Q:Why should I worry about diversification?

A:Diversification of assets is a key factor to lower the total portfolio risk and improve the Sharpe ratio of your total investments.

 

Q:How is diversification going to improve the overall performance?

A:The risk of an asset is measured by its volatility which is a math function of prices variation standard deviation. The total volatility of a portfolio is a math function of the volatility of each asset and the correlation between all assets taken two by two. The smaller the correlation between assets, the smaller the volatility. As a consequence of this, the portfolio Sharpe ratio will be deteriorated or improved.

 

Q:Has correlation between assets a lot of influence in the portfolio total risk?

A:Yes, the importance of intra-correlation in a portfolio is essential. The portfolio Sharpe ratio can be multiplied by 2 or 3. The same happens with maximum drawdowns which are a consequence of the total value-at-risk.

 

Q: I have selected assets which have been proven to be efficient because of good fundamentals and plan to include them in my portfolio. What else do I need to do if I am convinced that these assets are going to over-perform the market?

 

A: There is a lot more you can do to decide whether or not all these assets must be included in your investments. You must look how they are going to perform between them. In other words, are they going to react simultaneously in the same direction or in the opposite direction? You need to measure the intra-portfolio reaction because it directly influences the portfolio value-at-risk. Measuring and improving the level of intra-portfolio risk will improve the Sharpe ratio. As a fund manager you can then decide whether you wish to lower value-at-risk or keep it at the same level and leverage profitability.

 

Q: Let us assume my portfolio is composed of two assets. Each one has a Sharpe ratio of 1.5. and both are considered to be efficient compared to their benchmark How is diversification going to improve my total investment?

 

A:Selecting assets based on Sharpe ratio is certainly an excellent initial solution, but this initial selection must also be analyzed in terms of intra-correlation between these two assets because the resulting portfolio in the worse scenario will have a Sharpe ratio of 1.5, meaning you are not taking advantage of diversification effects. If those two assets are weakly correlated, the Sharpe ratio can be drastically improved.

 

Q:How does weighting affect the Sharpe ratio?

A:The modern portfolio theory has demonstrated through the efficient frontier theory that weights variations inside of a portfolio affects its total Sharpe ratio and an optimum exists for a given level of volatility.