Course 503: Modern Portfolio Theory
Diversification and an "Efficient" Portfolio
In this course
1 Introduction
2 Risk and Return
3 Diversification and an "Efficient" Portfolio
4 Applying Modern Portfolio Theory to Your Investment Reality

According to MPT, you can limit the volatility of your portfolio by spreading out your risk among different types of investments. In fact, by putting together a basket of risky or volatile stocks, the overall risk of the portfolio would actually be less than any one of the individual stocks in it.

Diversification depends more on how the securities perform relative to one another than on the number of securities you own, though. Markowitz compared a portfolio of 60 railway securities with another portfolio of the same size that included railroads, utilities, mining, and manufacturing companies. He concluded that the latter is better diversified. "The reason is that it is generally more likely for firms within the same industry to do poorly at the same time than for firms in dissimilar industries," he says.

The "right" kind of diversification requires that you own securities that don't behave alike. In other words, their price movements have low correlation with each other.

Correlation measures the degree at which two securities move in similar patterns. Its value ranges from -1.0, indicating two securities moving perfectly opposite each other, to 1.0, indicating two securities moving in tandem. So to spread out your risk, you would want the securities in your portfolio to have correlations closer to -1.0 than to 1.0.

According to Markowitz, the goal is to craft an "efficient" portfolio. An efficient portfolio is either a portfolio that offers the highest expected return for a given level of risk, or one with the lowest level of risk for a given expected return. The line that connects all these efficient portfolios is the efficient frontier. The efficient frontier represents that set of portfolios that has the maximum rate of return for every given level of risk. The last thing investors want is a portfolio with a low expected return and high level of risk.

No point on the efficient frontier is any better than any other point. Investors must examine their own risk/return preferences to determine where they should invest on the efficient frontier. But, theoretically at least, the efficient frontier allows you to reduce your risk at no cost in return. Or you can increase return at any particular level of risk.

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