Mean-Variance Analysis - Portfolio Theory & Diversification - Essay Example

Mean-Variance Analysis – Portfolio Theory & Diversification Introduction Modern Portfolio Theory or simply Portfolio Theory came into lime light in 1952 by Markowitz. That theory was a revolution in the field of investment such that Markowitz won the Nobel Prize on this theory. The theory encompasses the construction of a portfolio which can minimize the risk and at the same time maintains the required return for the investor (Markowitz, 1991). Construction of such a portfolio which has the aforementioned characteristics can be possible through diversification. The most common objective of diversification is “not to put all eggs in the same basket”. Diversification may have different forms. A well-diversified portfolio is the one in which all the constituents do not have any relationship among each other (Fabozzi et al, 2002). That relationship can be measured by using statistical technique of correlation. Correlation actually measures how much a constituent is associated or linked with the other constituent such that in case if the correlation is equal to or near to 1 among two constituents, then those two constituents would be called as highly associated with each other as having strong relationship between them. On the other hand, if the correlation becomes to 0, it means that there is no relationship between the constituents and they are independent of each other. The third possibility is that the correlation is computed as -1 or near to it which means that the constituents has strong negative relationship among each other and they are associated with each other in opposite manner. So according to portfolio theory, the risk of a portfolio can be minimized in case if the portfolio is well-diversified in terms if its constituents such that the constituents either do no have any relationship with each other i.e. correlation = 0 or they have opposite relationship with each other such that correlation = -1 or near to it. If the constituents selected for the portfolio having the positive correlation, it would not result in the reduction of the risk as every constituent would show a similar behavior that any other constituent would show. In this way, the ultimate objective of reducing the overall risk of the portfolio would not be accomplished. In case if the constituents do not have any relationship with each other then the constituents would show a unique behavior irrespective of any other constituent. As a result, if the price of any constituent decreases, it will not have any impact on the prices of other constituents and in this way, the overall volatility of the portfolio will remain substantially lower. The negative relationship among the constituents of the portfolio will compensate each other such that if the price of one constituent decreases, than it would be effectively compensated by the other constituent such that its price would be increased, thus it would result in managing the overall risk of the portfolio given that the required return of the portfolio is ensured. This kind of portfolio would be considered as well-diversified and ensure the same return but with the reduced level of risk. The individual return that can be earned on each constituent would be similar to those which are kept in a well-diversified portfolio, but the overall risk of the portfolio would be substantially less than every individual constituent. Diversification Principles There are different kinds of diversification strategies which are available for the investors, some of them are discussed as under: Diversification through Different Asset Classes The most famous diversification strategy holds that the constituents of a portfolio must be well spread in different asset class such that investment can be managed in different proportions under stocks, bonds, marketable securities, commodities, property and real estates, currencies etc (Shefrin, 2000). These asset classes provide a large area for diversification and hardly any relationship can be found among these asset classes. Diversification through Geographical Basis Another promising diversification strategy holds that the portfolio constituents should be selected on the basis of the diverse geographical boundaries such that if there comes any problem with respect to a constituent in one territory, it would not have any other impact on the constituent of any other territory. In this way, the portfolio can be well-diversified and thus can result in significant reduction of risk. Diversification through Different Industries & Sectors This diversification strategy is also quite famous especially in respect of stocks and bonds such that when a portfolio is constructed, stocks and bonds are the main constituents of that portfolio and the investment is made in such a manner that different proportion of the stocks and bonds are allocated for different industries and sectors. Generally those industries and sectors are considered for this purpose which does not have any significant relationship among each other. In this way, the overall risk is mitigated as the different industries do not have any apparent relationship with each other and behave in an independent manner. Diversification through Asset Class Variants Within a particular asset class, there are areas in which further diversification is possible. For instance, in case of stocks, the diversification can be made such that high growth stocks and value stocks are the different kinds of stocks. Size of the companies can provide a basis for diversification as it is possible to spread the investment in both small cap and large cap stocks. In case of bonds, different criteria for the purpose of diversification can be the maturity, coupon rates, rating of the issue and kind of issuer which are the major basis for constructing a well-diversified portfolio. In case of commodities, metals and energy futures also provide solid areas for diversification. Practical Application of Portfolio Theory In current business and financial environment, there are various kinds of practical applications of diversification and portfolio theory, exist. These applications may have different aspects. These aspects have the range of diversification and portfolio theory in the form usage (Blume, 1970). Different institutions use diversification for different purposes according to the needs and requirements of their customers. The following discussion highlights the application of diversification in terms of different users which include insurance companies, pension funds and other financial institutions including banks. Insurance Companies Insurance companies make the best use of diversification and portfolio theory such that it can expose its policyholders’ money to a very level of risk. Since the policyholders purchase different policies from the insurance companies with the intent of being compensated for any loss or damage that could arise by the insurance companies. Therefore, insurance companies try to make the best use of that money and invest in diversified areas to mitigate the risk of value depreciation of the premiums. As the insurance companies develop various kinds of policies in respect of different time horizons, therefore, diversification strategies are also formulated with the varying time horizons. Generally, the larger proportion of the sum of money is invested in the long-term risk-free bonds of the government so that consistent series of cash flows in the form of coupon payments can be reaped. However, very little proportion is allocated to the commodities and stocks as they are considered as the risky asset classes as compared to bonds and other interest-bearing securities. Pension Funds Diversification is also practically applied among the different pension fund organizations. Pension funds have various different kinds including provident funds, gratuity funds, annuity funds etc. All of these funds provide financial assistance to the retired employees. As there are various contributors to those funds including the employees, employers, government etc, therefore the whole sum of money is invested in different asset classes so that the cost of operating those funds can be recovered as well decent returns for the retirees can also be earned. Since the overall time horizon of the pension funds is quite long, therefore the fund managers generally select bonds as their premium asset class for investing their significant amount of money. The bonds generally have lower exposure to risk and the volatility factor of the bonds is the least among all other asset classes. Likewise, very fractional amount of investment is made in risky classes, among them stocks and commodities are more famous. Financial Institutions and Banks The other financial institutions that include banks of different kinds also use diversification and portfolio theory effectively in their areas. Since the time horizon is quite short for these institutions, therefore those assets classes are taken into account which provide higher liquidity with the least possible amount risk. These institutions generally invest in cash and equivalent treasury securities which are very short term in nature. Even the investments are made just for over night time period. Still these institutions do take care of making their portfolios diversified so that the overall risk of the deposits of their accountholders can be reduced to a significant level. Conclusion Diversification has many different practical applications in the current business and financial environment as more areas for investments have been explored after around 70 years of Markowitz’s Portfolio theory. The theory has been in continuous use across different areas and further research on the extension of this theory is being undertaken by researchers. With the innovation of new asset class, there is a likelihood that more advanced applications in respect of portfolio theory and diversification would come upfront. Work Cited Markowitz, H., (1991). ‘Foundations of Portfolio Theory’, Journal of Finance, 46, pp. 469-477. Blume, Marshall E. (1970). ‘Portfolio Theory: A Step toward Its Practical Application’, The Journal of Business,43(2), pp. 152-173. Fabozzi, Frank J., Gupta, Francis and Markowit, Harry M. (2002).’The Legacy ofModern Portfolio Theory’, The Journal of Investing, pp. 7-22. Shefrin, Hersh and Statman, Meir. (2000). ‘Behavioral Portfolio Theory’, Journal of Financial and Quantitative Analysis, 35(2), pp. 127-151. Read More