Chapter 7: Risk, Diversification & Portfolio Theory

Risk, Diversification & Portfolio Theory establishes the critical distinction between arithmetic and geometric averages when estimating the opportunity cost of capital, arguing for the use of arithmetic means in forecasting future expected returns. The text details the mathematical methods for measuring risk, specifically through variance and standard deviation, and examines how asset returns generally follow a normal distribution. A major focus is placed on portfolio theory and the mechanics of diversification, explaining how combining assets with imperfect correlations can significantly reduce portfolio volatility. The narrative distinguishes between specific risk (also known as idiosyncratic or diversifiable risk) which can be eliminated through diversification, and systematic risk (market or undiversifiable risk) which remains. Key concepts such as the correlation coefficient and covariance are explored to demonstrate how they influence portfolio variance. The chapter introduces the efficient frontier and Harry Markowitz's contributions to modern portfolio theory, showing how investors seek the highest expected return for a given level of risk. Furthermore, it incorporates the risk-free rate to define the Sharpe ratio, identifying the optimal tangency portfolio known as the market portfolio. This leads to the derivation of the capital market line and the two-fund separation theorem, which suggests investors maximize utility by combining the market portfolio with borrowing or lending. Finally, the discussion applies these insights to corporate finance through the principle of value additivity, concluding that corporations should not diversify solely to reduce risk, as investors can achieve this diversification more efficiently on their own.