Portfolio Diversification - Example

PORTFOLIO DIVERSIFICATION Name: Date: Portfolio Diversification With markets moving up and down with no constant rates for risks, investors need to device a way of maintaining their returns with minimal losses. The traditional way of focusing on the season when a specific asset is performing well is fading off. Current rates show that risks are highly volatile. Considering the main competitors that exist in the market, risk values vary with the forces of the stock market. With this in mind, investors need to come up with a strategy that would help in minimizing their losses. One of the best strategies most investors use is the diversification of portfolios. Diversification by definition represents the process through which business people or organizations invest in a portfolio of diversified assets with varying proportions of the time horizon of the investor, his tolerance to risk involved, and the goal of investing in the asset. The main objective of diversification is to minimize the range of risk in a portfolio. The process of holding such diversified portfolios with the aim of spreading risks is called portfolio diversification.1 Another reason why investors participate in risk diversification is to maintain a reasonable level of uncertain exposure. Diversification of portfolios gives a framework that an investor uses to rebalance the risk, which can assist in maintaining a suitable level of risk. The investor will base their judgments on the time factor, goals of investment and the risk tolerance2. Additionally, investors engage in portfolio diversification to temper market volatility. Portfolio diversification helps to reduce the volatility of the risk. This follows the characteristics of the performance of different asset classes under the same market conditions. For instance, bonds score high values when stocks are low. An investor reduces the volatility by combining the classes of different assets. The combination helps in smoothing the returns, limiting the probable losses that emerge from the overexposure to market segments, which are volatile.3 Investors also engage in diversification of portfolio with the intention of participating on the upside and mitigating loss on the downside. The process of maintaining a diversified portfolio has in impact on the management of the assets an investor owns. Identification of the performance of portfolios in future, to invest in the best possible asset is a hard task. With the diversification of assets, an investor can participate in the top performing asset, in the future, while limiting his or her chances of participating in the worst performing assets.4 Diversification of portfolios takes two categories: vertical and horizontal diversification. Under vertical diversification, in investor spreads his or her money between dissimilar assets. That is the investor considers the assets, which behave differently in the stock market, producing different returns. Horizontal diversification, on the other hand, happens when an investor holds dissimilar instances of the same asset. Using the modern portfolio theory, investors should diversify their assets according to the expected level of risk. Contrary to the theory, Warren Buffet encourages the investors to concentrate on the portfolios, which they understand best. Picking an asset, which performs well in the stock market, is like a gamble game, since no one is certain on how the asset will perform in the future. With this reasoning, investors are urged to diversify their portfolios for many reasons.5 Before considering the benefits of diversification, one should understand the method used in measuring the benefits of diversification. The common measure is dispersion. Dispersion represents the diversion of the values of the returns of stock away from their mean, standard deviation. This presents the best way of measuring the benefits of diversification. Other people use correlation, but this method has many limitations: diversification benefits depend on correlation and standard deviation of the risk. Additionally, the method does not give an intuitive measure for the diversification benefits.6 One benefit of diversifying the portfolio is the spread of risk. Within the assets that the investor owns, a few may perform poorly in the stock market. Their performance, under diversified portfolio may not significantly reduce the performance of the overall portfolio. The other performing assets absorb the risk that the low performing asset produces. Considering the time of boom, most of the stock in the portfolios may accrue enough returns. With the diversification of portfolio, an investor can get to benefit from the accrued returns, thereby improving the performance of the portfolio as a whole. The benefit covers up the expenses or losses that the poor performing assets accrue.7 In addition to the accrual of returns, diversification of portfolios ensures that some of the assets invested appear in the performing sectors. Contrary to this, poor performing sectors, may also take part of the assets, but the benefit from the performing sectors will act as a trade-off to the losses. The resulting pattern is an investor with portfolios, which are rarely in the top performance list and at the same time, not the biggest loser. This factor can aid long-term results for the invested assets, as the riskier strategies reduced promptly.8 Diversification of portfolios may also bring inferior investment patterns. In cases where investors have diversified their portfolios, managers underperform in the stock market due to structural limits like over diversification, pressure from short-term performance of stocks and subjection to whims and emotions from other investors.9 A clear scrutiny of diversification proves that the protection claimed by analysts is not that worth. To prove this factor, take an example of two investors, one owning 1 company, and another owning 100 companies. In a situation when the person owning one company loses the company, he suffers the entire loss, but an investor with 100 companies may not even realize if one company blows up. However, when the economy performs poorly, the person with 100 companies will suffer the biggest loss. One is not certain that the few companies will help in rejuvenating the previous level of portfolio performance.10 Part 2 Choice of the best portfolios depends on many factors. One key factor is the economic condition of the region. Investors need to concentrate on the economies, which are performing well for them to accrue maximum benefits. As a potential investor, I would consider choosing United States as my region. The reason behind choosing the region lies in the market performance of all sectors. The Unites States of America is the world largest economy with advanced technology. Holding the leading position in the world economy, I would expect the stocks of various sectors performing well. First, I would consider the assets basing on the sectors. Current news shows that health care, technology, and consumer discretionary stocks are the ones performing better. Thus in the investment portfolio, I would consider companies which emerge from the three sectors. Investing in the three sectors would guarantee maximum returns. However, I will also consider the averagely performing sector like financial, telecom, and industrial sectors. After choosing the sectors to invest, I will then consider companies, which I will concentrate. Many factors affect the decision on the company to chose. One is the historical performance of the company. Historical performance of a stock guarantees a constant return on the asset. The second factor is the current performance of the company. In order to yield maximum returns, I need to consider the best performing companies for the purpose of short-term benefits. Use of historical performance will help in accruing long-term benefits. With the above two main factors, I will first chose a few companies from the following, considering their current yield as per 2012. 1. Regeneron Pharmaceuticals, from the health care sector, with the stock price of $119.18, and yield of 115.01% 2. Sears Holdings Corporation from the consumer discretionary sector with the stock price of $72, and yield of 127.69% 3. Another company will be invenSense Inc. from the technological sector, with a stock price of $21.41, and yield of 114.96%. The above companies will form the top performing list of my portfolios for the short-term benefits, since no one is certain on their future performance. Among the averagely performing sectors, I would take the following companies: 1. Bank of America Corp from the financial sector with the asset price of $9.85, yielding 77.16% of the total face value 2. Terex Corp from the industrials sector with asset price of $23.99, and yield of 77.57% 3. SureWest Communications from the telecom sector, with asset price of $22.66, and yield of 88.36% Selection of the above companies was based on the average performance in the overall sectors of the United States economy. The investment on these sectors would ensure a balanced portfolio when the best performing companies fail to deliver in times of economic crisis. My last selection will be based on the historical performance of the companies. The selection of these companies will guarantee long-term returns from the assets. The following list contains contain companies which performed well for over 10 years, and they still hold a current market value of $500 million. Hansen Natural (HANS) This company sells water, juices, and sodas among other fluids. Their brand includes Monster Energy, Java Monster, and Hansen. The company has an operating margin of 27% and a profit margin of 17%. Revenue growth in the last quarter was 26% with a growth of 32% in their earnings.11 LiverPerson Inc. (LPSN) The company’s operating margin is 19% with a profit margin of 9%. The revenue growth collected over the last quarter was 21%, and their earnings grew by 36%. The company deals with services of connecting business with their customers. The company has no debt. Deckers Outdoor Corporation (DECK): market capital of $4.5 billion The company deals with footwear and outdoor accessories. The company has three primary brands: UGG, Teva, and Simple. The company has an operating margin of 21% with a profit margin of 13%. The revenues for the last quarter grew by 49% with the growth in earnings recording 48%. SXC Health Solutions Corp. (SXCI): market capital of $2.9 billion This company provides services in the healthcare sector. Their operating margin is 3% with a profit margin of 2%. Their revenue for the last quarter grew to hit 153% mark, with their earnings growth of 26%. Sirona Dental Systems, Inc. (SIRO): market capital of $2.8 billion This company provides dental equipments for dentists globally. Their operating margin is 17% with a profit margin of 15%. Return on stocks for the past on year was 32%. Their revenue growth over the last quarter was 34% with a 120% growth on their earnings. Choosing the above companies will guarantee long-term returns considering their performance history over the past ten years. Giving the allocations of the assets, I will invest 30% to the first group of firms, which will guarantee short-term returns. The list of the firms is provided in the first consideration. My second allocation will be in companies that fall in the average performing sectors. I will invest 25% of the money given to these companies. My last allocation will be on the above companies with promising history. The allocation will counter for 45% of the total investments. These companies will serve as long-term investments. Bibliography Adjaouté, Kpate and Jean-Pierre Danthine. Portfolio Diversification: Alive and Well in Euroland! New Jersey: Centre for Economic Policy Research, 2001. Baumol, William J. and Alan S. Blinder. Economics: Principles and Policy. New York: Cengage Learning, 2010. Campbell, John Y. Campbell; Andrew W. Lo, A. Craig MacKinlay. 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