying.