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MARKOWITZ MODEL
SIMPLE DIVERSIFICATION
Portfolio risk can be reduced by the simplest kind of
diversification.
Portfolio means the group of assets an investor owns.
The naive kind of diversification is known as simple
diversification.
In the case of simple diversification, securities are selected at
random and no analytical procedure is used.
Simple random diversification reduces the total risk. The
reason behind this is that the unsystematic price fluctuations
are not correlated with the markets systematic fluctuations.
DIVERSIFICATION & PORTFOLIO RISK
How simple diversification reduces the risk?
Unique
Risk
Standard 3 6
Deviation
The change in portfolio Stock Stock Portfolio
proportions can change the ABC(X1) XYZ(X2) Standard
portfolio risk. Taking the Deviation
same example of ABC & 100 0 3
XYZ stock, the portfolio
standard deviation is
66.66 33.3 0
calculated for different
proportions.
50 50 1.5
0 100 6
Values of Rp and standard deviation p for
varying degrees of correlation co-efficient
Proportion Proportion of Rp S.D p S.D p S.D p S.D p
of X Y security in rxy rxy rxy rxy
security in portfolio 1-X +1 -1 0 +.5
portfolio X
1.00 0.00 5.00 4.0 4.0 4.0 4.0
r=+1 r=-1
Rp Rp
S.Dp S.Dp
RISK & RETURN WITH DIFFERENT
CORRELATION
r=0 r=+0.5
Rp Rp
S.Dp S.Dp
MARKOWITZ EFFICIENT FRONTIER
Portfolio Expected Return (Rp)% Risk (S.Dp)
A 17 13
B 15 8
C 10 3
D 7 2
E 7 4
F 7 8
G 10 12
H 9 8
J 6 7.5