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The Critique Of What Measures The Benefits Of Diversification

1627 words - 7 pages

Introduction
The basic premise of investment would tell us that investors like return and definitely dislike risk. More often than not, people will invest in risky assets only when they expect to receive higher returns. Thus, people find it important to define precisely what the term "risk” means as it relates to investments. It is also important to examine procedures that people, more specifically financial analysts use to measure risk and to discuss the relationship between risk and return (Liang & McIntosh, 1999). As a fact, risk can be measured in different ways, and different conclusions about an asset’s riskiness can be reached depending on the measure used. Based in the work of Brigham and Houston (2009) in the book Fundamentals of Financial Management, “In the real world, where the correlations among the individual stocks are generally positive but less than +1.0, some, but not all, risk can be eliminated”. Therefore, it is somehow impossible to form completely riskless stock portfolios whose correlations were zero or negative. Investowords define diversifiable risk as, “The risk of price change due to the unique circumstances of a specific security, as opposed to the overall market”. These events are usually random thus their effects on portfolio may be eliminated through diversification, which means to say that bad events in one firm will be offset by good events in another. The authors of the paper were able to point out significant details such as providing concrete examples of these risks and ways to eliminate them. It also helped that they were able to discuss the differences of one risk to another and how it significantly affects an investment. On the contrary, although the authors provided a good discussion on these risks and presented in detail the computations needed to arrive at a percentage index or risk, the paper did not present enough background of the study to enable first-time readers to get their point. The paper is well made and can be understood by people who have read about the topic or have knowledge about investment’s risks and returns.
Measuring the benefits of diversification
Portfolio diversification mitigates the risk of financial exposure against some extreme events in the market place. The effectiveness of such diversification can be achieved through investing in different asset classes varying in terms of risk, volatility, and return, leading to the reduction of specific risk (www.direxionfunds.com). Furthermore, the correlation factor among the returns of different financial instruments within a portfolio should be taken into account. The works of both Harry Markowitz and James Tobin resulting in the Mean-Variance Model, which illustrates that risk minimization through portfolio diversification relies on correlations among return distributions of individual securities (Delcoure,2011). Thus, the benefits of diversification are greater when the correlation of the returns of individual securities is declining...

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