The of Portfolio Diversification - Case Study Example

PORTFOLIO DIVERSIFICATION: JACKIE JONES’ PORTFOLIO The situation After her husband passed away, Mrs. Jones was left with an investment portfolio consisting of 5 stocks which originally was valued at £1,500,000 but has now fallen 30 percent after the recent market downturn. Now in her fifties or so, her present concern is how to manage portfolio in such a way that it would appreciate in value and at the same provide her with steady source of income. She has approached her brokerage firm’s senior financial advisor in order to ask for guidance on how her portfolio can be managed well. Her close friend Mary had been a client of Bill Guru’s and was “very happy” with Bill’s advice and professionalism, in helping here rebalance and reallocate her portfolio that resulted in its increasing value over the years without much volatility. Bill wanted to diversify her portfolio and reduce its beta, thereby minimising the risk inherent in her portfolio. The case presumes that the individual betas of the 5 stocks are greater than the market index beta of 1. The Challenge It is the task of Bill Guru to explain to Mrs. Jones what diversification meant and what the advantages were of having a diversified portfolio. He also needed to explain why at her stage in life she would need her portfolio to be rebalanced and her assets reallocated to meet her needs both for capital appreciation and for steady income. At the same time, Bill would have to discuss with Mrs. Jones the possibility of putting part or all of her assets in other forms of investments such as money market funds or fixed income securities such as Treasury bills or Treasury bonds. The possibility of transferring all of her investments to fixed income securities would preclude the question of a beta coefficient as the latter applies only to stocks in relation to the main market index such as the FTSE. On the other hand, if a significant part of her assets continues to be invested in stocks, the beta would be a relevant concept. He will need to explain the impact of the overall market on her stock portfolio as the market is subject to systematic risks. Also he has to explain that there are factors that affect a particular stock and a particular industry, factors that are unique or specific to the stock in question. The rebalancing of Mrs. Jones’ portfolio may take any form that is tailored to the particular situation and needs. Some kind of distribution among different types of securities would have to be discussed with her that would take into account the need for steady income in the form of interest and dividends as well as steady appreciation of her equity capital. It would also be the task of Bill Guru to inform Mrs. Jones of the impact of interest rates on her investment. An increase in interest rates would have a direct depressing effect on a portfolio consisting of bonds, and this would have to be explained to her. The new bond issues would be more attractive to investors, thus current bond holdings would have to fall in price in order to be competitive. Her portfolio of stocks would also be affected by an increase in interest rates because such a situation means tight money supply, but the effect would not be immediate. Mrs. Jones has also heard stories about tips and individuals acting on tips who have money. As an investment professional, it is the duty of Bill to enlighten Mrs. Jones on the implications and pitfalls inherent in acting on tips, rumors and insider information. While Bill Guru is a professional investment advisor and should know his job, this writer is being tasked with the duty of offering an advice to both Bill and Jackie. The following discussion will focus on the following areas of consideration: 1) the concept of risk and return, with emphasis on the capital asset pricing model, 2) the proper rebalancing and allocation of assets tailored to the specific needs and requirements of Mrs. Jones. Discussion The concept of risk and return. The risk of an investment is related to the uncertainty of outcomes. An investment that has an absolutely certain return of 5 per cent is considered to be riskless, whereas another investment that has a likely return of 12 per cent with a possibility of minus 15 percent during a mild recession and 30 per cent under good economic conditions can be said to be risky. Because most investors do not like risk, they would require a higher rate of return for riskier investments. For this reason an individual would require an anticipated return on a common stock investment that is higher by, say, 5 per cent, compared to a bank certificate of time deposit or a Treasury bill. This additional 5 per cent is called a risk premium, which represents the risk of a common stock over and above the risk-free rate of interest. There are three basic components that comprise the required rate of return from an investment, namely, 1) the real rate of return, 2) the anticipated inflation factor, and 3) the risk premium. The real rate of return is the compensation of the investor for postponing consumption and making his money available to others to use until it is returned. The anticipated inflation factor is added to the real rate of return based on actual circumstances, and combined with the real rate of return, which together make up the risk-free required rate of return. For example, if the real rate of return is 3 per cent and the inflation factor is 4 per cent, the risk-free rate will be 7 per cent. The third component is the risk premium. If the investor wants a 12 per cent return on his investment in a common stock, this means that his risk premium is 5 per cent. When one contemplates the range of investment options, one would consider Treasury bills as risk free, corporate bonds as carrying moderate risk and therefore implying a small risk premium, and common stock as highly risky with the associated higher risk premium. Among common stocks, large, stable companies would require a lower required rate of return compared to small companies which basically are more risky investments. Systematic and unsystematic risk. The total risk in a stock can be divided into systematic risk and unsystematic risk. The discussion so far focused on unsystematic risk, i.e., the risk inherent in a specific stock by virtue of its unique situation. At the same time the stock can be affected by exogenous factors. The price of a stock can be affected the introduction of a new product, a new and effective marketing campaign, new management, loss of market share, lawsuits, among many other factors. In the valuation of stocks, it is not sufficient to consider the individual stock alone in considering the risk profile. If two stocks are combined, the combined risk level changes. Part of the risk of one stock can be “diversified away” with a second investment, which means that part of the risk has been eliminated. This is particularly true in the case of stocks whose businesses are negatively correlated such as oil and petrochemicals or US stocks vis-à-vis Asian stocks, among others. Stocks that are positively correlated do not offer risk reduction engendered by diversification. With 5 stocks in a portfolio such as Mrs. Jones,’ some degree of diversification is probable if the stocks were picked from different industries or at random. The greater the number of stocks in a portfolio, the greater is the diversification. Systematic risk is measured by the movement of a stock in relation to the market. In a diversified portfolio, each stock is affected by changes in the overall market. If the market goes up or down, a specific stock may go up or down to the same degree. The joint movement of the security and the market index is defined as the beta coefficient. If a stock has equal volatility as the market – e.g., if the stock rises or falls by 10 per cent as the market rises or drops by 10 per cent – the beta coefficient is 1. If the stock is 30 per cent more volatile than the market, its beta coefficient is 1.3. It is assumed that a stock with a relatively high systematic risk or beta is expected to provide higher returns to compensate for the higher risk. Stocks with a beta coefficient of less than 1, such as most utility stocks, are less sensitive to the movements to the market than normal. The capital asset pricing model (CAPM) The capital asset pricing model was devised by Professors Sharpe, Lintner and others in the 1960s and 1970s to give the analyst a meaningful way of evaluating assets on the basis of their risk characteristics. Space constraint precludes a discussion of the technical formulations and complexities of the model. Suffice it to say the model takes over from and supersedes previous studies under the rubric of classic portfolio theory. Earlier in this paper we mentioned the risk-free asset such as Treasury bills, which by definition has a zero risk premium. A stock investment is assumed to be compensated for under the capital asset pricing model for the systematic risk but not for the unsystematic risk because the latter is associated only with the particular company or industry and not with the market as a whole. By assembling a large portfolio of common stocks, an investor can diversify away or eliminate the unsystematic risk. Hirt and Block (1986) cite the example of semiconductor stocks which can be combined with countercyclical housing stocks in order to neutralise unsystematic risk. They added that all but 15 per cent of unsystematic risk may be eliminated with a carefully selected portfolio of 10 stocks and all but 11 per cent with a portfolio of 20 stocks (Wagner and Lau, cited in Hirt in Block 1986). From the foregoing, it can state that total risk is the sum of systematic risk and unsystematic risk. Also, one can say that unsystematic risk can be diversified away so that only systematic risk is relevant under the capital asset pricing model for which the investor can receive a return corresponding to his risk. Excess returns are returns in excess of the risk-free rate or in excess of a market measure such as the S&P500 stock index. The excess returns can be plotted on a chart to determine the joint movement between the excess returns of an individual security and those of the market. This answers the question whether the portfolio manager has been effective in diversifying away the unsystematic risk, whether and to what extent a fund’s movement can be described as market related rather than random in nature. The regression line would determine whether points of observation fall close or very close to the line. If they are very close to the regression line, the excess market returns are responsible for the excess returns of a specific security or fund. The degree of association between the independent variable (market excess returns) and the dependent variable (the security or fund’s excess returns) is measured by the coefficient of determination R2. A high degree of correlation will produce an R2 of .7 or better. Where this measure falls below this threshold, it indicates that the fund manager has not been effective in his diversification efforts: the unsystematic risks have not been diversified away. According to a study done by Wagner and Lau (cited in Hirt and Block, 1986), a high degree of diversification can be achieved with between 10 and 20 efficiently selected stocks. With 5 stocks, the coefficient of determination derived from the study was found to be a mere .79, compared to .89 for 20 securities in a portfolio. With regard to the stability of beta coefficients over time, the same study has shown that individual securities according to a study by Blume (1975, cited in Hirt and Block) tend to approach 1. What this explains is that a security with a beta of 1.5, for example, will tend gradually to move towards 1. The same is true with those with betas below 1. The betas of industry groups have also tended to behave according to the same pattern. Over time, the betas of one period in general tended to be consistent where the number of securities per portfolio was large. For those portfolios with less than 10 securities, the correlation between period lengths tended to be less than .9. The significance of these studies consists in the fact that the risk carried by an investment in common stock is affected by both systematic and unsystematic risks. Under the capital asset pricing model, the unsystematic risk which applies to individual securities is unrewarded by the movements in the overall market. However, if combined with other stocks, particularly those in other industries, the unsystematic risks can be diversified away or eliminated, so that the risk to a portfolio is solely or for the most part accounted for the movements in the market. Thus regardless of whether the beta is different from 1 (the index beta), the returns of a portfolio of securities moves in tandem with the market. It needs to be explained to Mrs. Jones that his portfolio of stocks will have to be expanded to at least 10 or probably 20 securities in order for the unsystematic risk to be eliminated. If the total portfolio amount is not optimal, particularly if some will have to be in the form of cash or cash equivalents and fixed income securities, it may be necessary to invest the segregated amount in a diversified mutual fund of her choice, or even in an index fund or an exchange-traded fund which also tracks a specific index. It must also be emphasised to Mrs. Jones that a diversified fund is not immune to all risk but only to unsystematic risk. The economy, and the market index, can also suffer from the impact of macro factors such as a recession or stock market panic or from the effects of developments abroad as the world has tended progressively to move towards increasing globalisation. In addition to fundamental analysis and macroeconomic analysis, it may be necessary to learn and apply some techniques of technical analysis in order to time entry and exits. A mutual fund, if chosen as an investment vehicle, should be a member of several funds where it would be easy to switch from equity to bonds to cash whenever necessary or whenever it would be wise to do so. Building a sound and appropriate portfolio. Investing is serious business and strategically designed for the long haul. It is not gambling or speculating based on tips or rumors. Despite what other people say, Mrs. Jones should be advised not to heed tips or rumors for the following reasons: 1) They could be fabricated lies, unfounded and false, 2) Brokers are not necessarily the best sources of information, and they could be motivated for reasons other than promoting the investor’s interests, 3) If correct, the market may already have discounted it because others had got the information first and traded on it, so entering the market now might be too late and a losing proposition, and 4) It could send her to jail because it is inside information, and trading on inside information is against the law. One may also hear the phrase “playing the market,” as if one were playing roulette or baccarat. This is not a good attitude for an investor. Everyone needs a sound investing strategy, one that fits an individual’s situation and financial goals. Financial advisers often ask the investor to answer a questionnaire which would enable them to evaluate the investor’s specific circumstances, goals, and risk preferences, and on that basis to suggest an appropriate asset allocation. The different types of investments are evaluated before the allocation process is initiated. The first thing to consider is the time frame, then the goals to be achieved during these time frames. The goals could be a new home, travel, supporting aging parents, taking up a Ph.D. program, and so forth. Goals can be classified into short term goals and long term goals. Then consider risk tolerance: How much volatility can the investor live with? Volatility is important because in times of wild swings in the market, one can be pressured to exit in panic when the market is down, before the market can recover as it usually would, whether it can take months or years. Scenarios like these should be made very clear to Mrs. Jones. Financial advisers like Schwab (2000) base their asset allocation on the results obtained from the questionnaires. There are basically five model portfolios that can be generated from the questionnaire and/or interview. These model portfolios are described below: 1. Conservative Plan – This is for investors who seek current income and stability and less about growth. This will have 25 per cent cash, 55 per cent bonds 20 per cent large and international stocks. 2. Moderately Conservative Plan – This plan is for investors seeking current income and stability, with some modest potential for increase in the value of investments. Composition: 15 per cent cash, 45 per cent bonds, 40 total of diversified stocks (20 percent large-capitalisation stocks, 10 per cent small-capitalisation stocks, 10 per cent international stocks). 3. Moderate Plan – This plan is for long-term investors who want some growth and do not need current income. Less volatility than the market. It has 10 per cent cash, 30 per cent bonds and 60 per cent stocks). 4. Moderately Aggressive Plan- This plan is for investors who want good growth potential and do not need current income. Some volatility is expected but not as much as a portfolio wholly made up of stocks. This will have 5 per cent cash, 15 per cent bonds, and 80 per cent stocks. 5. Aggressive Plan – This plan is for long-term investors who want high growth potential and do not need current income. Substantial volatility is expected in the value of securities but also compensated with potentially high long-term returns. The portfolio consists of 95 per cent stocks, 5 per cent cash and no bonds. These model portfolios are graphically shown below: Conclusion and Recommendation This paper has demonstrated in simplified language the meaning of diversification to Mrs. Jones. It is believed that Bill Guru would have been able to make her appreciate the advantages of a diversified portfolio, not only in terms of common stocks but also in terms of a combination of common stocks with fixed income securities and cash. As a rule of thumb, Mrs. Jones should have from two months to six months living expenses in the form of cash which she can draw upon, particularly during emergency. I would not recommend that all the financial assets of Mrs. Jones be in common stocks, as she will need cash for regular and extraordinary withdrawals, and the dividends from stock investments will not be sufficient to meet her needs. A certain percentage will be in cash or cash equivalents and also in bonds, which earn regular interest. The moderate plan as shown above will be recommended because it is a balanced portfolio appropriate at her present stage in life. She may choose an index mutual fund or an exchange-traded fund because this has less volatility than other types of funds and is managed professionally. BIBLIOGRAPHY Brealey, RA, Myers, SC, Marcus, AJ. 1999 Fundamentals of corporate finance. 2nd edn. Irwin/ McGraw-Hill, Boston, MA Brigham EF & Gapenski, LC 1996, Intermediate financial management, 5th edn., Dryden Press, Orlando, FL Hearth, D & Zaima, JK 1998, Contemporary investments: Security and portfolio analysis, 3rd edn. Dryden Press, Orlando, FL Hirt, GA & Block, SB 1986, Fundamentals of investment management, 2nd edn, Dryden Press, Orlando,FL. Madura, J 1989, International financial management, 2nd edn, West Publishing Co., St. Paul, MN Scwab-Pomerantz, C & Schwab, CR 2002, It pays to talk, Crown Business: New York Read More