Working Behind Diversifying Investment - Coursework Example

work Diversification In the area of finance, diversification is considered to be one of the efficient risk management techniques. Diversification implies the process of mixing a wide variety of investments within one portfolio. Through the process of diversification investors tries to spread out their investments into different components in order to reduce risks associated with the expected return from the investments. The basic idea working behind diversifying investment is that if an individual invests all his money in a single security they he is greatly exposed to the fluctuations in the expected return on the that security, but if he spreads out his investments among more than one security, then the impact of fluctuations in the expected return on a single security will be far less on the diversified portfolio. (Elton, 2003) To illustrate how diversification works in favor of reducing risk of the portfolio, one example can be used. Suppose, there exists only two companies - one sells raincoat and another which sells sunscreen. It is quite obvious that the an investors invests all his money in the company that sells raincoat, then his investment portfolio will perform brilliantly during the rainy season as in this season demand for raincoat is the highest, but it will give a poor performance in those season when the weather uses to be sunny. The reverse will be the case if the investor invests all his money in the company that sells sunscream as in this case portfolio will give a high performance when the weather would be sunny, but performance will be poor in rainy season. Under such condition, the best possible way to reduce the weather related risk associated with the performance of the portfolio is to spread the total investment among the two companies. Once the portfolio get diversifies risk of return reduces and the investor starts to get descent return irrespective of weather condition. Diversification can be of three categories. First, to reduce risk of returns investors can split their investments among multiple investment instruments, like shares, mutual funds, bonds etc. second, investor can also diversify his investment portfolio by diversifying his investment into different mutual funds, such as small cap, large cap, growth funds, balances fund etc. and thereby can offset large loses in one field by higher gains from another field. Third, investment can also be diversified at inter industry level, or by geography. (Sharpe, Alexander and Bailey, 1999) On the basis of the technique of diversification, diversification can be of two types- horizontal diversification and vertical diversification. In case of horizontal diversification, an investor diversifies his total investment between same types of investment tools. On the other hand, in case of vertical diversification, a portfolio is diversified between different kinds of securities. However diversification can eliminate only the unique risk of an asset and not its market risk. A numerical example: Let us assume that an investor invests $80 in shares of Company A which gives a return of 10 percent and $40 in shares of Company B which gives a return of 20 percent. The portfolio return may be calculated as follows: (.10*$80) + (.20*$40) = 8+8 = $16; in percentage terms the return is ($16/$120)*100 = 13.33 percent. Again let the risk of Company A’s shares be 30 (σ1) and that of Company B be 40 (σ2). The risk of the total portfolio may be calculated as follows: Portfolio risk = √{x12 σ12 + x22 σ22+2(x1x2 σ1 σ2)}; where x1, x2 are the returns on the shares of two companies = √{.102*302 + .202*402 = 2 (.10*.20*30*40)} = √{(.01*900) + .04* 1600+ 2(.02*1200)}= √(9 +64 + 2*24) = √121 = 11 The portfolio risk is less than that of the stocks of both companies. There diversification helps is reducing the risk of the total portfolio. (Brealey and Myers, 169 - 170) How diversification leads Markowitz efficient frontier? In his portfolio theory Markowitz has analyzed how through the process of diversifying, investor can move to efficient frontier where portfolio investment is maximized. An investor can reduce portfolio risk simply by holding combinations of instruments which are not perfectly positively correlated. In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification will allow for the same portfolio return with reduced risk. However one would surely like to know the optimal combination of assets in a portfolio. Markowitz offers a solution to this problem. He has focused on the usual practice of portfolio diversification, showing how to reduce risk or standard deviation of the returns. He has even built the basic foundation or principles of constructing a portfolio. This development has further guided us to decide upon the relationship between risk and return. If all the assets of a portfolio have a correlation of +1, i.e., perfect positive correlation, the portfolio volatility (standard deviation) will be equal to the weighted sum of the individual asset volatilities. Hence the portfolio variance will be equal to the square of the total weighted sum of the individual asset volatilities. If we are faced with the option of holding either of two assets A and B, where A has a greater spread of possible returns (risk is more) than B while the expected return is more in case of A too. Therefore although A has a higher return, it also has higher risk. At this juncture it is wiser to hold more than one asset to reduce the total risk. The efficient frontier is the locus of that set of possible combinations of the assets which will give an investor optimal return and risk combination. Expected return (r ) Standard deviation (σ) All points lying on the curve drawn above represent efficient portfolios and this shows how the risk-return combination alters according to the share of investments in each of the stocks. This is how diversification may lead to the efficient frontier conceptualized by Markowitz. (Brealey and Myers, 2002, pp.189-191) The following FTSE companies are chosen and their short term opportunities from the technical details led to this choice of combination. The companies are Anglo American, Royal BK SCOTL GR, Rexam, Reed Elsevier and Lloyds Banking. ANGLO AMERICAN (AAL.L) Alpha: -0.0071 Beta: 1.7767 R2: 0.6073 Source: Yahoo Finance, UK, 2009 The company has a chance of going back to a price of 971.6105 and this signifies the rising volatility over the last month. The choice of this company should have a fluctuating influence on the basket and thus make the results interesting. However its unique risk is low (0.71 percent) and return is 60.73 percent. ROYAL BK SCOTL GR (RBS.L) Alpha: -0.0273 Beta: 2.8025 R2: 0.3119 There is an expected rise in return of 23.81 percent and there is a bullish trend in the short term which makes the investment worthwhile. REXAM (REX.L) Alpha: -0.0021 Beta: 1.1906 R2: 0.609 There has been increasing volatility and price rallies over 230 and this makes it interesting to invest in its stocks on a short term basis. REED ELSEVIER (REL.L) Alpha: 0.0008 Beta: 0.668 R2: 0.3189 The short term movement for this stock is not predicted and its unpredictability makes it interesting. Although return is not that high, unique risk is low. This will help add a variety to the portfolio. LLOYDS BANKING GRP (LLOY.L) Alpha: -0.0269 Beta: 2.1957 R2: 0.2971 This is again a stock with different technical characteristics. The risk is not as low as others and return is also low. This is another variation that would strongly influence the mini-portfolio. Now, for the purpose of calculation, let us represent the companies AAL.L, RBS.L, REX.L, REL.L and LLOY.L with numbers from 1 to 5 respectively. Their standard deviations may be represented by σ1, σ2, σ3, σ4 and σ5 respectively. Their returns may be represented by r1, r2, r3, r4 and r5. Before calculating the portfolio return and risk let us summarize the five companies’ data in a table, as follows: Name of company Return (%) Risk (%) ANGLO AMERICAN (AAL.L) 60.73 .71 ROYAL BK SCOTL GR (RBS.L) 31.19 2.73 REXAM (REX.L) 60.9 .21 REED ELSEVIER (REL.L) 31.89 .08 LLOYDS BANKING GRP (LLOY.L) 29.71 2.69 If one is investing equally in the five stocks, then with a budget of £100, then each will get an allocation of £20. The total return on the mini portfolio is: R = (.6073 + .3119 + .609 + .3189 + .2971) * £20 = £ (12.146 + 6.238 + 12.18 + 6.378 + 5.942) = £ 42.884 In terms of percentage this is equivalent to 42.884 percent {(£42.884/ £100)*100} This return is lower than that of AAL.L and REX.L but higher than the others. The risk has also been diversified since there is a variety in the combination chosen. References 1. Brealey, R.A. and Myers, S.C. (2002), Principles of Corporate Finance, McGraw Hill Higher Education 2. Elton, G. et al (2003). Modern portfolio theory and investments analysis. Wiley. Chapters: 4-6 & 10-11 3. Sharpe, W., Alexander G., Bailey, J. (1999). Investments. Prentice Hall. 1999. Chapters 6-8 4. Yahoo Finance, (2009), “LLOYDS BANKING GRP (LLOY.L)”, FTSE100, available at: http://uk.finance.yahoo.com/q/tt?s=LLOY.L (accessed on March 19, 2009) 5. Yahoo Finance, (2009), “REED ELSEVIER (REL.L)”, FTSE100, available at: http://uk.finance.yahoo.com/q/tt?s=REL.L (accessed on March 19, 2009) 6. Yahoo Finance, (2009), “REXAM (REX.L)”, FTSE100, available at: http://uk.finance.yahoo.com/q/tt?s=REX.L (accessed on March 19, 2009) 7. Yahoo Finance, (2009), “ROYAL BK SCOTL GR (RBS.L)”, FTSE100, available at: http://uk.finance.yahoo.com/q/tt?s=RBS.L (accessed on March 19, 2009) 8. Yahoo Finance, (2009), “ANGLO AMERICAN (AAL.L)”, FTSE100, available at: http://uk.finance.yahoo.com/q/tt?s=AAL.L (accessed on March 19, 2009) Read More