I have two situation, the first is I have twenty shares, but they are highly correlated, the second is I have twenty other shars, but are low correlated with each other, compared with the first situation should i add more stocks to diversify? or should I add less stocks?
Add if (E®-Rf)/sdev > (E(Rp)-Rf)/sdev*correlation with new security…
how you derive this formula?
The majority of the time that formula will tell you to add the stock to the portfolio unless the correlation between the current portfolio and new stock is fairly high. You are simply comparing Sharpe ratios of pre and post new stock. Check pg. 407 Volume 6
i think you guys just blew his mind. He just wanted to know it take more stocks to diversify a portfolio with lower correlation then a comparable high correlation portfolio.
Thanks, my quetion is another topic, I am asking we should add more or add less in scenario 2 (compared with scenario1, if both two scenario have to add stocks)
I always thought the important thing was to know how your prospective stock was correlated with all the stocks in the portfolio rather than the portfolio stocks correlation with each other…
Haha yeah I think so. linping, to answer your original question, provided that the risk profiles of the two stocks are fairly similar you would most likely always add the security with low correlation to the existing portfolio. Add more.
^ now I think you got this reversed. Pls clarify, what is the relationship between correlation and n? I think you need a lower correlation for diversification to be effective, and a higher n is the solution.
thanks very much, but I think we should add less, because giving low correlation, scenario 2 has low variance(risk) given sigma§ sqaure=1/n*Sigma(stock) sqaue+(n-1)/n *Cov, since cov is low in scenario 2, variance of the portfolio 2 should has less risk, thus it needs less stock to diversify, (compared with scenario1)
I totally misunderstood the first post. I thought we were adding the stocks to an existing portfolio. You are correct.
no. I’m talking about adding stock to existing portfolio, portfolio 2 has 20 stocks, but each stock low correlation, portfolio 1 has 20 stocks, but each stock high correlation with each other. I’m asking if I already add 10 stocks to porfolio 1, should I need to add more than 10 or less than 10 stocks to portfolio 2? if this 10 stocks has no correlation with exsiting portfolio. so how you come N increases with low correlation, under which other circumastance? pls justify if you are talking another topic.
why N(number of stocks) increases with low correlation?