Monday, June 24, 2013

Benefits of Diversification

Below, Corrections displays the benefits of diversification.  Returns from the the 1990-1991 stock period, we display the simulated standard deviation from a randomly-chosen portfolio of a given number of stocks and holding it for a year (click to enlarge).
Obviously, choosing a random number of stocks gives the same expected return.  But choosing more stocks reduces the expected noise around that return.  Choosing only one stock will yield a more noisy process than another.  As more stocks are included, the standard deviation of portfolio returns converges down to the market's standard deviation of returns (around 18% for annual returns).

1 comment:

  1. Why did you choose the 1990-1991 period? If you diversified (no pun intended) across years is the result different? What happens if it's in a boom year or crash year? My sense is that it probably won't change the curvature much if at all but am curious to have some data to support that.