Diversification and Portfolio Risk Reduction in Corporate Finance

CORPORATE FINANCE
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CORPORATE FINANCE
Question 2
The diversification concept forms the basis of outlining the impact of a new stock in the
portfolio. Diversification is considered beneficial as there are two kinds of risk associated
with investing in risky financial asset classes. One of these is the systematic risk while the
other is unsystematic risk. If the investors form a well-diversified portfolio, they can
minimise the unsystematic risk but the systematic risk would remain. Considering that
formation of a diversified portfolio leads to potential minimisation of unsystematic risk,
hence to that extent addition of a new share would reduce the overall portfolio risk. (Petty et.
al., 2015).
However, the precise impact of addition of new stock on risk reduction would be dependent
on the correlation between the returns of the new share with the existing portfolio. A negative
correlation in this regards is favourable since it would lead to higher risk reduction as
highlighted in the following formula for portfolio risk for a two stock portfolio (Damodaran,
2015).
P1,2 denotes the correlation coefficient in the above formula and it is not hard to see that if this
is negative, there would be a net reduction in the portfolio risk. This can also be understood
by mirroring the respective movements of the two stocks. Stocks having negative correlation
coefficient on their returns would tend to move in opposite direction and hence extreme
variations from mean would be curtailed owing to a natural hedge mechanism in place
(Parrino & Kidwell, 2014). It would be imprudent to conclude that risk would not be reduced
in case of positive correlation. Risk reduction would be exhibited in stocks having positive
correlation between returns but the extent is lesser. However, a key advantage of portfolio