International Financial and Financial Management

A high return investment fixed with a low risk cost is an idyllic situation for an investor. Though, in reality, these sorts of investment seize to exist.

Whether you’re risk loving, neutral or adverse, rational investors seek for the highest return for a given level of risk, or by seeking the lowest risk for a given level of return. Yet how should these different types of investors manage such risk?

It is the part of a wise man...not to venture all his eggs in one basket. -Miguel de Cervantes

Or should an investor:

 

Put all your eggs in the one basket and – watch that basket!? – Mark Twain

Given both options, most investors would choose not to venture all of their eggs into one basket. The term behind this saying is known as diversification (Markowitz, 1968). Here, we will explore diversification in detail, how it is done in practise and critically analyse the theory behind it.

Diversification and Portfolio Theory

Portfolio Theory is a model which was introduced by Markowitz in 1952. The notion behind this framework was to enhance the expected return of an investor’s portfolio by diversification. Diversification is quite simply a varied selection of investments within a portfolio (Markowitz, 1952). Supposedly, the more diversified your portfolio, the less unsystematic risk you are faced with (Byers et.al., 2013).

Here within the diagram below, we can see that systematic risk is constant. It is the risk of playing the game thus, it is unavoidable. Unsystematic risk is the dependent variable within the diagram. The greater number of investments held within a portfolio results in a reduction of unsystematic risk. With the concept of diversification embodied within Markowitz’s model, we can see why this is an attractive framework to use as an investor.

 

Though holding a number of investments has its criticisms. According to the financial times, US analyst Rob Arnott argues that holding over ten cheap assets would be “reducing your ability to add value” (Stevenson, 2009). Why? Firstly, you’ll be spreading your capital among many investments. Therefore, a greater number of investments within your portfolio results in less capital contributed within each individual investment. This then reduces your marginal return. By over diversification, you will be losing out on the gains of the advantageous investments that you contributed less capital towards. Secondly, it is harder to maintain your portfolio. Referring back to my previous blog, Stock Market Efficiency: is it working? We had discussed the concept of semi-strong form efficiency which involves newly available information exposed to the market (Arnold, 2013). If I held too many investments within my portfolio, there is a possibility of overlooking information which had altered the pricing of one of my securities. As a consequence, the value of this investment is potentially jeopardised.

Construction of Portfolio Theory

Even though the concept of diversification is relatively simple, the construction of Markowitz’s model is, at a high end view, quite unclear.

There are two important components within the model; that is the envelope curve and efficient frontier. The envelope curve is the shaded curve within the diagram below and represents the range of risky assets available to hold within the portfolio. However, assuming that investors act rationally, their portfolio constructions will only ever be represented along the arc symbolized across AEF. Why? Because this arc symbolises the maximum return available for the risk taken. This being said, Investors will construct their portfolios along the arc. This is commonly known as the efficient frontier.

 

 

 

 

 

 

 

 

Nevertheless, Marjowitz’s model has its criticisms; one being that not all investors expose themselves to risky securities. As mentioned in the introduction to this blog, there are different attitudes towards risk (Tobin, 1958). Tobin (1958) recognised this flaw in the theory and further adapted Portfolio theory to consider risk adverse investors who would typically borrow and lend at a risk-free rate of return e.g. Government Treasury Bills. This formed the capital market line - symbolised as RMN within the diagram below.

 

 

 

 

 

 

 

 

 

However, here we can also criticize this adapted theory. There is realistically no such thing as a risk-free rate (reference). Investors or companies will have to pay a premium for whatever level risk an investor is willing to hold. This therefore questions the rationality of his assumption.

Further Criticisms of Portfolio Theory

The implementation of this model uses historic returns (Arnold, 2013). As mentioned within my previous blog, Stock Market efficiency-is it working? academia’s such as Kendal (1953) and Fama (1970) stated that you cannot predict future share prices within historic data alone. Though this fundamental concept is generally accepted by many investors, it heavily contradicts Markowitz’s theory.

Additionally, Markowitz’s theory makes the assumption that the market is efficient. Noted in my previous blog, we had established that this is far from true. Robert Shiller’s behavioural finance (2003) explains that the under/over reaction in markets questions the validity of specific pricing securities. If historical returns have been volatile due to overreactions in the market, then the standard deviation for the anticipated return will be given a wider range. If there is a wider range, then this gives an investor uncertainty to what predicted return they will receive, and, as a result, makes the model unhelpful.

These days, the portfolio model is all done on a database. On excel, we can collect historic data, calculate the standard deviation and see the risk faced. Though, the issue behind this and pointed out by John Kay is that we do not know the nature behind the numbers. In an interview with the Financial Times, John Kay (2009) argues:

“Unless you understand the behaviour that produced them, you cannot assess their durability… diversification is a matter of judgment not statistics. “

Conclusion

So exactly how should you diversify a portfolio? From the evidence gathered, it is clear that the concept of diversification is vital for risk management. Nevertheless, we need to be aware of the concept of over-diversification.

A survey conducted by Solnik (1974), investigated risk reduction in portfolios containing one and fifty shares. The results showed that risk was reduced dramatically by the first four securities held within a portfolio. To conclude, 90% of diversification benefits can be obtained via a small portfolio.

Though Markowitz’s model introduced us to an important topic, the model has numerous flaws and should not be followed religiously. The financial times interviewed Markowitz on his own practices, to which he responded:

“I should have computed co-variances of the asset classes and drawn an efficient frontier-instead I split my contributions 50/50 between bonds and equities.”

If the creator does not religiously follow his own model, then perhaps no one should. A point worth repeating is John Kay’s argument on the nature of securities. It is a matter of judgement. When selecting securities, it is worthy idea that investors should consider the nature of a security, as well as the expected return.

References

Byers, S. S., Groth, J. C., & Sakao, T. (2013). Using portfolio theory to improve resource efficiency of invested capital. Journal of Cleaner Production.

Kay, J. (2009). Financial models are no excuse for resting your brain. The Financial Times. Retrieved November 2014 from, http://www.ft.com/cms/s/0/de074228-eca7-11dd-a534-0000779fd2ac.html#axzz3OeEw69DR

Markowitz, H. M. (1968). Portfolio selection: efficient diversification of investments . 16. Yale university press.

Markowitz, H. (1952). Portfolio selection*. The journal of finance, 7(1), 77-91.

Solnik, B. (1974). Why not diversify internationally? Financial Analyst Journal, 30. 48-54.

Stevenson. D. (2009). David Stevenson: Diversification made easy. The Financial Times. Retrieved November 2014 from, http://www.ft.com/cms/s/2/d9eca09c-8bf9-11de-b14f-00144feabdc0.html#axzz3OeEw69DR

Stevenson. D. (2010). Portfolio 101: Lesson 2 - Portfolio theory. The Financial Times. Retrieved November 2014 from, http://www.ft.com/cms/s/2/6789bbd0-b73f-11df-839a-00144feabdc0.html#axzz3OeEw69DR

Tobin J. 1958. Liquidity preference as behavior towards risk. Review of Economic Studies 25 (6/7): 65-86.