Print Email Download Reference This Send to Kindle Reddit This
submit to reddit

Diversification And Its Importance In Portfolio Management Finance Essay

I often hear finance managers say an investment related proverb that goes like this; “be risk diverse, not risk adverse”. An inquisitive, or even not so inquisitive mind may wonder “what does this concept really mean?” and “why is it so important when investing?” This paper seeks to provide answers to the querying mind and to explain, not only by definition but also via demonstration the importance of having a diversified portfolio. It will also include reasons why investors should be risk diverse and not risk adverse.

Part 1: Diversification, Risk Management & Market Cycles

Investopedia defines diversification as “a technique that reduces risk by allocating investments among various financial instruments, industries and other categories.” Its main aim is to maximize returns hence the reason it is invested in different area that will each react differently when exposed to similar conditions. . In short, diversification denotes the old saying “don’t put your eggs in one basket”. The article some sample portfolios emphasized the importance of having a diversified portfolio. It sees diversification as “the spreading of one’s money among various sorts of investments to limit risk and maximize growth potential.” These investments are primarily categorized by stocks, bonds and cash. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk (Investopedia).

Risk Management

If one caught a whale the first time he or she ever picked up a fishing pole, perhaps they’d think of themselves as being lucky. If they year after year they reeled it back in with the same result, they’re assume that pond was the right place to be. Likewise, investors who purchased their first stock during one of the most extraordinary bull market in history (1982 -1999) conditioned themselves to believe that their pond (the equity market) was the correct place to be for year to year returns. What these investors discovered later though is the fact that markets move in cycles and like fishermen, they must monitor and adapt to the changing conditions.

More than 100 years of equity market history has shown that there are uncertain cyclical movements in the market. With that fact being established, it is paramount that investors prepare for risk and build a portfolio that can withstand any economic environment. In doing so, they (the investors) should diversify among assets that have been historically proven to be defensive against risks that may be encountered in the three major economic environments; noninflationary growth, inflationary growth and recession. The article Rethinking Risk states that” a properly diversified portfolio can help preserve principal while taking advantage of opportunities that arise as the economy transitions across cycles”.

While history repeatedly shows the cyclical movements of the market, many investors today view bull markets as normal and therefore tend to chase returns at the expense of risk management with the reason being, prior to 2000s; no person significant losses were experienced. The term baby boomer is used to describe the generation that lived through the bear market (1966 to 1982). These boomers began to seriously invest during the bull period from 1982 – 1999. There they had consistently gained high levels of return with low volatility. What many of these investors faired wasn’t losing money; rather it was missing out on gains. For those who considered the bull markets to be the norm, the two bear markets of 2000s really did come as a shocker. Investors are therefore advised to rethink their assumptions about the equity market as it related to investing and risk. All investments involve risks. The closer the investor is to retirement the riskier the asset becomes because their compensation, savings and assets will generally decrease (outliving savings).

Phases of Investing

Asset Accumulation

Pre-Retirement

Retirement

Time until retirement

10+ years

Less than 10 years

Retired

Risks

-Not enough growth to out space inflation

-Losses may lead to abandoning strategy

-Lots to lose and less time to recover

-Purchasing power

-Inflation

-Portfolio longevity

-Limited contributions

Diversification

It is important that investors prepare themselves in the event that for one of the economic environment were to occur. Different asset classes have historically outperformed during different economic environments, hence portfolio diversification is importance when one intends to pursue financial goals across market cycles. Diversification is the key to risk management. As aforementioned, it is simply investing in a variety of assets which in turn assures investors that if a situation like the bull market fails and some asset classes were to fall, other assets in the portfolio will be able to offer stability. Analysis of the market’s history indicates that the allocation of assets needs a logical approach with sound knowledge of risk. In the 1990s the market moved upward and hence investors, due to their growth potential were attracted to stocks within the technology and communications industries. Technology then went downhill causing the investor that invested only in that sector to pay the price. When the market recommenced its gain between 2003 and 2007, investors no longer invested in one sector; rather, they included international and emerging markets stocks and private equity to their portfolios. But as we can remember, when the market went into recession in 2007, all the asset classed plummeted together.

What happened then can be simply explained. In the investors’ quest of returns, they evaded assets such as cash and long term government bonds that offered lower growth potential than of equity but they have been proven to withstand the pressure of recession. What happened there therefore was a case which involved them diversifying their sources of returns but failed to do so according to risk.

Investors should therefore diversify among asset classes that have been proven to defend against risks that may arise from the three major economic environments mentioned earlier.

Equities and other equity-like investments have historically been proven to perform well when noninflationary growth is existent. These investments seek growth, which helps protect against shortfall risks in retirement.

Currency hedged government bonds and cash are investors’ best market downturn defense during recessionary periods. While the fact that they lower growth potential is evident, they are also good defendants of steep market loss risks.

Commodities have during inflationary periods, revealed its capabilities of protecting against the risk the inflation poses towards corroding one’s buying power. Commodities are unpredictable and may not meet the suitability requirements of all investors.

The table below taken from Invesco Portfolio Principles: Rethinking Risk, shows the annualized performance of various asset classes stating from the year, 1929. The data is presented within six time periods that represents five distinct market environments.

The importance of Diversification

Time Frame

1929- 41

(13 yrs)

1942 - 65

(24 yrs)

1966- 81

(16yrs)

1973- 81

(9yrs)

1982-99

(18yrs)

2000 -09

(10yrs)

Market Environment

Deflation

Low-inflationary growth

Inflation

Low inflationary growth

Credit Supply Reduction*

Corporate bonds 6.30%

Stocks 15.93%

Inflation 6.93%

Commodities 16.87%

Stocks 18.77%

Long-term government bonds 8.81%

Long-term government bonds 4.76%

Inflation 3.05%

T-Bills 6.38%

Inflation 9.32%

Corporate bonds 13.61%

Corporate bonds 7.01%

T-Bills 0.82%

Corporate bonds 2.61%

Stocks 6.35%

T-Bills 7.53%

Long-term gov’t bonds 13.51%

T –Bills 3.02%

Inflation -1.60%

Long-term gov’t bonds 2.16%

Corporate bonds 3.07%

Stocks 6.11%

Commodities 7.63%

Inflation 2.60%

Stocks -2.47%

T- Bills 1.61%

Long-term gov’t bonds 2.57%

Corporate bonds 2.86%

T-Bills 6.30%

Commodities 2.28%

Commodities index was not incepted

Long-term gov’t bonds 2.84%

Inflation 3.32%

Stocks -4.00%

The period denoted by * did not represent true deflationary period because consumer prices did not fall. The reduction in credit supply however led to economic contractions somewhat similar to what would be experienced in a deflationary environment.

Sources: Ibbotson, Lipper Inc. Stocks are represented by the S&P500 Index; inflation by the consumer Price Index; Commodities by the S&P 500 GSCI Index; long-term government bonds by the Ibbotson U.S. Long-Term Government Bond Index; T-Bills by the Ibbotson U.S. 30 Day T-Bill Index; and corporate bonds by the Ibbotson U.S. Long-term Corporate Bond Index. An Investment cannot be made directly in an index. Past performance is not a guaranteed future result.

Part 2: Risk adversity vs. Risk Diversity

Risk is often defined as a measure of the probability and severity of adverse effects [Lowrance 1976]. It is the fundamental of investment and is also very essential. An investor trade to make money, and the only way that can happen is by taking some form of risk. If excessive risk is taken however, it can be very disastrous. There is nothing wrong with being risk adverse (risk friendly), however, problems exist where there is undiversified risk in a portfolio that may lead to it being risk-free hence return-free. Must I note that there is nothing wrong with an investor that is both willing and able to take a more that average level of risk, however, it must be done rationally. It must also be noted that a higher risk level does not signify putting all your eggs in one basket since higher-risk portfolios are customarily comprised of various classes of assets that are sensibly managed.

Risk adverse investors dislike risk, as a result, they tend to avoid adding high risk investments to their portfolio which will consequently make them lose higher rates of return opportunities. Such “safer” investments seeker investors generally prefer investments with low returns such as index funds and government bonds.

The Risk – Reward trade off

Financial – Dictionary defines risk reward tradeoff as “The concept that every rational investor, at a given level of risk, will accept only the largest expected return.” In a circumstance where two investments are given at the same risk level, ceteris paribus, rational investors will chose the asset that with the highest return. It is because of this concept; riskier bonds pay a higher coupon rate and bonds pay lower returns than that of stocks reason being that bond investments are safer because they are less risky. (Finance-Dictionary). It is basically deciding the amount of risk one can take when developing their portfolio. “The risk-return tradeoff is the balance an investor must decide on between the desires for the lowest possible risk for the highest possible returns… low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns” (Investopedia). Here is an example taken from Investopedia.com that explains how the risk-reward theory works.

The risk-free rate of return is usually denoted by the quoted yield of "U.S. Government Securities”. For this purpose the risk-free rate is assumed to currently be 7%. Therefore, for having no established risk, an investor can earn 7% per year on his or her money. However if the index funds are averaging 13 -15.5% per year, no one will settle for 7%. It must be noted that index funds don't return 15.5% every year, instead they return -5% one year and 25% the next. Putting that example in simple terms, in order to receive higher returns, investors must be willing to take on considerably more risk.

Sample Historical Portfolios

The graph inserted below highlights the historical performances and risk of portfolios ranging from 100% stocks to 0% stocks. It shows the average return and standard deviation, which is also a measure of risk) for the portfolios individually. The data in this portfolio ranges from the period 1927 to 2007.

(Crackerjack)

The graph depicts the risk-return tradeoff where the higher the percentage of stock in the portfolio increases the returns and the risk. Higher returns symbolize the involvement of risk and obviously, a lowered risk level will signify lower returns. It is also good to note that as the investment fluctuated so did the range of returns.

The Pie chart below represents a portfolio that I will recommend which consist of the allocation of 60% stocks

Crakerjack

The graph below highlights the historical returns for the portfolio above from 1927 to 2007

Crackerjack

Facts about that portfolio

From 1927 to 2007, the average annual return for a diversified 60% Stock portfolio was 9.5%.

During any consecutive 3 years from 1927 to 2007, this portfolio lost money 8 times out of a possible 79 periods. In 2 of those 8 times, it lost less than 1.2% of its original value.

The two worst 3 year periods were 1929-1931 and 1930-1932 (Great Depression), when the portfolio lost about 46% of its original value.

From 1927 to 2007, the average annual return for a diversified 60% Stock portfolio was 9.5%.

During any consecutive 3 years from 1927 to 2007, this portfolio lost money 8 times out of a possible 79 periods. In 2 of those 8 times, it lost less than 1.2% of its original value.

The two worst 3 year periods were 1929-1931 and 1930-1932 (Great Depression), when the portfolio lost about 46% of its original value.

(http://www.crackerjackgreenback.com/category/diversified-portfolios/)

Recommendations

When investing it is important that investors include securities from all the asset classes. This ensures at least a portion of the investor’s holdings is doing well.

One can also invest in securities of the same asset class that are not affected by the same variables

When investing it is advised that one should not invest in variables that may increase or decrease in price at the same time

Diversified portfolios are less volatile with sounder returns so it is therefore advised that portfolios be diversified.

Conclusion

There is no success without risk. If people could have predicted the future, they would have known when there will be a recession, inflation or a great depression. Since predicting the future is virtually impossible investors have to let faith be their guide. They have to take the risk and wait to see how the market will play out. Risk is good, it is important…it is essential.

Print Email Download Reference This Send to Kindle Reddit This

Share This Essay

To share this essay on Reddit, Facebook, Twitter, or Google+ just click on the buttons below:

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay.


More from UK Essays