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News Bulletin : ADA News Bulletin October 2010
35 OCTOBER 2010 If you were to create the perfect investment it would provide you with high returns and have low risk. In reality these sorts of investments are almost impossible to find and often involve an element of luck rather than investment selection skills. Most professional investors rely on investment theories and processes that allow them to optimize the amount of risk which is commensurate with return. The concept of building a diversified portfolio is the basis of a Nobel Prize winning economic concept called Modern Portfolio Theory (MPT). MODERn PORTfOLIO THEORY Modern portfolio theory was first developed by Harry Markowitz and published in the 1952 Journal of Finance under the title ‘Portfolio Selection’. MPT says that investors need to look at more than the expected risk and return of one particular stock and instead consider that an investor can reap the rewards of diversification by investing in several stocks. Using mathematical analysis Markowitz showed that the risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that invests in two risky stocks; one that benefits if it rains and one that does well if the sun shines. In this case the portfolio will do well regardless of the weather. Adding one risky asset to another can reduce the overall risk in a portfolio as the opposing risks cancel each other out. In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one’s investments. TYPES Of RISKS Modern portfolio theory states that the risk for individual stock returns has two components: Systematic risk – These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks. Unsystematic risk – Also known as ’specific risk’, this risk is specific to individual stocks and can be diversified away or reduced as you increase the number of stocks in your portfolio. This risk represents the component of a stock’s return that is not correlated with general market moves and is specific to that particular stock selection. For a well-diversified portfolio, the risk of each stock contributes little to portfolio risk. Instead, it is the difference – or covariance – between individual stock’s levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks. hoW do IIdentIfythe beSt level of dIverSIfIcatIon? I am often asked “What is the best level of diversification for a stock portfolio?” Some fund managers like to have widely diversified portfolios holding 50 or 60 stock positions while others like to concentrate their holding across 15 to 20 stocks. Once you understand the benefits of diversification it becomes clear that there is a limit to how much risk you can eliminate through diversification alone. As you increase the number of investments the covariance between additional investments begins to increase making it hard to find additional investments that actually increase diversification. At some point the incremental reduction in risk through further diversification is negligible and investors have to look elsewhere to improve the risk profile of their portfolio. However, using mathematical modelling the optimal portfolios can be plotted along a curve to show which portfolio has the highest expected return possible for the given amount of risk. This is known as the efficient frontier and is illustrated in Figure 1. Fig 1. The efficient frontier theorises that for every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph. The resulting line is the efficient frontier. Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line. The chart (Fig 2) shows the dispersion of risks in a portfolio and illustrates the concept of asset allocation and how it can affect risk and return in your portfolio. Fig 2. Source: Sigma Investing – Portfolio efficiency. The individual investments in a portfolio all have their own unique levels of risk but it is the collective risks of the portfolio that are of concern to investors. Through diversification investors are able to reduce their risk by combining risks that effectively cancel each other out. doeS add I ng alteratIve aSSetS to aportfol I o reducetheoverall portfol I or I Sk? As indicated earlier, the use of alternative asset strategies can reduce the risk in your portfolio. Rather than look at the risk in your stock portfolio consider the risks across your entire portfolio and all of the assets held. Many will ask “How am I supposed to assess the risks of my portfolio?” You need to consider how the returns of your portfolio are linked or interrelated and think about whether or not a decline in one area of investment can be offset by investments that are not closely correlated to that part of your portfolio. investment insight Return% Risk % (Standard Deviation) A portfolio above this curve is impossible High Risk/High Return Medium Risk/Medium Return Low Risk/Low Return Optimal portfolios should lie on this curve (known as the “Efficient Frontier”) Portfolios below the curve are not efficient because for the same risk one could achieve a greater return. Strategic asset allocation Efficient frontier Individual assets Volatility (risk) Expectedreturn
ADA News Bulletin September 2010
ADA News Bulletin November 2010