Diversification in Stock Portfolios - Speech or Presentation Example

In the second economy, the price of one stock does not affect the price of the other and hence the stock returns are independent.

Diversification in stock portfolios represents a reduction of risk by investing in a variety of stocks. It is a common approach based on the old saying that ‘one should not put all his eggs in a single basket’. An investor who diversifies her assets among numerous investments or stocks can lessen the instability of her portfolio, proviso the stocks are imperfectly correlated (Campbell, 2000). Correlation is an evaluation of how two stocks move in comparison to each other, they are said to be correlated if both of them move in a similar trend. If all the stocks in a particular portfolio shift in a similar direction i.e. when markets are favorable all the stocks show an upward movement and when markets are not favorable all of them show a downward slide; then such a portfolio cannot be considered to be properly diversified. Thus, mere investment in various stocks does not diversify one’s portfolio; one has to also consider the correlation between the stocks in which one’s asset has been invested.

An association between two stocks can be positively correlated, negatively correlated, or non-correlated. In some instances, these positive correlations are easily visible, for example in the cases of gasoline and crude oil or silver and gold (Tanous, 2008, p.48).  In such cases, as one market moves, the other tends to move in the same trend.  Therefore, diversification would not be accomplished by buying both gold and silver or gasoline and crude oil. Negatively correlated stocks tend to progress on opposite tracks, when one moves up, the other moves down. While negative correlations do offer diversification opportunities, they might not be the best strategy to employ as they tend to neutralize the returns achieved. 

When looking for diversification prospects, it is significant to focus on stocks that are non-correlated to one another. Such stocks are independent of each other and it is best to hold the stocks that will profit independently (Patel, 2004). The returns on two or more completely correlated stocks would shift toward positive and negative directions together and a portfolio of such stocks would be precisely as risky as the individual-specific stocks (Besley &Et. Al, 2007, p.320). Thus, investing in the first economy, where the stocks in the portfolio are inclined to shift in the same way, is not advisable.  Investing in stocks that do not correlate with one another can help to reduce risk without compromising on the returns (Patel, 2004, p. 78). Thus, it is advisable to invest in stocks in the second economy.