Diversifiable Risk

Diversifiable means that do not put all your eggs in one basket or place all your money in one company.

We have all heard the adage do not put all your eggs in one basket. Well, this applies to your portfolio as much as to other aspects of life. If you place all your money in one company you are vulnerable to adverse news (e.g. a product failure, chief executive's resignation, government rule change) causing a plummet in price. So holding one company's shares in your portfolio will typically result in a high standard deviation. However, if you split your fund between two companies, at anyone time there is a fair chance that bad news affecting one is offset by good news affecting the other, so that overall portfolio returns do not oscillate as much. This principle works even better if you have three, four or five shares in your portfolio - standard deviation tends to decrease. Diversification is a cheap and practical way of reducing your risk. You are highly recommended to do it.

Correlation

Correlations measures the degree to which the returns of two assets move together. 

Correlation measures the degree to which the returns of two assets move together. Correlations are described on a scale that stretches from -1 to + 1. A perfect positive correlation (+ 1) means that the two assets move in lock step with one another. So, if TESCO's share price went up or down by a certain percentage and Sainsbury always went up or down by the same percentage then TESCO and Sainsbury would have perfect positive correlation. A correlation of -1 is perfect negative correlation. This time the movements are exact opposites. If you had an umbrella company that did well in a wet year and its share price rose, you might also have an ice cream company that does badly in a wet year but well in a warm dry year. So the returns for these companies move in opposite directions, depending on the weather. If they moved exactly proportionately in the opposite directions the correlation coefficient would be -1. If they moved in opposite directions most of the time but not perfectly, then the correlation coefficient could be say -0.5. Assets that do not have any common movement at all - if one goes up the other may either go up or down - show a correlation of O.

Diversification is going to be most effective with shares that are negatively correlated. You may have noticed that when the London equity market is up the equity markets in the US and in Europe are also (generally) up. This impression is confirmed by the calculation of correlations which turn out to be around 0.6-0.9 (don't ask about the maths to figure this out).