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Equity Portfolios: Diversification

Look at the summer sales volumes of two business, X and Y, both located in a holiday resort.

If we directly invest in X or Y, the change in sales revenue will form the major constituent of our total return. On average X and Y give about the same return, but if we diversify our investment, putting half in X and half in Y, the movement in our portfolio's revenue looks like this.

Our return is now half X plus half Y, which is much the same as before, but now much of the volatility has disappeared and so our risk/return trade-off has improved significantly.

If we reveal that X sells ice cream and Y sells umbrellas, then we can see that for both of them, the weather is a major risk factor affecting sales - but with opposite effects for each business.

Such factors, which affect some but not all businesses, are called elements of specific risk.

By investing equally in both X and Y, we have nullified the major specific risk of both businesses, so we are effectively left with the overall trend of both. The largest remaining influence on sales is probably the amount of tourists around with money to spend on ice creams or umbrellas. Background socio-economic factors affect all businesses and are called elements of market risk.

This idea can be generalised to movements in share prices, which are simply reflections of overall market expectations of futures business fortunes.

Share prices that more often than not move in opposite directions are said to be negatively correlated - and the cancellation effect of diversification is most dramatic with such investments.

However, diversification benefits can be achieved wherever two investments are anything less than perfectly positively correlated.

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