Theoretical Concepts Underpinning Portfolio Diversification - Assignment Example

Theoretical Concepts Underpinning Portfolio Diversification Risk The potential that a particular activity or a certain type of action will lead to an outcome that is undesirable is called risk. Risk can also be defined as the effect of uncertain events on objectives. The events may or may not take place and lack of information can cause uncertainties. The probability of a specific event that can take place in the future can also be regarded as risk. Diversification A technique of risk management that takes into account a broad selection of investments within a portfolio is called diversification. (Lakshmanan and Amer-Yahia, n.d.). 1The rationale that guides this technique argues that a portfolio consisting of different kinds of investment on an average will give higher returns as well as pose a lower risk compared to any other individual investment that is found within the portfolio. As a result the positive performance of some investments will rule out the not so positive or negative performance of the other investments. The benefits from the process of diversification can only be accrued if the securities within the portfolio are perfectly uncorrelated. The first form of diversification takes place when the company has the potential to develop beyond the existing product market. The related form of diversification can be further categorized into backward diversification, forward diversification and horizontal diversification. Unrelated diversification takes place when an organization has the potential to develop interests that is complementary to its existing activities. When a company involved in media services can think of diversification in financial services, such kind of diversification is called unrelated diversification (Chatterjee and Wernerfelt, 1991). 2 Theoretical concepts underpinning portfolio diversification Portfolios are used by risk managers in order to diversify away the un-priced risk of the securities of the individuals. The speed of the diversification is taken into account while evaluating the effects of portfolio diversification. The speed of the diversification can be measured using different ways. The diversification speed of the value at risk is regarded as the rate at which the value at risk changes because the number of assets included in the portfolio increases. (Ansoff n.d. p. 113). 3The criteria of value at risk are evaluated at a probability level that is fixed. One can also launch the converse analysis where the level of the value at risk is kept fixed and the level of the probability changes with increase in the number of assets. A majority of the theoretical literature in finance assumes that returns are distributed normally. The speed of diversification is different in cases of normal and other distributions. The diversification speed is higher for the finite variance classes relative to the speed of normal distribution. The speed is lower relative to the speed of the diversification of the risk level (Hyung and Vries, 2004, p. 3). 4 Suppose there are two stocks one with return 0f 8% and another with 15%. The expected range of return of the investor is 8% to 15%. The standard deviation of the former stock is .05 while that of the later is 2. The investor will quantity the associated risk of the two assets and diversifies the investments accordingly. Country wise diversification can also arrive in the scenario (Marineilli, 2011, p. 2). 5 Measurement of the benefits of Diversification Suppose A and B are two portfolios. The former portfolio has an expected return and return volatility of 7.5% with equal weighing of both types of assets. But the later portfolio is leveraged in such a way that the weighing of the risk free asset is -50% while that of the risky asset is 150%. The expected return of the later portfolio is 12.5% and the return volatility is 22.5%. The behavior of the investors should be indifferent between the portfolios as one can convert the risk return characteristics of one portfolio to another by the process of leveraging or de-leveraging. A volatility difference of 15% is associated with the two portfolios. This implies that a reduction of 3% is equivalent to return reduction of 1%. Now suppose the investor considers another investment with 12% expected return. The investor calculates that the overall portfolio has expected return of 10.2% with 14.25% volatility. The benefits are in two ways: Increase in return and reduction in volatility. (Liang and McIntosh, 1999, p. 2)6 Limitations The process of diversification suffers from some limitations. The process of diversification slows down the growth in the core business. The diversification process can contribute to accelerate the management costs as the firm or the investor willing to initiate the process of diversification need to go through research process which is expensive and time consuming. The process can also act to add the bureaucratic complexity. Additional activities will get accrued because of the diversification process. Apart from the additional direct costs of finance there may be other bureaucratic complexities which is necessary to the purpose of coordination and control the activities (Ibragimov and Walden, 2006, p. 4).7The process of market consolidation might lead to losses which may result in subsidization by the profit making units for the relatively weaker ones. The process of diversification can also result in negative synergies. Acquisition lead diversification across the national borders can call upon organizations to deal with both political and legal requirements of multiple countries where the organization has varying interests. In 1985 someone was not allowed to hold more than 25% shares of any company which has the broadcasting license. The person was forced to apply for U.S. citizenship. Acquisition led diversification can also lead to failure which there is some type of mismatch between the core competencies of the one who is the acquirer and the business that is acquired. Reference page Lakshmanan L. and Amer-Yahia, S. (n.d.). 1. (19th April, 2012). Chatterjee, S. and Wernerfelt, B. The Link between Resources and Type of Diversification: Theory and Evidence. (1991). https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CDgQFjAA&url=http%3A%2F%2Fweb.mit.edu%2Fbwerner%2Fwww%2Fpapers%2FTheLinkbetweenResourcesandTypeofDiversification-TheoryandEvidence.pdf&ei=TeiQT7HuIom8rAeop_ShBQ&usg=AFQjCNEt2kLy_SseG-9jDHtlQr5XhenlFg. Ansoff H. Strategies for Diversification. (n.d.). 113. (19th April, 2012). http://foswiki.org/pub/Sandbox/SimiWiki/Strategies_for_diversification.pdf. Hyung and Vries, Portfolio Diversification Effects of Downside Risk, (2004), 3. (19th April, 2012). https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0CDoQFjAB&url=http%3A%2F%2Frepub.eur.nl%2Fres%2Fpub%2F6602%2F2005-0082.pdf&ei=0eiQT4bSFI-0rAezj736BA&usg=AFQjCNGr3mj5KRvuXS9w7s0TCSiWXhaahg. Marineilli, F. The Relationship Between Diversification and Firm’s performance. (2011). 2. (19th April, 2012). https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CCgQFjAA&url=http%3A%2F%2Fwww.iese.edu%2Fresearch%2Fpdfs%2FDI-0907-E.pdf&ei=6uiQT8j2DJDtrQf0--yMBQ&usg=AFQjCNHLoJxYADNWqusqldHwMa3kDhepYA. Read More