Salient Capital has written a very good white paper on the effects of diversification. Using simple concepts from modern stock portfolio theory, the authors describe what they call the “free lunchtime effect” and make an integral distinction on how risk reduction occurs in a stock portfolio. There is nothing truly new here however the presentation properly shows both different channels of diversification and the key impact of their free lunch time effect. This effect is the gain from diversification through keeping uncorrelated possessions.
When you add an asset to your portfolio, you truly impact volatility through two channels. One, there’s a de-risking channel because volatilities are not the same. You can reduce collection risk with the addition of property which are less dangerous just. That’s easy. But, there is a significant cost because coming back will also fall and at best be the weighted average of the earnings between property. De-risking diversification alone, when the relationship between resources is one, does not improve information ratios.
It is the second channel through distinctions in correlation that provides investors with a real advantage. As the relationship declines, the advantage of diversification increases. That is true diversification because you can lower risk for the collection by more than simply the weighted average of asset volatility contained in the portfolio.
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You get a gain in the information percentage of the portfolio. The table above shows the impact of adding bonds for an equity portfolio through the easy mix of an equilibrium 60/40 blend. Since bonds have a lesser volatility, you shall get a lower risk, but there is the added benefit from the known fact that the two assets are not flawlessly correlation. However, you may take a deeper view and find out that most of the risk reduction originates from de-risking rather than diversification.
The lower return originates from just keeping a less risky asset which acquired historical lower performance. If it’s low correlation that provides the most portfolio benefit and not de-risking, it makes sense to hold a dangerous asset with corresponding higher return that provides more bang for the buck from its low correlation. It generally does not make sense to carry a low correlated low-risk asset.
The physique below shows the added free lunchtime effect from holding a risky asset which is uncorrelated. This solution is all powered by the easy formula for locating the volatility of two resources. Every one of the action is within the correlation between the two property. So if you would like the free-lunch time effect, what possessions should you buy?