3.2 Diversifying investments dilutes risk
In this and the next few sections, you will explore how the trade-off between risk and return can be improved by holding a mixture of shares or other investments in a portfolio. This can be viewed as part of the third stage of the investment planning model – the process of deciding on investment strategies that fit with our time horizons and risk appetites. Let’s look first at the subject of diversification.
The analysis you need to undertake here and in the next two sections is a little complex, so there will be animations to guide you.
Download this video clip.Video player: ou_futurelearn_mmi_vid_1083.mp4
Transcript
MARTIN UPTON:
This animation shows why diversifying your investments is a good idea.
Company shares that trade on the stock market are often closely associated with each other. Imagine there was one company selling sun hats and another company selling ice cream. Putting both these shares in a portfolio may not be a good idea, since they are both exposed to a similar risk, the risk of bad weather.
If the weather is cold and wet, both companies might suffer from lower than expected sales and, therefore, lower than expected profits. As a result the price of shares in both companies will be likely to fall.
But what if an investor also bought some shares in a company selling hot chocolate? Here, as a result of the same spell of bad weather, high sales and higher than expected profits can lead to an increase in the share price of the company.
The risk of loss from cold weather has been reduced through diversification. By holding a combination of shares, ones that are unlikely to all move in the same direction at the same time, investors can reduce the risk of loss. So our imaginary portfolio is in better shape for including the hot chocolate company.
Investors use statistics to help establish which combinations of shares are most suitable for diversification. The type of statistics used can be illustrated by considering the example of three companies, Gelato, Solcap and Hotchoc. Gelato makes ice cream, Solcap makes sun caps and Hotchoc makes hot chocolate.
As you can see the share prices for Gelato and Solcap tend to move together over time. When one rises, the other rises, And when one falls, the other falls.
In statistics, this type of close association is described as a strong correlation between variables. Here the variables are the share prices. When the variables are not very well associated with each other, this is described as weak correlation.
In addition to the strength or weakness of correlation we also look at the direction of the association, is it positive or negative? The association between Gelato and Solcap share prices is positive, this means that the share prices move in the same direction.
As you can see, in cold spring weather, Solcap is priced at £160 and Gelato at £150 per share. But when a particularly warm summer comes they both have much higher prices with Solcap at £227 and Gelato at £313 per share as a result of higher than expected profits.
When Gelato’s share price is low the share price of Solcap is low; when Gelato’s share price is high, Solcap’s is high. This type of association between Solcap and Gelato is called a positive correlation.
Perhaps in that spring the weather was worse than expected, so both shares were low in price, while in summer the sequence of good weather led to better results than expected for both ice cream and sun hats.
While positive correlation offers the possibility for diversification, it is not to the same extent as negative correlation.
Now let’s consider an example of negative correlation, the share prices of Gelato and Hotchoc. These shares tend to move in opposite directions to each other, with higher share values of Gelato tending to be associated with lower values of Hotchoc. When Hotchoc is £66 per share, the share price of Gelato is £150; but when Hotchoc goes down to £46, we see that Gelato is up to £313. When there is negative correlation between the price changes, this provides more of an opportunity to reduce risk through diversification.
In our example, the investor might combine Hotchoc shares with shares in Gelato, in order to spread the risk associated with future weather conditions. With this first investment management principle in mind, that diversification reduces risk, we turn in the next section to the next question: how do we determine our desired combinations of different shares within a portfolio?
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