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Discussion on: Diversification to reduce the risk of a portfolio of assets

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The portfolio can be defined as a group of more than one investment or asserts, that is, collection of more than one investment is called a portfolio. The portfolio theory helps to diversify the investment amount in different assets, which reduces the investment risk. The main objective of portfolio theory is to maximize the investment return at the given level of return or minimize the investment risk at the given level of return. The modern portfolio theory originally, was proposed by Harry M. Markowitz, (1952). Harry M. Markowitz received the Nobel memory Price in 1990 for portfolio theory from economy science. The portfolio theory deals with how a risk average investor chooses optimal portfolio which minimizes the risk and maximize the investment return.

The portfolio return is weighted average rate of return of individual securities which are included in the portfolio and it is denoted by E (Rp). The weight being the proportion of rupees amount of portfolio is invested in individual securities divided by the total amount of portfolio. Note that, the sum of weight is always equal to one. Like the expected return of portfolio, the portfolio risk is not weighted average risk of individual assets which are included in the portfolio. The portfolio risk is the function of risk and relative weight of individual assets as well as covariance or correlation co - efficient between return of individual assets of the portfolio. The total risk of a portfolio is measured by either variance or standard deviation of the portfolio. The portfolio risk is maximum if the correlation co - efficient between return of these assets is perfectly positive and the portfolio risk is minimum if correlation coefficient is perfectly negative. Note that, it is possible to create a zero risk portfolio from two assets if the correlation coefficient between these assets is perfectly negative (r = -1). Thus, higher the correlation co - efficient between return of portfolio’s assets, the greater will be portfolio will be portfolio risk and vice versa.

An investor may invest in one or more assets. When he/she invests more than one assets the combination of asset is a portfolio. If I am a business person and I invest the capital in Butwal power Company, Other commercial Banks, Educational Institute and Medical center and others business is portfolio of investment. If I have loss in any sector but other sector almost recover the loss in portfolio so it is less risky investment procedure. We have different types of risk associate in business. Suppose one is overall risk which affect all business at a time like natural disaster, and County economy crisis or political instability but other is within organizational risk. Like employees sticks for their demand and they closed the organization for few days due to this we have risk. But Portfolio refers to the collection of securities. The investor invest in a portfolio of asserts in order to reduce the risk of his/her investment. Risk of a portfolio is reduced when all eggs in one basket’ is a bit of time tested folk wisdom. The basis rational behind making portfolio is derived from the folk wisdom (Landsman & Makov, 2018).

Reducing the risk by means of portfolio is known as diversification Harry M. Markowitz, (1952) has highlighted the need of analysis of correlation between the return of the assets in order to reduce the risk. Analysis of correlation between securities for making portfolio is known as Markowitz’s diversification. If the correlation between two securities is perfectly positive, there will be no benefits of making portfolio of such securities. It is just like putting eggs in two baskets tied together - the fall of one basket id accompanied by the fall of another. The benefit of diversification is achieved when the correlation between two assets is less than +1. If the correlation between two securities is -1, the risk can be reduced to zero at a particular combination of the two asserts.

References
Landsman, Z., & Makov, U. (2018). A Generalized Measure for the Optimal Portfolio Selection Problem and its Explicit Solution. European Journal of Operational Research .

Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, Vol. 7, No. 1. , 77 - 91.