Diversification of Assets. Explain how diversification of assets eliminates specific risk. Use a numeric example to illustrate your reasoning.

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Explain how diversification of assets eliminates specific risk. Use a numeric example to illustrate your reasoning. (Do NOT use the same numerical example as in the textbook or lecture notes and seminars!)

Use an example of two assets, one with higher return and volatility than the other.

(i)         Calculate the expected return and standard deviation for each asset and compare.

Every asset has an expected return on it as they are forward looking and has a risk attached also. Risk refers to the possibility that the actual return may differ from the expected return of an asset be it more than or less than what was expected. The risk is subject to a combination of both the specific and market risk.

Diversification is a strategy that investors can use to reduce the risk each asset. It is done by investing in a percentage of each asset and placing it into one portfolio.

As investors are assumed to be rational and risk averse. Risk by nature is symmetric, meaning return can be higher or lower than expected however, risk aversion is an asymmetric attitude that investors have to holding financial assets i.e. they are more concerned with the possibility of losing a given amount than the possibility of gaining the same amount. This attitude can be depicted on the diminishing marginal utility of wealth diagram, where the utility (u) from an added amount of wealth is far less than the decrease in utility from a reduction in wealth of the same amount.

Source: Richard G Lipsey and K Alec Chrystal, 2007

This means investors look for the highest return possible for a given risk and look for the lowest risk for a given return. Also, they would not be interested in a risky investment offering the same rate of return as a higher investment; they’d want a higher return for a risky investment than that of a safe investment.

So that investors know better what assets to hold they predict from past results the expected return on each asset for the different states in an economy.

With these figures we can calculate the expected rate of return characterised as  with the formula:

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For asset A A = (0.25x19) + (0.65x15) + (0.1x11) = 15.6

For asset B B = (0.25x20) + (0.65x19) + (0.1x6) = 17.95

Here, Asset B has a higher expected rate of return however with these figures we can now find out the variance and the standard deviation. The variance of the return is a measure of risk. This is the statistic that measures the dispersion of the probability distribution of return which will tell us the risk so therefore, the bigger the dispersion the bigger the risk. “An asset which has shown a wide ...

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