I am currently a Level 2 CFA candidate as well as a Part 2 FRM candidate.
Several years ago, I immersed myself in my studies after a friend of mine told me about the CFA Institute, so much so that my long-suffering wife has often referred to herself as a “CFA widow.”
For my first post, and for first-timers to finance especially, here’s an awesome explanation that helped me achieve the ‘aha!’ moment on diversification. This should help in your Dec Level I prep!
In preparing for Level I, I initially struggled with the concept of diversifying a portfolio.
If my portfolio consisted of two stocks, I reasoned, then if the price of stock A goes up when the price of stock B goes down (and vice versa), I would have the negative correlation that I want, but how would I make any money? Wouldn’t the price drop of one stock eat into the profit I would have made from the other stock going up? Sure it would.
Or so I thought.
Here’s the explanation that clarified this issue for me once and for all:
Let us suppose, in an imaginary world, only two companies existed: an umbrella company and a sunscreen company. Let us further suppose that the mean growth for each company is 10% and the standard deviation for each company is also 10%.
In this simplified imaginary world, only two types of weather exists. It either rains cats and dogs or the heat is sweltering. The people who inhabit this world don’t like to plan ahead. On the days that it rains, they buy umbrellas. On the days that it is very hot, they buy sunscreen and go to the beach.
I am interested in investing in one or both of these companies. Let’s say I buy stock in the umbrella company and we have a drought for six months. My investment will not be doing so well.
Similarly, if I were to invest in the sunscreen company and it rained everyday, I would be very disappointed.
On the other hand, if I were to buy stock in both companies at the same time, I would be guaranteed a 10% return and my standard deviation would be 0. I will have diversified away my unsystematic risk without sacrificing my return.
Suddenly this highly elusive topic became clear in my mind. And for those of you struggling with this, in your minds as well.
Do you have any ‘aha’ moments where a simple explanation just clarifies everything for you? Let me know in the comments below!
Howard Schwartz is a current Level 2 CFA candidate based in New York City. Read about his bio in our Guest Contributors page.