Efficient Diversification

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“The concept of efficient diversification implies that for an investor wishing to efficiently assume risk in their portfolio; the risky part of the portfolio should consist of weighted proportions of all possible risky assets.”

Abstract: Minimizing investor’s portfolio risk was a dominant goal influencing decision making of investment. The effective method of reducing risks was to efficient diversifying the portfolio. The author’s purpose in this article was to share thoughts and concerns about the statement and analyze whether investors actually followed the concept of efficient diversification in their investment.

Efficient diversification was a term familiar with most investors. The concept of the term suggested that putting all of your eggs in one basket was a risky decision. (Bodie, Kane and Marcus, 2009) Efficient diversification was an organizing principle of modern portfolio theory, which largely defined by the work of Harry Markowitz (1991), maintaining that any risk-averse investors would pursue after the highest expected returns for any particular level of portfolio risks. Essential efficient diversification meant that for an investor who wanted to take risks in their portfolio, then he should select a proportion of all possible assets that existed in the world. The objective of efficient diversification was to minimize the portfolio risk with broadly possible investments. By holding a very widely diversified portfolio containing the investments of numerous risky assets in different economic spheres, the risks in the investment portfolio could be dramatically reduced. Securities market as a platform which large amounts of capital traded on was a typical model of the overall financial market. In the stock market, price volatility measured the variance of portfolio return. The greater fluctuation in shares prices, the more risks an investor would bear in holding these particular securities. The following part of this article was going to critical evaluate the meaning of efficient diversification and analyze investors’ performances in this sample market. Efficient diversification was a great “free lunch”. Economists were famous with the announcement that ‘There is usually no such thing as a free lunch’ (Arnold, 2008). However, efficient diversification did offer the free lunch. The reduction in risks was acquirable by efficient diversification. Any investors who broadly spread their wealth among many investments should reduce the volatility of their portfolio, only if the correlation coefficient of these investments was not perfect positive. The more the tendency of correlations among portfolio assets to negative, the more efficient the diversification would be. For instance, as showed in TABLE 1, an investor whose investment portfolio only had stock A, relocated his capital to stock A and B. The standard deviation of his portfolio varied from 30% to 26% and the expected return changed from 18% to 20% synchronously when the correlation was 0.2—a little bit positive. If he relocated it again and adds stock C which correlation was negative 0.4 in the portfolio, the deviation would rapidly decrease to 16% with expected return of 24%. (Table 1) The reduction of expected return was not needed and thus there was no bill for lunch. Even more, there were higher returns and lower risks. The more imperfectly correlation investments in the portfolio, the less risks investors would take. (Rao, 1995) Nevertheless, efficient diversification was difficult to implement in the real world. The first barrier to achieve efficient diversification was that investors did not have enough capitals to put in all possible risky assets. Taking US stock market as an example, we found that there were 7679 companies issuing their stocks in US Stock Exchange and the total shares in the market was over 2 billion. (Financial times, 2005) According to Alton and Gruber’s (1977) research, the standard deviation could be hardly decreased...
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