Final answer:
In stock portfolio management, including stocks with a high positive correlation can be risky as it may lead to amplified losses during market downturns. Diversification using stocks with low or no correlation is ideal. Historical profit records do not guarantee future capital gains in stock investments.
Step-by-step explanation:
Understanding Stock Portfolio Diversification
When compiling a portfolio of stocks, the goal is to maximize returns while managing risk. One important aspect of risk management is diversification, which aims to spread investment risk across various assets. When it comes to the correlation between the stocks in a portfolio, diversification benefits are generally best achieved by including stocks that exhibit low or no correlation with each other. This is because the performance of one security has little effect on the others within the portfolio.
To answer the specific question, stocks that exhibit a high positive correlation tend to move in the same direction. Therefore, if one stock in the portfolio experiences a drop in value, others are likely to follow suit, potentially amplifying losses. Conversely, stocks with high negative correlation would move in opposite directions, which could be beneficial for reducing risk, but not necessarily for maximizing overall portfolio returns. Having no correlation would be ideal as it provides the best risk-spreading benefit.
Historically, having a high risk level without proper diversification has been detrimental to an investment portfolio. The stock market crash of 1929 is an example where risky investments and borrowing heavily to invest led to a catastrophic outcome for many investors.
Regarding the inability of a financial investor to earn high capital gains simply by buying companies with a demonstrated record of high profits, it's important to note that past performance is not indicative of future returns. A company may have been profitable historically, but due to market competition, changes in consumer preferences, or evolving technology, profits do not guarantee future success or stock price appreciation. Moreover, if these high profits are already recognized by the market, the stock price may already reflect this, leaving little room for capital gain.