Introduction to Corporate Finance

PART 2: VAlUATION, RISK AND RETURN

This is a key point. Individual shares generally display much higher volatility than do portfolios

of shares.^12 Diversification, the act of investing in a variety of different assets rather than just one or

two similar assets, explains why a portfolio usually has a lower standard deviation than the individual

securities that make up that portfolio. We can offer some simple intuition to explain this. In any given

year, some securities in a portfolio will have high returns, while other securities in the portfolio will

earn lower returns. Each year, the ups and downs of individual securities at least partially cancel each

other out, so the standard deviation of the portfolio is less than the standard deviations of the individual

securities. The diversification principle works not only for individual securities but also for broad classes

of investments, which are often referred to as asset classes.

Figure 6.7 demonstrates the impact of diversification with just two stocks, Coca-Cola and Archer

Daniels Midland (ADM).^13 In each year from 2000–10, we plot the return on these two stocks. Recall

from Table 6.6 that both Coca-Cola and ADM have an average return close to 10.5%, so we have drawn

a horizontal line across the bar chart to highlight the average performance for these companies. Also,

recall that the standard deviation of Coke’s returns is 21.3%, and for ADM the figure is 24.8%. Notice

that in the years 2001–03 and 2006–08, Coca-Cola’s returns and ADM’s returns were moving together,

in the sense that both stocks displayed above-average or below-average performance in the same year.

However, in 2000, 2004, 2005, 2009 and 2010, one stock had an above-average year, while the other had

12 The same statement could be made for other types of assets (for example, that individual bonds are more volatile than a portfolio of bonds).

13 Figure 6.7 uses data from 1993–2010, but we only show the year-by-year returns from 2000–10.

FIGURE 6.7 ANNUAL RETURNS ON COCA-COLA AND ARCHER DANIELS MIDLAND

The figure illustrates how diversification reduces volatility. Both Coca-Cola and ADM earned an average return of about

10.5% from 1993−2010, but the two stocks did not always move in sync. In some years, one stock had an above-average

year while the other stock performed below average. The net effect of this is that a portfolio containing both Coca-Cola and

ADM would be less volatile than either stock held in isolation.

Coca-Cola

ADM

50–50 portfolio

– 40%

– 30%

– 20%

– 10%

0%

10%

20%

30%

40%

50%

Year

Annual return

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Coca-Cola standard deviation 21.3%

ADM standard deviation 24.8%

Portfolio standard deviation 19.9%

average return

= 10.5%

diversification
The act of investing in a variety
of different assets rather than
just one or two similar assets