How portfolio diversification can minimize or eleiminate exposure risks to portfolios
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Published: Mon, 5 Dec 2016
Portfolio diversification is the means by which investors minimize or eliminate their exposure to company-specific risk, minimize or reduce systematic risk and moderate the short-term effects of individual asset class performance on portfolio value. In a well-conceived portfolio, this can be accomplished at a minimal cost in terms of expected return. Such a portfolio would be considered to be a well-diversified. Although the concepts relevant to portfolio diversification are customarily explained with respect to the stock markets, the same underlying principals apply to all types of investments. For example, corporate bonds have specific risk that can be diversified away in the same manner as that of stocks. In investment Risk and Return, it is assumed that all investors are rational and will therefore hold portfolios that are diversified to the point where specific risk has virtually been eliminated and their only exposure to risk is to that which is inherent in the market itself. Thus, the residual risk of a portfolio should be equal to market risk, which is systematic risk, and unsystematic risk. Unsystematic risk can be reduced by investing over a broader market, i.e., a larger universe.
Portfolio diversification provides a good example of the effects of diversifying across asset classes. A portfolio invested 50% in domestic large-cap stocks and 50% in international large-cap stocks would have approximately half the residual risk of a portfolio comprised solely of domestic large-cap stocks, assuming that the investments in each market were sufficiently diversified to eliminate specific risk.
CAPM and the Market Price Risk:
The theory that investors are not rewarded for holding any diversifiable risk is taken to its logical limit in the Capital Asset Pricing Model (CAPM). This model is based on the evidence that all investors will hold portfolios which are invested in every single asset in existence. The rationale behind this is that if an investible asset is not included, then an opportunity for diversification, and therefore risk reduction, has been missed. According to the theory, investors will combine the market portfolio with a risk free asset (e.g. a short term government debt instrument). The proportion of the risk free asset held will increase the greater the investor’s risk aversion. The CAPM, which is concerned with pricing market risk, when determining what additional expected return is required for additional market risk. The only risk considered by a rational investor is market risk; we need to measure each security’s risk in these terms. The key elements here are as follows: The higher the weighting a security has, the greater will be its influence on the market return. The risk if measured in terms of market risk, the greater must be the compensating expected return. The higher the risk free rate, the higher will be the required expected return.
Diversification works in the long run, despite rising correlations during extreme financial crises. From 1970 through 2007, a portfolio of 60 percent S&P 500 Index and 40 percent MSCI EAFE returned 11.3 percent per year with an annualized standard deviation of 13.75 percent. For the same time period, the S&P 500 returned 11.1 percent per year with an annualized standard deviation of 15.07 percent.
Even when you throw a devastating and volatile year like 2008 in the mix, the benefits are still apparent. From 1970 through June 2009, the diversified portfolio had higher returns with less volatility than the S&P 500 alone. The diversified portfolio returned 9.6 percent per year with an annualized standard deviation of 14.6 percent, while the S&P 500 returned 9.4 percent per year with an annualized standard deviation of 15.6 percent.
The conclusion from this data is not that diversification didn’t work in 2008 and that it “came back” in 2009. The conclusion is that even though diversification is not a panacea for financial crises, it’s the winning strategy for the long run.
How Does Diversification Work
The concept is based on the fact that returns for certain types of investments, or asset classes, tend to move in opposite directions. As a result, poor stock returns may be counterbalanced by investments in bonds, and vice versa.
You can diversify your portfolio by spreading your investments among different types of asset classes, such as U.S., international and emerging market stocks, bonds and also short-term money market investments. Exchange traded funds are an effective way to provide diversification since each individual fund holds hundreds of stocks and/or bonds. Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns. This reduction in risk arises because worse than expected returns from one asset are offset by better than expected return from another. But there is a minimum level of risk that cannot be diversified any way and that is the systematic portion.
In volatile markets relationship among investments can become highly correlated, meaning returns for both types of investments move in the same direction, which reduces the effectiveness of diversification. That’s why a portfolio diversified among stocks and bonds still lost value during both recent bear markets. It’s also why investments spread across U.S., international and emerging-market stocks didn’t fare well either. All major investment sectors but one, government securities, declined.
It’s a good idea to see if your diversified portfolio still reflects your financial situation and goals.. If you’ve set up a 60/40 stock/bond investment mix but haven’t changed it in a year, you may need to rebalance your portfolio since your equity-oriented mutual funds likely fell in price more than your income-oriented mutual funds in the past year. In this case, if you want to maintain your 60/40 mix, you’ll have to sell some of your bond funds and invest the proceeds into equity funds.
Diversification does help, however, and it always has even if, during extreme times, it hasn’t been able to prevent losses entirely. It’s true that, with the exception of government securities, all investment sectors were hit by the 2008-2009 declines. But investors with a diversified portfolio of stocks and bonds lost a lot less than those with an all-stock portfolio — even one that included international or emerging market stocks. Diversification also worked for investors during the first bear market of this decade: the 2000-2002 dot-com declines.
The chart above is relatively easy to interpret; we consider the ‘risk-free’ asset Rf with its corresponding Beta of zero and return of 8% and our stock with its Beta of 1.6 and its expected return E(RA) of 20%. When we connect the dots and measure the slope of the line (rise/run), we get a slope of 7.5%. From this graph, we can ascertain that our stock has a reward to risk ratio of 7.5% meaning that our stock has a risk premium of 7.5% for each ‘unit’ of systematic risk. Obviously, the higher the reward to risk ratio, the better, meaning we’d want to see higher E(RA) and/or lower Beta; either of which would increase the slope.
In a final example, let us now compare our stock in the previous example (called Stock A) with a second stock (Stock B). Stock B has a Beta of 1.2 and an expected return E (RB) of 16%. When we construct our Security Market Line, we end up with a slightly different picture than we had with Stock A. The reward to risk ratio (or slope of the line) for Stock B is 6.67%. What this tells us (all other things equal) is that in essence, Stock A is a ‘better’ choice than Stock B simply because it generates more reward for each unit of systematic risk undertaken.
This analysis is especially useful when one is selecting portfolio components and wants exposure to a particular industry or sector, has multiple candidates, but doesn’t want to include them all for fear of being overweight that particular area. In this manner, the candidates may be lined up and compared to see both visually and quantitatively where the best bang for the buck lies.
A closer look at the investment returns of a 100% U.S. stock index compared with a diversified investment mix of 60% stocks and 40% bonds between December 31, 2007, and June 30, 2009, shows that diversification was effective over that period. An investor in a diversified 60/40 mix lost 18%, or about half as much as the all-stock index, which lost 35%.
International investors were hit hard as well: The MSCI ACWI (All Country World Index) ex USA, which doesn’t include the U.S. market, lost 37% and the MSCI Emerging Markets Index declined 36%. For the 2000-2002 bear market, an all-stock portfolio fell 47.4% while the 60/40 mix declined only 16.8%.
In fact, a diversified portfolio has helped investor’s weather market volatility over several different time periods. For the past three years, an all-stock portfolio lost 22.7% while the 60/40 mix declined only 5.4%. During the past five years, the stock portfolio lost 10.7% while the mix increased 4.7%. And as of June 30, 2009, over a full 10-year period, the stock portfolio lost 20.1% while the diversified mix gained 19.4% an almost 40% advantage over stocks.
As a conclusion I would say portfolio will work as long as the assets in the portfolio are negatively correlated and they are being taken from different markets and different kind of assets. Because if one asset returns drops still other assets return can increase. So portfolio diversification is still working.
The relationship between risk and return is a fundamental financial relationship that affects expected rates of return on every existing asset investment. The Risk-Return relationship is characterized as being a “positive” or “direct” relationship meaning that if there are expectations of higher levels of risk associated with a particular investment then greater returns are required as compensation for that higher expected risk. Alternatively, if an investment has relatively lower levels of expected risk then investors are satisfied with relatively lower returns.
This risk-return relationship holds for individual investors and business managers. Greater degrees of risk must be compensated for with greater returns on investment. Since investment returns reflects the degree of risk involved with the investment, investors need to be able to determine how much of a return is appropriate for a given level of risk. This process is referred to as pricing the risk.
Return Characteristics of Public and Private Real Estate
Public and private equity real estate has been the relationship between these two markets in terms of risk and return characteristics. The most well-known private real estate performance benchmarks around the world are the NCREIF (U.S.), the PCA (Australia), and the IPD indices in various European countries. Pubic real estate benchmarks include NAREIT (U.S.), S&P/ASX200 LPT Index (Australia), GPR (Global), and FTSE EPRA/NAREIT (Global). Taking these total return indices at face value, public and private real estate markets in the past have behaved differently, with public real estate showing greater volatility.
Furthermore, correlation studies of private and public real estate indices show that, while both have low correlations with bonds and large-cap stocks, they also have low correlations with each other, and in general, public real estate displays a higher correlation with small stocks. As for the portfolio diversification effects of publicly listed real estate securities, the private real estate portfolios with 10 percent mixes of REITs resulted in higher risk-adjusted returns for all three countries (see below). The results imply that a holding in U.S. REITs would lead to improvements in portfolio performance even if the optimal portfolio already contains private real estate.
Several other studies show similar results. According to a portfolio diversification study performed by Ibbotson Associates in 2006, adding REITs to a wide selection of diversified portfolios, from 1972 to 2005, enhanced risk-adjusted returns as compared with portfolios without REITs. Furthermore, research sponsored by the European Public Real Estate Association showed significant portfolio benefits to using real estate securities from six European countries
Risk in relation to gold is very high as it is a volatile asset as changes take place rapidly and it’s expected to have a high return. It can be seen that gold is more negatively correlated to U.S. stocks than any of the other asset classes. If an investor has a safe and physical gold, the cost of keeping the gold will be practically nothing. One other quality that makes gold a sound investment is its ease to liquidate. It is common that most businesses that sell gold will usually also buy gold, making gold one of the easiest assets out there to sell. One last characteristic that makes gold one of the greatest investments out there is gold’s intrinsic value and lack of counterparty risk. Other assets like a stock can become worthless overnight if the company was not run correctly or if its goods or services for any reason becomes obsolete; but because of gold’s intrinsic value and its lack of counterparty risk. Gold is unlikely to become worthless overnight.
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