Major Financial Principles - Essay Example

?FINANCE PRINCIPLES Table of Contents Table of Contents 2 A.Portfolio Diversification 3 Mean – Variance Diversification 4 Efficient Frontier 5 B.Construction of Diversified Portfolio 6 References 12 Bibliography 13 A. Portfolio Diversification Portfolio diversification can be defined as the designing of a portfolio which includes several assets like stocks, bonds, commodities, etc. The main purpose of diversification of portfolio is to reduce the overall risk associated with the portfolio without compromising much on the return. It is the motive of every investor to maximize return and minimize risk. The volatility or risk associated with a portfolio is minimized due to diversification because of the fact that not all the assets included in the portfolio move along the same direction. It can be explained as, if one of the asset in the portfolio is giving negative return, then it would not have a significant impact on the overall return of the portfolio because the other assets might be performing well and thus making up for the asset which is not performing well. Diversification helps an investor to have consistent return on its portfolio over a period of time. An investor who is risk-averse in nature would always strive to have a completely diversified portfolio in order to minimize risks associated with it. Quantitative measure of portfolio is possible with the advent of several portfolio selection theories. Using those quantitative measures one can have the benefits of diversification to the maximum amount possible. The diversification strategy proposed by Markowitz is based on the covariance between the returns generated by the assets included in a portfolio. The diversification theory proposed by Markowitz is related to the risks associated with the portfolio as a whole and not the risk associated with any asset in isolation. Markowitz used variance as a measure of risk. Markowitz tried to develop a diversified portfolio by including those assets in the portfolio which are not perfectly positively correlated with each other, so that the variance in return of the portfolio is minimized without affecting much on the return of the portfolio.1 Mean – Variance Diversification Mean – Variance diversification portfolio theory utilizes marginal analysis as a means of achieving optimal level of diversified portfolio. It is based on the fact that diversification should be enhanced until and unless marginal cost is less than the marginal benefit. The advantage of this theory is the minimization of risk. The costs that are considered in this theory are holding costs and transaction costs. The standard deviation of the returns generated through the combination of assets is used as the risk measure in case of this theory of diversification. Marginal benefits associated with diversification of portfolio get increased with decrease in correlation between asset returns. On diversification of the portfolio the expected value of standard deviation goes on decreasing. Optimal diversification depends on the expected correlations between each pair of assets in the portfolio, the buying costs of each of the assets, the holding costs of the assets and expected premium on equity used as asset in the portfolio.2 Risks associated with any portfolio can either be unsystematic risks or systematic risks. As discussed earlier risk gets reduced with diversification. However, diversification reduce risk only to a certain level, beyond which it is not possible to reduce risk because changes in the market conditions as a whole affects in variation of prices of all the assets included in the portfolio and it is not possible to reduce or eliminate this variability beyond a certain level. Hence it is necessary to divide risk into two parts, namely systematic risk and unsystematic risk. The risk which represents that portion of the variability in asset caused by the market movements are known as systematic risk. This type of risk is unavoidable in nature and is sometimes termed as beta as mentioned in the Capital Asset Pricing Model (CAPM). The portion which represents risks those are avoidable in nature like labor strikes, natural disasters, etc. are termed as unsystematic risks.3 For a portfolio which is well diversified, the risk associated with each of the assets included in the portfolio contributes a very little portion to the overall risk associated with the portfolio. The overall risk associated with a portfolio is actually the covariance of each of the assets included in the portfolio. Hence an investor gets benefited through holding portfolios which are well diversified rather than investing in individual assets. Efficient Frontier The optimum level of diversification can be measured through the study of efficient frontier. A portfolio is considered to be efficient when it generates maximum amount of return with a given level of risk associated with it or minimum amount of risk for a known fixed return level. The dominance principle concept forms the basis of identifying san efficient portfolio. Dominance principal in turn states that a particular portfolio which is characterized by generating maximum return against a known level of risk supersedes any other portfolio which is characterized by having the similar risk levels. This is based on the utility maximization theorem. According to the approach related to optimization of portfolio, in long run only the efficient portfolios are considered to be feasible. Efficient frontier is actually a line which is constructed through joining of the corner portfolios. If a risk return graph is prepared and the corner portfolios are plotted on the graph, it can be observed that the line which joins those points forms the efficient frontier. Each of the corner portfolios that is plotted in the graph are unique in nature by offering the best possible return against a known level of risk. Each of the portfolios that lie on the efficient frontier is better than any other portfolio which falls in the zone lying below the efficient frontier line.4 B. Construction of Diversified Portfolio The recent Global Financial Crisis (GFC) had a significant negative effect on the global financial market. Since the onset of GFC the interest rates have been falling at significant rate and the current global financial condition can be considered to be low interest rate regime. The financial flows in between international markets are mostly governed by the decision of allocation of the assets by the institutional investors. If we look at the assets under management held by the institutional investors those are included amongst the 17 OECD countries, it can be found out that strong growth was observed during 1995 – 2000. Then from 2002 to 2007 there was a considerable increase in assets (Table -1). Then with the onset of GFC, it declined considerably in 2008. It recovered a little in the year 2009 (Chart 1). Table 1 Source: (International Monetary Fund)5 Chart 1 Source: (International Monetary Fund)5 Hence the developments in long term regarding asset allocation globally can be considered to follow three of the following principal trends: a. Portfolio globalization with a slow decline in the biasness towards home country. It can be observed from the trend of broadening of assets distribution over different countries. b. There has been a long-term decreasing trend in the share of insurance companies and pension funds in the total asset base of investment companies. c. The asset allocation globally has shown a trend of official sector having significant importance. The strategies of asset allocation for both the official and private institutional investors are observed to have changed considerably since the onset of GFC. The investors are found to be more conscious about risks relative to sovereign credit and liquidity issues.5 Before deciding on choosing the investment options in different assets for portfolio diversification, it is necessary to clearly define one’s financial goals in life. It depends on the life cycle of the investor and in which phase of career he is currently situated. The investor has to set his risk appetite. He has to decide on his capability of enduring maximum amount of risk in the portfolio. Once all these things are known, one can start building his own portfolio in the best possible way to suit his requirements. Diversification of assets is the key towards reducing the overall risk involved in a portfolio. The correct combination of different assets is very important while creating a diversified portfolio. One has to decide how many stocks and how much bonds should be included in the portfolio. While bonds are associated with stability having lower risks but its potential to generate growth in the long run is limited. Moreover bonds would not be able to beat the inflation rate in the long run. Stocks are considered to be associated with higher growth rate in long run. However stocks are supposed to be far more risky than bonds. Hence a right balance between stocks and bonds are quite necessary to build a diversified portfolio.6 In order to build a completely diversified portfolio, it would be best to combine both stocks and bonds in the portfolio. It is so because of their opposing characteristics regarding returns and risks. If we look at the US market and the returns of its constituent financial assets like the stocks and bonds, it can be found that stocks and bonds has shown a negative correlation between each other (Chart 2). Chart 2 Source: (Bloomberg)7 Now suppose I have $1 million to invest in different assets for creating a completely diversified portfolio. As discussed earlier the primary requirement to build a diversified portfolio is to choose between assets which have varied return characteristics. My ultimate aim would be to maximize return and minimize risk in the portfolio. Hence it would be better to include different types of investment instruments like deposits in savings account in banks, CD’s, stocks, mutual funds and government bonds. Now while making the decision of investment one has to keep in mind the objective associated with it like the return that the portfolio is expected to generate in a given period of time. The willingness of the investor to take risk or no tolerance for risk will also play an important role while deciding on the investment options that are needed to be chosen. Now being a young aged person I can afford to tolerate greater volume of risk. Hence majority of my investment would be in stocks and mutual funds. Moreover since the US economy is in a development and recovery stage after the GFC, the stock prices are at a relatively low level. Hence 70% of $1million would be invested in stocks and mutual funds. Although these investment options are associated with more risk than CD’s and Government Bonds, still I have invested in them because I can afford to take risk based on my age and I do not have significant financial liabilities too. In order to have diversified portfolio with the risks being diversified, my mutual fund investments would be spread over growth funds, equity funds, income funds and bond funds. Funds like Spiders would also be chosen which are index funds and are based on the S&P 500 index. 8 This would ensure further increased diversification of risk. Next government bonds and CD’s would constitute 25% of my investment. In the upcoming years I would have different financial liabilities and would be liable to pay various fixed payments like mortgage and rent payments. Hence sufficient funds are needed at that time to pay off all these liabilities. Interest rate risk can be avoided by having government bonds included in my portfolio. Now the remaining 5% that is left to be invested would be utilized to make a savings account deposit in bank. It would ensure the availability of liquid cash required for emergency needs. It would thus be utilized as a safety net. Hence this would be the pattern of my investment in order to fulfill my objective of obtaining a completely diversified portfolio where the overall risk becomes less than the risks associated with some of the individual assets like mutual funds and stocks. References 1 Frank J. Fabozzi. The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies. 2nd Ed. USA: John Wiley & Sons, 2011. 2 Meir Statman. “The Diversification Puzzle.” Financial Analysts Journal. 60 no. 4 (2004): 46-47. http://www.scu.edu/business/finance/research/upload/diversification-puzzle-060205.pdf. 3 James E. Hotvedt and Philip L. Tedder. “Systematic and Unsystematic Risk of Rates of Return Associated with Selected Forest Products Companies.” Southern Journal of Agricultural Economics. (July 1978): 1-2. http://ageconsearch.umn.edu/bitstream/30276/1/10010135.pdf. 4 Dhanesh Kumar Khatri. Security Analysis and Portfolio Management. India: Macmillan Publishers, 2010. 5 International Monetary Fund. “Global Financial Stability Report Grappling with Crisis Legacies.” Imf, September 2011. http://www.imf.org/external/pubs/ft/gfsr/2011/02/pdf/text.pdf. 6 Alliance Bernstein. “Fortune or Misfortune? The Power of a Diversified Portfolio.” http://www.alliancebernstein.com/CmsObjectABD/PDF/Research_WhitePaper/R21359_FortuneMisfortune_0408.pdf. 7 Bloomberg. “S&P 500 Index.” Bloomberg. http://www.bloomberg.com/quote/SPX:IND/chart. 8 Oldrich Kyn. “How to Invest 1 Million.” Econc10. http://econc10.bu.edu/Ec341_money/exams/Howtoinvest_lg.htm. Bibliography Hagin, Robert. Investment Management: Portfolio Diversification, Risk, and Timing--Fact and Fiction. USA: John Wiley & Sons, 2004. Elton, Edwin J., Martin J. Gruber, Stephen J. Brown and William N. Goetzmann. Modern Portfolio Theory and Investment Analysis. 8th Ed. USA: John Wiley & Sons, 2009. Read More