Risk II: Diversification
- Three hypothetical assets
- The correlation coefficient
- Three views on diversification
- The ultimate benefit of diversification
- The role of funds
- The big picture
- Excel section
The idea that the risk of an asset can be thought of as the volatility of its returns measured by the standard deviation seems plausible, doesn’t it? Well, the problem is that it doesn’t extend well to portfolios of assets. And diversification, the issue discussed in this chapter, is the main culprit. You have probably heard the expression ‘Don’t put all your eggs in one basket.’ At the end of the day, this chapter explores the financial side of that time-tested truth.
Three hypothetical assets
Let’s start by considering the returns of the three ...