In this video I give a definition for Diversification
VIDEO SUMMARY
Portfolio Theory – Part 3 (Diversification)
In this video we are going to continue talking about portfolio theory. Specifically, we are going to talk about diversification. I want to give you a really firm definition of diversification because I think that not a lot of people know what it actually means. Some people think it is just investing in different areas, but it is a little bit more specific than that. So I really want to nail it down. Here is the definition for diversification. It is combining investments together with negative correlations to reduce portfolio risk. So when we look at this definition, what we realize is that it is all about negative correlations.
So what is a correlation? Correlation is a term from statistics that refers to the description of the movement of two investments. So what you do is you run a linear regression analysis and one of the outputs of that is what is called the correlation coefficient. These correlations describe how two investments move compared to each other. What you get is a range between positive 1 and negative 1 and all correlations fall within that range. If the number is positive, they are positively correlated. If it is negative they are negatively correlated. And if it is zero, that means there is no correlation, or there is no discernible relationship.
Let me give you some examples to explain. A positive correlation would be two investment opportunities that tend to move in the same direction. So let us say you are looking at two stocks. When one stock goes up, the other stock tends to go up. You would describe those investments as positively correlated. An example of where this would happen would be if you had two very similar companies. Let us say the companies are relatively the same size, they are in the same industry, and they create similar products. So the two companies are very similar, and you can think of lots of examples of this. What happens is their stock prices tend to move in very similar ways, because if some big event happens in the economy, it is likely going to effect both of these companies in the same way. So if one company stock goes up, the other company stock is going to go up as well. Then let us talk about negative correlations. So a negative correlation would mean that if one investment opportunity goes up, the other investment opportunity would go down. So they would move in opposite directions. The most famous example of this is the asset classes of stocks and bonds. Historically you see this trend over time that as stock prices go up, bond prices go down. This tends to happen in really good economic conditions because people are moving their money out of the bond market and into the stock market to take advantage of higher profits. So stock prices tend to go up and the bond market tends to go down. The opposite is also true. In more uncertain economic conditions, stock prices go down and bond prices go up as people move their money out of the stock market into less risky asset allocations like the bond market. So this is an example of negative correlations. If we had a correlation of 0, that would be no correlation. So we would have two stocks where we cannot really predict how they are going to move against each other. If one stock goes up, we do not know if the other stock is going to go upwards or down. We really do not see any predictable relationship. So correlations can fall on this range. It could be 0.75 correlated or a negative 0.25 correlated. You are just trying to understand the description of how these two investment opportunities are related.
The key here, when we talk about diversification, is we are really focusing on these negatively correlated investment opportunities, because what happens is the fluctuations tend to even themselves out. So if you have two investments, and they are negatively correlated, if one investment loses money, the other investment gains money. So overall they even each other out and you are experiencing less risk. Let us consider the instance of stocks and bonds. If you had all your investments purely in the stock market, you would experience these fluctuations of up and down, up and down, as the stock market experiences fluctuations. So there is risk there. You are experiencing uncertainty. Whereas if you have a portfolio of stocks and bonds, the negative correlations between those would help to even those fluctuations out. So overall you are experiencing less risk, less fluctuations, and less uncertainty. Something else I want to mention is that you may make the strategic decision not to diversify, not to partake in diversification, because you may not want to reduce the overall return in a specific asset class. So there is more that goes into the strategic decision of how to use diversification in your portfolio. But in general, what I want to get across in this video is the definition of diversification. If you really understand what it means, you can make better financial decisions. So in the next video, we are going to continue talking about diversification in portfolio theory, and we are going to go through the math. I am going to show you exactly how this fits into those equations.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.