Efficient Diversification

2432 Words Mar 21st, 2011 10 Pages
Discuss:
“The concept of efficient diversification implies that for an investor wishing to efficiently assume risk in their portfolio; the risky part of the portfolio should consist of weighted proportions of all possible risky assets.”

Abstract: Minimizing investor’s portfolio risk was a dominant goal influencing decision making of investment. The effective method of reducing risks was to efficient diversifying the portfolio. The author’s purpose in this article was to share thoughts and concerns about the statement and analyze whether investors actually followed the concept of efficient diversification in their investment.

Efficient diversification was a term familiar with most investors. The concept of the term suggested that
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Investors, especially small investors could not afford that kind of investment. Institutional investors might have these capitals to invest, but they were not capable to spread their wealth on all possible shares. That was why many economists such as Evans and Archer (1968), Stevenson and Jennings (1984), Gup (1983), Reilly (1985), advised investors that they should relocate their portfolio containing 10 or so stocks rather than all possible stocks to reduce the risks effectively. In this regard, since no one could actually invest all possible assets, the concept of efficient diversification was meaningless.
The second shortcoming of the efficient diversification statement was that some assets cannot be purchased or invested. For instance, there was a stock option in the share market. Stock option was a privilege that gave investors the right, but not the obligation, to buy or sell a stock at an agreed price within a certain period or on a specific date. (Cantrell, 2007) Investors cannot trade on this stock at the certain price without the stock option, although they knew that adding the stock in their portfolio would definitely increase their expected return and reduce the variance of the portfolio. Besides, shares such as company shares different from shares in the stock market were limited to circulate in the market. These kinds of shares were traded on with
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