Page 66 - FINAL CFA SLIDES DECEMBER 2018 DAY 11

Session Unit 12:

39. Portfolio Management: An Overview

LOS 39.a: Describe the portfolio approach to investing., p. 102

Portfolio (approach) perspective suggests that rather than looking at the individual risk and returns
characteristic, taking a holistic view by combining assets with negative correction in their risk-return
characteristics can reduce/diversify overall portfolio risk whilst not reducing overall portfolio return.

Other words, modern portfolio theory concludes that the extra risk from holding only a single security

is not rewarded with higher expected investment returns. Conversely, diversification allows an
tanties
investor to reduce portfolio risk without

Diversification ratio captured the benefits of portfolio approach: it is the ratio of the risk of an
equally weighted portfolio of n securities (measured by its standard deviation (SD) of returns) to the
risk of a single security selected at random from the n securities.

• Average SD of returns for the n stocks = 25%, and
• Average SD of returns for an equally weighted portfolio of the n stocks = 18%,

Portfolio Diversification ratio is 18 / 25 = 0.72 (the greater the ratio, the larger the benefit)

Portfolio diversification works best when financial markets are operating normally; diversification
provides less reduction of risk during market turmoil, such as the credit contagion of 2008. During

periods of financial crisis, correlations tend to increase, which reduces the benefits of
diversification.