FinanceLesson 2 of 2 in the course How to Think about Investing

Diversification, Correlation, and Portfolio Risk

5 flashcards · 5 quiz questions · 5 match pairs · 3 fill-in sentences · English

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Summary

Investors often hold multiple investments rather than relying on a single stock. This lesson explains how diversification can reduce the impact of company-specific setbacks and why the relationship between assets matters.

A portfolio is a collection of investments held by an investor. Diversification means spreading investments across different assets, such as stocks in multiple companies, rather than concentrating all funds in one investment.

All flashcards

What is a portfolio?
A portfolio is the collection of investments an investor holds.
What does diversification mean?
Spreading investments across assets so that any one holding has less influence on the overall outcome.
What does a correlation coefficient measure?
It describes how two variables move relative to one another; 11 is perfect positive correlation and −1-1 is perfect negative correlation.
Why can less-correlated stocks reduce portfolio volatility?
Their returns are less likely to move together, allowing gains in some holdings to offset losses in others.
Why may several airline stocks provide limited diversification?
They share exposure to industry conditions such as fuel costs and travel demand, so their returns may be highly correlated.

Quiz questions

  1. A product-liability lawsuit affecting one company is an example of which type of risk?Answer: Firm-specific, or unsystematic, risk.
  2. Why does diversification not eliminate the risk from a broad change in interest rates?Answer: Interest-rate changes can affect many companies and therefore create systematic risk.
  3. What typically happens to the risk reduction from each additional stock as a portfolio grows?Answer: The additional risk reduction tends to diminish.
  4. Which portfolio is more likely to be better diversified: 15 highly correlated stocks or 10 less-correlated stocks?Answer: The portfolio of 10 less-correlated stocks.
  5. How should the suggestion that about a dozen stocks may provide reasonable diversification be interpreted?Answer: It is a rough guideline; the suitable number depends on correlation and concentration.

Based on Principles of Finance by Julie Dahlquist, Rainford Knight (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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