portfolio theory and diversification
Diversification: A method of reducing risk through asset allocation. ... The assumptions of CAPM are the same as those of Portfolio Theory (Perfect capital markets, one period model, homogenous expectations and unlimited borrowing/lending at the risk free rate. It is difficult to test CAPM as it is very difficult to calculate the return of the market portfolio as no index includes all stock exchange quoted companies. Portfolio theory is concerned with the construction of portfolios from a collection of investments using mathematics to identify the mean, the variances of multiple, individual distributions together with the covariance of the distributions. So if the expected return, variance of return, and covariance of return are known the expected return and variance of the whole portfolio can be determined. It is what arises from this statistical result that is important to portfolio managers. ... Diversification stems from the early work of Markowitz (1959) Portfolio Selection: Diversification of Investments whose main assumptions were: · The portfolio return is a weighted average of the individual asset returns, and portfolio risk may be less than the weighted average of the individual asset risks. This is the effect of diversification. · The portfolio risk will be lower, the lower the correlations between the constituent asset returns. ... A well diversified portfolio will own a collection of equities each with varying degrees of risk, therefore in order to maximise shareholder wealth we must choose maximisation of returns whilst minimizing risk. ... Understanding what is meant by diversification helps with identifying the ways in which individuals and firms can diversify. ... This is where the life cycle theory of asset allocation and Friend & Bloom – relative risk aversion index RRAI for the kth investor take their basis. ... When there are limitations to portfolio diversification, investors (and managers) become concerned with total risk. ... As discussed diversification is a logical approach to the reduction of risk whilst achieving no subsequent reduction in returns, as the diversification process will reduce the variability of the shareholders wealth and keep it constant, it is not important to the shareholders whether the company diversifies as it is their own investment portfolios where this will be considered.