Portfolio Diversification

6 Key excerpts on "Portfolio Diversification"

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  eBook - PDF

  Financial Analysis with Microsoft Excel

  • Timothy Mayes(Author)
  • 2020(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 14 Portfolio Statistics and Diversification 452 spread one’s funds across several investments in the hope that some will be profitable enough to more than offset the losses of others. This is known as diversification, and it is the subject of the current chapter. Portfolio Diversification Effects A portfolio is a collection of assets. An individual’s portfolio consists of all of the assets that the individual owns. For the manager of a mutual fund, the portfo- lio comprises all assets under management, whether they are stocks, bonds, real estate, another asset class, or a combination of asset classes. From the stockholder’s point of view, a corporation is similar to a mutual fund. That is, a corporation is simply a portfolio of investments (projects) managed by a professional manage- ment team. Why do investors, whether individuals or corporations, typically own portfolios that consist of more than one asset? Because a portfolio of multiple investments typically offers lower risk than owning a single asset. Often, a portfolio will have less risk than any of the individual investments that it contains. There may be a cost, in the form of a somewhat lower expected return when compared to the highest return alternative, but the overall risk/return trade-off is improved. This reduction in risk is known as the diversification effect. It will be helpful to examine the effect that the addition of risky assets has on the overall risk of the portfolio. Let’s look at an example using stock selection (though the same concept applies to capital investment projects). Suppose that you have $10,000 available for investment purposes. Your stockbroker has suggested that you invest in either stock A or stock B, but you are concerned about the riskiness of these stocks. During your investigation you gathered the historical returns shown in Table 14-1.

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  Trading Systems and Methods

  • Perry J. Kaufman(Author)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  If the objective function is the return, then the method that yields the highest net profit is the best answer. If the objective function is the return ratio, then the highest return divided by risk is the best answer. Passive investment is a buy-and-hold strategy and is used as a performance benchmark. String, a single entry in a table, such as one possible allocation of assets. One string might assign 5% to each of 20 assets while another string allocates 3% to each of 10 assets and 7% to each of the remaining 10 assets. ■ DIVERSIFICATION Diversification means spreading risk, the well-established way of lowering risk by trading multiple markets. For the purposes of risk reduction, it is necessary to distinguish between systematic risk, which can be reduced by diversification, and market risk, which cannot be eliminated. The benefits of diversification are great-est when the markets traded have different price movement and the methods of making trading decisions are unrelated. Typical investment portfolios contain a variety of fixed income, equities, real estate, and art, as well as different investment philosophies. These all combine to provide different rates of return with different patterns so they do not suffer losses all at the same time. Unfortunately, this is not always the case. Market risk, including price shocks and catastrophic risk, is not predictable, and can surprise even the most sophisticated investors. The subprime crisis of 2008 proved that diversification can disappear under stress. Even with a random scenario of up or DIVERSIFICATION AND PORTFOLIO ALLOCATION 1091 down , prices of two independent markets will move the same direction 50% of the time. Minimizing and avoiding market risk is the subject of this and other sections in this chapter.

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  Managing Your Investment Portfolio For Dummies, UK Edition

  • David Stevenson(Author)
  • 2013(Publication Date)
  • For Dummies

    (Publisher)

  The bottom line? Don’t bother picking individual shares or trying to time the market, just allocate across different asset classes in an intelligent, diversified manner. Including alternative assets in your portfolio Including alternative assets, such as currencies and commodities, in a well-balanced portfolio can improve returns (flip to Chapter 5 for all about Combining assets and betas Economists are so smitten with the idea of diversification – some call it the diversification premium – that they suggest it’s the one free lunch left in investing. Although in recent years even that seems to come at a rather hefty price as markets begin to move as one during periods of stress. The prime mover in the academic field of diversification analysis was economist Harry Markowitz, who showed how investors can combine different asset classes and betas with-out increasing risk. Later economists and analysts have taken Markowitz’s ideas and fleshed them out. The fund manager at Yale University’s endow-ment fund David Swensen, for instance, spent decades running hugely diversified portfolios investing in everything from forests to private equity funds and hedge funds. I discuss some of his accumulated learning in the later section ‘Investing in University Endowment Funds’. 14 Part I: It’s All about Portfolios alternative-asset investing). A study by research firm Ibbotson Associates discovered that the average improvement in returns from these uncorre-lated assets was worth 1.33 per cent per year. The company also found that asset allocation and active diversification accounted for 81.4 per cent of the monthly variation in balanced return funds. Deciding how much diversification is enough Accepting that diversification is a good thing is great, but then you need to apply this piece of wisdom within your portfolio. Back in September 2005, US analysts Paul Merriman and Richard Buck attempted to resolve the question of how to go about building ‘one portfolio for life’.

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  Understanding Investments

  Theories and Strategies

  • Nikiforos T. Laopodis(Author)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  Chapter 2 ). Then, we discuss, from the conceptual and mathematical points of view, the notions of correlation, covariance and regression (with more illustrations in Appendices A and B). Next, we proceed with the construction of simple portfolios consisting of two risky assets and then augment them by including the risk-free asset. We will then see the differences in the risk/return outcomes from these different portfolios. We conclude with some common diversification fallacies that arise in the asset allocation step of the investment process (following the top-down approach to investing).

  7.2 The diversification principle

  We first defined diversification in Chapter 2 . To refresh your memory, the diversification principle refers to the inclusion of many different risky assets in a portfolio so as to reduce the risk exposure to any particular asset. Here is a simple diversification example that applies to you as a student. In college, you take courses across the curriculum namely, from arts and sciences such as English, mathematics, science, and so on, as well as courses in your chosen field of study (major and/or minor, if any). Furthermore, in your field of study (assume it is finance) you take core courses (such as investments) and electives (such as international finance). By taking so many different courses across several disciplines during your college years, you diversify your knowledge portfolio. As a result, when you graduate you will not only have a well-rounded knowledge on your major (and get the best job) but also on many other areas so that you can converse with people intelligently! Thus, you will have maximized your benefit (potential) and substantially reduced the risk of being socially and personally uncompetitive.

  At this point, it is interesting to provide a brief historical account on the diversification principle. Before Markowitz’s seminal paper, the market’s wisdom was to “put all your eggs in one basket, and watch it well”, as voiced by Andrew Carnegie, a Scottish-American business man and steel industry giant, in the late 1880s.1 Investors in the early 1900s had few options to invest their money. Banks offered a fixed rate of return and there were a number of industries for stocks and bonds, such as railroads, utilities, and real estate. In 1915, there were few blue chip stock investments and the Dow Jones Industrial Index was comprised of only 12 companies, most of which were in the industrial sector. Benjamin Graham, during the early 1900s, attempted to predict the stock market’s movements (or timing the market) but after huge losses of his fund (during the Great Crash of the 1930s), he changed his advice into consulting the fundamentals or value investing, as we have learned in Chapter 2

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  eBook - ePub

  The Permanent Portfolio

  Harry Browne's Long-Term Investment Strategy

  • Craig Rowland, J. M. Lawson(Authors)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  truly diversified in 2008 did just fine.

  The Permanent Portfolio utilizes strong diversification because it approaches the idea of diversification from a very different, and more sensible, perspective than many other investment strategies. Before we discuss the Permanent Portfolio's approach to diversification, however, let's discuss how other diversification strategies can run into problems.

  When Diversification Fails

  When diversification fails it is normally related to several key factors:

  1. The strategy took too much risk in a single asset class.

  2. The portfolio held assets that ultimately were exposed to the same types of risk.

  3. The strategy was designed based upon false assumptions about asset class correlations.

  4. The portfolio held no hard assets.

  5. The portfolio had little or no cash reserves.

  In order to understand what solid diversification involves it is important to gain a better understanding of why these factors are allowed to creep into the design of investment strategies in the first place.

  Taking Too Much Risk in One Asset Type

  Many investors imagine that their portfolios are diversified, but the reality is that investors often concentrate too much money into one particular type of asset, typically one that they personally favor. Often such portfolios are based on little more than chasing past returns (though the investor may not actually be aware of it, especially if he is acting on the advice of an investment manager). If the bet on the individual asset fails, the portfolio fails.

  Remember the idea of expectations that was discussed in Chapter 4. The key point from that discussion is worth repeating here: Any investment, even your favorite, is under no obligation to provide you with any minimum level of return, and it may not perform according to your timeline or expectations. Investors are strongly encouraged to get the idea out of their heads that their favorite asset is always going to perform well going forward, because it may not happen according to their plan (and it may not happen at all).

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  Investments

  Analysis and Management

  • Gerald R. Jensen, Charles P. Jones(Authors)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  The Impact of Diversification on Risk The Markowitz analysis demonstrates that a portfolio’s standard deviation is less than the weighted average of the standard deviations of the portfolio’s holdings. Thus, diversification reduces portfolio’s holdings—as the number of portfolio holdings increases, portfolio risk declines. In fact, almost half of an average stock’s risk can be eliminated if the stock is held in a well-diversified portfolio. Systematic and Nonsystematic Risk Diversifiable (nonsystematic) risk Portfolio risk generally declines as more stocks are added because we are eliminating the nonsystematic risk , or company-specific risk. This is unique risk related to a particular company. However, the extent of the risk reduction depends on the degree of correlation among the stocks. As a Nonsystematic Risk Risk attributable to factors unique to a security Finally, what about the “aggressive” investor building a retirement portfolio? Note that even with this objective, only 75 percent of funds are invested in equities, because the investor still needs diversification and some stability. 10% CREF bond mark et 10% 15% 75% 10% fixed income 15% real estate 15% TIAA real estate 75% Equities 75% CREF stock Source : TIAA-CREF website. Other asset allocation examples are readily available. AAII, the American Association of Individual Investors, has a website with a section on asset allocation models. Suggested alloca-tion breakdowns are shown for conservative, moderate, and aggressive investors using seven asset classes. Asset allocation calculators are also readily available. By supplying your data, a suggested asset allocation model tailored to you can be generated. As one example, see http://www. ipers.org/calcs/AssetAllocator.html. The Impact of Diversification on Risk 217 general rule, correlations among stocks are positive, but less than 1.0.

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