#1. How exactly does diversification help in reducing your portfolio risk?
Diversification allows investors to allocate funds between different assets which helps in reducing the risk. Such diversification could be done between different asset classes or between securities within those asset classes. Diversified portfolios have a lower risk (measured by variance or standard deviation) than any other un-diversified portfolio or risk of individual asset position within that portfolio. This is due to the relationship that exists between different assets (called correlation) such that the overall risk is lowered by including additional assets in the portfolio.
#2. How expected return and standard deviation can be used in determining an efficient portfolio?
It is observed from human psychology that we humans want to bear the minimum risk and achieve a greater level of returns. However, in real life (also, as per portfolio theory written by Markowitz in 1952), risk and return go hand in hand.
The main purpose of this entire exercise of portfolio optimization is to maximize the overall portfolio returns and minimize the portfolio risk with the help of Sharpe's ratio. We maximize the Sharpe's ratio which in turn uses expected return and standard deviation for the purpose of determining an efficient portfolio.
#3. What is correlation and how does it help in diversifying a portfolio?
#4. How correlation coefficient is different from covariance?
One most important aspect of portfolio management is the diversification benefit which is captured by the correlation coefficient- to measure the amount of diversification among the assets contained in a portfolio. And for that, we have to identify the covariance- which measures the directional relationship between each pair of stocks in a portfolio. So, covariance is a statistical measure that describes the directional relationship between two random variables (whether they are positively or negatively correlated) and correlation is a statistical measure that quantifies the direction and strength of linear association between those variables (from -1 to +1).
#5. Do you think the more diversification the better?
There is no doubt that diversification helps in reducing the overall portfolio risk but,
diversification not only results in reducing the overall portfolio risk but after a certain point, it starts reducing the return possibilities as well and which can result in over-diversification. It occurs when the number of investment assets in a portfolio exceeds the level where the marginal loss of expected return is greater than the marginal gain of reduced risk. This pitfall in portfolio management actually erodes investor returns. Experts believe that a well-diversified or an optimal portfolio should comprise assets between 15 to 30 (spread across different asset classes, sectors, and industries) to diversify away, the unsystematic risk.