Fundamentals of Financial Management, Third Edition

3.3 PORTFOLIO RISK

The preceding discussion shows how the risk of a particular investment is computed. The investor tries to reduce the risk involved in the existing portfolio through diversification. Diversification means simultaneous investment in different securities: which may be within the country or outside the country. But diversification will help reduce risk only when the co-variance/correlation of returns between the existing portfolio and the new portfolio is negative. This means that if returns in one set of investments is increasing, they are falling in the other set. If co-variance/correlation is positive it means that if returns in one set are increasing, they are increasing in the other set too, this means that diversification ...