Lesson 1 of 7 · All lessons in this module
- The portfolio approach and diversification
- The portfolio management process: planning, execution, feedback
- Individual investors and DC versus DB pension plans
- Institutional investors and their needsVideo lesson
- The asset management industry
- Mutual funds: open-end, closed-end and fund types
- SMAs, ETFs, hedge funds and private equity
Free lesson: the first lesson of every module is open to everyone.
Lesson 1 of 7 · 14 min
The portfolio approach and diversification
Judge every investment by what it adds to the whole portfolio, because combining assets that do not move in lockstep cuts risk far more than it cuts return, although that protection can shrink just when markets crash.
In short
- The portfolio approach evaluates each security by its contribution to the risk and return of the whole portfolio, not in isolation.
- Concentrating wealth in one company (especially your employer) can be ruinous: if it fails, you can lose your job and your savings at the same time.
- Diversification lowers volatility without necessarily lowering expected return: portfolios affect risk more than returns.
- The diversification ratio = standard deviation of the equally weighted portfolio ÷ standard deviation of a randomly chosen single security. Lower means more risk reduction.
- Diversification is risk reduction, not risk elimination and not downside protection: in a severe crisis correlations rise and assets fall together.
- Modern portfolio theory (Markowitz) says the relationships between assets matter; later work (Sharpe, Lintner, Treynor) led to the CAPM, where only systematic (non-diversifiable) risk is priced.
Why think in portfolios at all
Every investor, from a saver planning retirement to an insurer that must pay claims, has to decide how to invest for future needs. One basic choice comes before picking asset classes: do you assess each security on its own, or by what it does to the portfolio as a whole? The portfolio approach takes the second view.
The most vivid argument is disaster avoidance. Picture an engineer at a fast-growing firm who keeps all his retirement savings in his employer's shares because they have beaten the market for a decade. If the firm collapses, his savings and his salary disappear together. The old advice not to put all your eggs in one basket is exactly the portfolio approach.
Employer-sponsored retirement accounts have shown this pattern repeatedly: employees free to sell company shares often kept large holdings, and when the company's share price collapsed, so did their retirement wealth. Holding many assets spreads that company-specific risk away.
A concentrated position in your own employer is a double bet: your human capital (your wages) and your financial capital depend on the same company.
Portfolios cut risk more than they cut return
Suppose you must buy one of several shares next year and have no reliable way to tell which will do best. Your expected outcome is like picking one at random: you get the average return of the group and roughly the average volatility of a single share.
Now invest equal amounts in all of them. The equally weighted portfolio earns the average of the individual returns, so its expected return is the same as the random pick. But its standard deviation is lower than the average single-share standard deviation, because the shares do not all rise and fall together; some losses are offset by gains elsewhere.
Because the expected return is unchanged, a simple gauge of the benefit is the diversification ratio: portfolio standard deviation divided by the standard deviation of a randomly selected single security. A ratio of 70% means the portfolio carries 70% of the single-security risk for the same expected return. Choosing companies from different industries, rather than one industry, would usually push the ratio lower still.
Weights matter too. Equal weighting is only one choice. Other mixes of the same assets can deliver the same expected return with even lower risk, or more return for the same risk. The set of best risk-return combinations is the focus of portfolio optimisation.
| Random single security | Equally weighted portfolio | |
|---|---|---|
| Expected return | Average of the securities' returns | Same: average of the returns |
| Standard deviation | Roughly the average single-security SD | Lower: less than the average SD |
| What drives the difference | None | Imperfect co-movement (correlation) between securities |
No guarantee of downside protection
Diversification works because assets do not move perfectly together. But those co-movement patterns are not fixed. In calm markets, equity indexes in different regions may move fairly independently; in a global crisis they can all fall at once.
When correlations rise, the diversification ratio climbs toward 100% and the portfolio behaves almost like any single index. Diversification still spares you the very worst performer, but it does not stop the portfolio from losing heavily. If an economy or market fails completely, diversification within it offers little.
So the correct exam phrasing is that portfolios reduce risk. They do not eliminate risk and do not guarantee downside protection.
Modern portfolio theory in one paragraph
Diversification is an old idea, but its formal theory began with Harry Markowitz's 1952 work on portfolio selection, the basis of modern portfolio theory (MPT). Its key message: investors should hold portfolios and pay attention to how the securities in them relate to each other, not just to each security's own risk and return.
Building on this, Sharpe, Lintner and Treynor showed how holding assets in well-diversified portfolios determines each asset's risk premium (expected return above the risk-free rate). Once diversifiable risk can be spread away, only the remaining systematic (non-diversifiable) risk should affect price and expected return. That idea underlies the capital asset pricing model (CAPM). MPT has limitations, but its intuitions remain the foundation of portfolio management.
Formula
- Diversification ratio
Both have the same expected return, so the ratio isolates risk reduction. Lower ratio = bigger diversification benefit; a ratio near 100% means almost no benefit.
Worked examples
Example 1 Measuring the diversification benefit
An analyst studies four listed retailers. Picking one at random gives an expected annual return of 9% and a standard deviation of 32%. An equally weighted portfolio of the four has a standard deviation of 20%. What are the portfolio's expected return and diversification ratio?
Example 2 Diversification in a crash
In normal years, an equally weighted portfolio of five regional equity indexes has a standard deviation of 15%, against 20% for a randomly chosen index. During a global crisis, the figures become 33% and 34%. Compare the diversification ratios and explain the change.
On the exam
Expect conceptual items: what the portfolio approach provides (risk reduction, not elimination or downside protection), that portfolios affect risk more than returns, the meaning of a diversification ratio, and MPT's emphasis on how securities relate to one another.
- Saying diversification eliminates risk or guarantees downside protection. It only reduces risk, and less so in crises.
- Thinking the equally weighted portfolio's standard deviation is the average of the individual standard deviations. It is lower whenever correlations are below one.
- Reading a higher diversification ratio as better. Lower is better; it means less risk for the same return.
- Assuming portfolios mainly boost returns. Their main effect is on risk.
Check yourself
Q1The main benefit of combining securities into a portfolio is most likely:
Q2A randomly chosen share has a standard deviation of 25%; an equally weighted portfolio of the same shares has 18%. The diversification ratio is closest to:
Q3Compared with picking one share at random, an equally weighted portfolio of the same shares most likely has:
Q4According to modern portfolio theory, investors should focus most on:
Q5Under capital market theory, the risk that should affect an individual asset's price is:
Answer the 5 questions: +10 XP for each one you get right first time.
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