Is a diversification strategy a good way to improve the EXPECTED RETURN of a portfolio?
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Every asset class has a different investment purpose. The portfolio return is the sum of interest, dividends, and capital gains. The risk attached to a particular portfolio is the variation expressed as the standard deviation of returns of each asset class. Standard deviation is a statistical measure of the amount of variance of the return from the average at any one time. In 1952, Harry Markowitz developed his theory on portfolio diversification. Later, Bill Sharpe added work on the optimization of return and risk. The two men shared the Nobel Prize for Economics in 1990. Their work illustrates how diversification can reduce risk to acceptable levels, and increase returns over the long term.
Markowitz and Sharpe discovered that if a portfolio was diversified by asset class, then the overall return from the portfolio could be improved for a given risk tolerance. Diversification lowers the risk attached to a portfolio due to the fact that returns of the various asset classes are not totally correlated. A portfolio of securities has an expected return that is a proportional blend of the expected returns of the individual securities. Risk is the possibility of unexpected changes in return as measured by standard deviation. Risk is not a proportional blend, but rather is beneficially lower by different amounts based on asset mix, and the asset correlation.
When a portfolio contains one asset class, the risk of the portfolio is the risk of the ...
The 925 word solution presents a good discussion about diversification in portfolios.