Equity Recap

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Investment diversification is the financial application of the saying “don’t put all of your eggs into one basket”. Diversification as it concerns investing may apply to all total investments (cash, bonds, stocks etc.) or a specific asset class, such as a stock portfolio. With stocks, research shows that to reduce risk while maintaining the same expected return one should engage in diversification. A simple example of this is to own stock in an auto company and stock in an oil company. Say that an engine comes out that gets 200 mpg in a car. The auto company will experience more sales of cars and the oil company will lose sales of gasoline, but the investor will still have around the same portfolio value. Diversification can be measured by a stock’s Beta which is a measure of standard deviation, calculated from a stock’s price movement. The market (usually S&P500) carries a Beta of 1. A stock Beta >1 implies the stock’s price moves more volatile than the market, and < 1 vice-versa. A stock can have a Beta = 1 and also a negative Beta, meaning the price moves opposite of the market.

Diversification combined with the modern efficient portfolio theory will allow for one to achieve the greatest return for any portfolio of stocks. The efficient portfolio theory is somewhat complicated and lengthy so I won’t go into it in detail here, but there are several concrete truths. Risk and return are positively correlated, meaning the more risk the more reward, noted by the upward-sloping line CAL above. Diversification allows a sloping of the Efficient Frontier Line, meaning one can achieve more reward for the same amount of risk, which is why the line is a hyperbola. Where these two lines meet is the most efficient portfolio possible, which also takes Sharpe’s Ratio to effectively find. So if you aren’t diversified in your stock portfolio you are playing below the Efficient Frontier Line, which means you are throwing away free money. Therein lies the importance of diversification.