Class, in order to reduce risk through diversification your investments should be uncorrelated, thus when one investment goes up the other one goes down, this will reduce overall volatility. So let’s try an experiment. See the data below:
Let’s assume stock A and stock B are 100% uncorrelated with each other. During a Bull market stock A has a 50% chance of making 50% return and during a Bear market stock A has a 50% chance of losing 25%. Now during a Bull market stock B has a 50% of losing 25%, but during a Bear market it has a 50% chance of making 50%.
Calculate their expected returns by taking the probabilities times the gains or losses and add them up. I will do the calculations for you.
Stock A: (.5) * 50% + (.5) * -25% = 12.5% Expected Return
Stock B: (.5) * -25% + (.5) * 50% = 12.5% Expected Return
Now, class, see the results above and tell me is there any risk? In this situation does it matter if we have a Bull Market or a Bear Market and why?
