Diversification Portfolio - Assignment Example

Diversification Portfolio (By Student’s Name) (Professor’s Name) (Course Title) (Date Due) Section I Introduction: Diversification is simply defined as the portfolio strategy that is aimed at reducing the risk exposures through combining various investment varieties. For example, dealing with stocks, bonds and real estate are all processes that move towards achieving a similar goal, but with different mechanisms of business. With this form of diversification, there are low chances of volatility since not all the assets classes of the industries or even the individual companies can move up and down in their total value at the same period of time or rather at a similar time-frame. It therefore acts to positively minimize on both the upsides and the downsides of investment value thus, allowing for only the more consistent performance in the wide range of economic performances. The upsides of investment value may include the profits, and since the strategies used to achieve a predetermined goal are several, all of the companies have to ensure equitable share of this profit. The same case applies to the downsides which may include the losses. Diversification is mainly a type of strategic form that the managers are using in order to improve the performance of their respective firms. The facts of studying and using this strategy are motivated by the two seemingly incredible circumstances; the first one is that diversification is continuing to be a very important strategy for the corporate growth purposes. The second fact is that while the Management and Marketing systems always favor the related diversification samples, the Finance sector, on the other hand, makes a strong case against the use of corporate diversification. In order to come up with the better understanding of diversification, it is advisable to address the contradiction that exists on the associative relationship between the use of diversification and the general firm performance. “Diversification is a means through which the firm expands from its core businesses into other different product markets.” 1 The research done on diversification showed that by 1974, only 14% of the studied Fortune 500 firms engaged their businesses on single portfolios strategies. The remaining 86 % of the firms preferred to diversify their operations. “Many firms according to the research done are diversifying their businesses. The European corporate managers are also in favor of the diversification strategy. In the recent past, many US firms are beginning to be moderate on their zeal for the diversification and are also consolidating around their respective core businesses. However, it is should be noted that this trend does not have much impact on the Asian corporations that continue to remain highly diversified.” 2 From any economic activity, there are various costs and benefits associated to the diversification portfolios, for instance, the performance of the firm must entirely depend on how the managers will achieve the balance on the costs and benefits in each concrete case. The economic perspective also states that the benefits of diversification do not only fall on the managers and investors entirely, but also on the general population, not forgetting the nation since it helps in promoting the national GDP. On its advantageous side, the diversification processes do prolong the firm’s life span. On the other hand, the finance researchers argue that diversification portfolios only benefit the managers, since it buys them the insurance, while the shareholders usually bear all the costs imposed by such insurance. Carried out research finally indicated that those firms that used the diversification portfolio were perceived to portray longer life spans than those companies that operated on the single portfolios. The reason for this is that when losses occur, they are subdivided among the affiliate companies and the profits shared too. On the other hand, if the company operates on single portfolios, they suffer the entire losses alone, which may lead to bankruptcy and hence closure of the firms. Diversification importance can also be measured by looking at the depth capacity of the firm. It is perceived to improve the depth capacity, and could also reduce the chances of bankruptcy through choosing to go to the product or markets, and also improve on the asset market deployment and profitability. The strongest fold of deploying diversification procedures is that by doing so the skills developed when one business is transferred to the other business, can increase both the labor and capital productivity tremendously. The firm that is diversified can therefore transfers its funds from the cash surplus unit into the cash deficit unit, without necessarily incurring the taxes or the transaction costs. Firms that are diversified do pool disorganized forms of risks and can also minimize on the inconsistency which manifests itself on the operations cash flow of the firm, while it also enjoys the relative advantage on the hiring procedures since the key employees’ possess greater sense of their job securities. 3 The diversification benefits may also be measured through assessing the firm’s size, whereby the executive compensations are correlated highly, thus suggesting that diversification provides the benefits to the managers which are, on the other hand, unavailable to the investors. From the economics perspective, they view this as barely an agency problem whereby the managers tend to lose more if they become unemployed, due to the poor performance or because of bankruptcy. This makes it a great limitation for this underlying theory. The other problem that can result from the diversification portfolio is the moral hazard effects, since there are chances of people altering the behaviors after they enter into the contract as the conflict interest by providing the insurance for the managers who have really invested in the specific skills. The managers in charge may also have some interests in diversifying away from the certain amount of the firm’s specific risks and thus may look upon the diversification as either a form of compensation. Diversification can also be expensive and thus places a considerable amount of pressure to the top management positions. 4 It should be noted that when making decisions to diversify financial portfolios, investors are advised to minimize the chances of standard deviation of the portfolios since they bear the law of diminishing returns as it emphasizes on the elimination of progressive risks. Standard deviations of stocks are usually calculated by use of the systematic risk whereby the Beta formula is applied altogether. On the other hand, Portfolio weight refers to the percentage composition of certain assets in a financial portfolio. The major need for including the aspect of portfolio weight in the financial portfolio investments is for the purpose of minimizing the risk in the expected returns on the investments made. The fundamental principle to b made when deciding on the perfect asset portfolio combination is greatly depended upon the portfolio weights. Section II The current global conditions in the market are mainly concentrating on minimizing the systematic risks that are bound to affect the economy of the people and the nations as a whole. The IMF has been recently requested through the international community to come up with concrete strategies that might help in reducing these risks. The important element on the need of anticipating and identifying the systematic events are thus playing the role of underlying the market conditions and its ability for these events to subsequently change the fragile market conditions. “At the most high level, the value of assets on books of the financial segments is dependent mostly on the underlying financial environment. When the uncertainty level is quite high, the temporary shock can therefore lead to various defaults, thus causing significantly negative aftershocks. On a much similar perspective, when risks pertaining to the investor’s appetite are low or have tight global liquidity, then even the smaller aftermaths can end up having great effects on the global financial market.” 5 Basing on the awareness of the current market on the adverse effects of the risks and possible measures to avert them, I would opt for the diversification on both the stocks and bonds duties. The reason for this choice of strategy is because the stocks play a role on the development and also diversification in the growth phenomenon especially in the developing nations has received the considerable attention in the history of development for over 50 years now. The correlation between both bonds and stocks market does play a greater role on the asset allocation in as well as the risk management. In the tranquility of time, most investors would prefer to invest more on the equity markets in order to seek the maximum returns while there is turbulence in the market condition, they “flee” to the bond markets. The bonds and stocks are distinguished as low, moderate or high volatility regimes in the weekly stock returns, with mostly the high-volatile regime being associated with the economic recessions. “The most common econometric approaches used on the modeling correlations of the multiple assets are described in the multivariate versions of the general autoregressive condition heteroskedasticity (GARCH) model type.” 6 Since the developing countries are most dependent on the aids from the developed countries who dwell mostly on stocks to raise their revenue, it makes the undeveloped countries most vulnerable to the external risks, which therefore becomes the key challenge to confront the policy makers in the particular countries where the there is expansion on the aids being allocated. There is therefore need to stabilize the stock market and also to upgrade the value added on the challenging North-South trading structures. The need to venture on the stock and bonds diversification is with the urge to meet the unemployment challenges and the general lower growth in the many developing countries. “Following the success of High performing Asian economies that experienced the substantial increases on their stock returns, and specifically the stocks traded on the manufactured goods, and also high growth rate of their respective GDP over just a few decades has thus prompted the interest to specialize on the stock/bond diversification since it is the engine of growth.” 7 The critical part when dealing with this diversification is however the percentages being allocated on each sector. The amount being allocated to the stock market should always be higher than the bond allocations. My percentages roughly range around 40% on the stock value duties and a subsequent 60 % on the bonds assets. The reason for this allocation criterion is for the purpose of getting ready enough for the unpredicted market conditions in the current financial market. Stocks are very volatile and can fluctuate from time to time while the bonds are quite secure. When the country for example dwells more on the stock returns, then the negative changes of the market trading patterns would greatly impact minimally on the particular state, while, on the other hand, benefiting the other trading partner country. Persistent occurrence of such situations implicate lack of growth completely on the part of the undeveloped countries hence raising the unemployment rate to occupants of that particular country that is affected with the sudden fluctuations in the market conditions. The stock and bonds are correlated in the essence that they mutually depend on each other for the consistency of them in the market, and thus huge imbalances would mean the business is brought to a standstill. The current market is also facing fluctuations in terms of currency especially on the dollar currency. However, this s is phenomenon is not expected to carry much weight since what matters is the mixture of the product in the market to ensure its consistent existence in the market portfolio. The geographical region of the United States has a stable currency in terms of the dollar as compared to their respective trading partners. Governments are also expected to support broader stock and bonds base value, thus focusing on the portfolio diversification which can indeed help in lowering the instability experienced in the market earnings, thus the revenues collected, improving on the value-added to these assets, hence enhancing the growth through various financial platforms 8. For instance, taking the current stock prices of the coca-cola company and Apple inc. as $ 100 and $ 105 and correlation rates as 0.54 and 0.45 respectively, we can calculate the variance of the two stocks as follows: my choice of 60% in stocks will yield th following results: Var (Rp) =W^2 (Apple) SD(R apple) ^2 + W^2 Coca-cola SD(R coca-cola) +2W Apple W Coca-cola Corr (R apple. R Coca-cola) SD(R apple) SD(R Coca-cola) Rp= n E(i-1) Wi Ri = (0.60) ^2(0.54) ^2+ (0.60) ^2(0.45) ^2+ 2(0.60) (0.60) (0.40) (0.54) (0.45) =0.104976+0.243+0.405+0.0839808 = 0.8369568 SD (Rp) =Square root of Variance= 1/0.8369568^2 = 0.7004 =70.04% Notes 1. Aaker, David. Marketing Research: Private and Public Sector Decisions. New York: Wiley Press, 1980. 2. Hoskisson, Robert. And Michael, Hitt. Antecedents and Performance Outcomes of Diversification: A Review and Critique of Theoretical Perspective. Journal of Management. Los Vegas: McMillan Press, 1990. 3. Williamson, Wayne. Markets and Hierarchies: Analysis and Antitrust Implications. New York: McMillan Free Press, 1975. 4. McDougall, F. M. and Round, D. K. A Comparison of Diversification Affect Performance? Financial management. Los Angeles: Winter Press. 5. Hardy, Donald. and Ceyla, Pazarbasiouglu. Determinants and Leading Indicators of Banking Crises: Further Evidence. IMF Staff Papers, 1999. 6.Hamilton, J.D. and Susmel, R. Autoregressive Condition Heteroskedasticity and Change in Regime. Journal of Econometrics, 1994. 7. Hamilton, J.D. and Susmel, R. Autoregressive Condition Heteroskedasticity and Change in Regime. Journal of Econometrics, 1994. 8. Brunnermeier, Markus. and Lasse Pedersen. Market Liquidity and Funding Liquidity. Review of Financial Studies, 2009. Bibliography Aaker, David. Marketing Research: Private and Public Sector Decisions. New York: Wiley Press, 1980. Amin, Gutierrez de Pineres. and Ferrantino, Moses. Export Diversification and Structural Dynamics in the Growth Process: The case of Chile. Journal of Development Economics, 1997. Brunnermeier, Markus. and Lasse Pedersen. Market Liquidity and Funding Liquidity. Review of Financial Studies, 2009. Fahim, Al-Marhubi. Export Diversification and Growth: An Empirical Investigation. Applied Economics Letters, 2000. Hardy, Donald. and Ceyla, Pazarbasiouglu. Determinants and Leading Indicators of Banking Crises: Further Evidence. IMF Staff Papers, 1999. Hoskisson, Robert. And Michael, Hitt. Antecedents and Performance Outcomes of Diversification: A Review and Critique of Theoretical Perspective. Journal of Management. Los Vegas: McMillan Press, 1990. McDougall, F. M. and Round, D. K. A Comparison of Diversification Affect Performance? Financial management. Los Angeles: Winter Press. Williamson, Wayne. Markets and Hierarchies: Analysis and Antitrust Implications. New York: McMillan Free Press, 1975. Read More