Portfolio Diversification Issues - Essay Example

Portfolio Diversification Name College Course Tutor Date The financial markets in the second half of 2007 onwards has been experiencing financial upheavals. This was epitomized by the bubble in the US property market. Portfolio is a combination of assets which an investor chooses for investment purposes. An investor will always seek to invest in those assets which does not exhibit positive correlation in order to mitigate against risk (risk diversification) for the aggregate assets (portfolio). Risks in a portfolio can be systematic (non-diversifiable) risk or unsystematic (diversifiable) risk. Diversifiable risk can be eliminated by holding diverse assets. Risk is part and parcel of investment in the stock market and as such investors always factor the same in their investment strategies. Diversification has always been depicted as the origin of return even if the market is efficient in terms of information. The aim of diversifying a portfolio is to smoothen the volatility of the market over time. Some assets in the portfolio will decrease in value while some will increase in value, diversification therefore seeks to strike the balance between the two scenarios to achieve the overall gain while minimizing risks. Global diversification of investment both locally and internationally is widely accepted norm in management of financial assets. However with cross-border flows of assets and international market correlation the benefits of asset diversification will greatly be diminished. Harry Markowitz the father of modern portfolio theory provides academic basis why investors should diversify their investments. Consider a case in which an investor invests in only one class of assets, Australian equities, and the price fluctuations of the investment will greatly impact its investment especially if the value of the investments nosedives. If the investor had invested in more than one asset the risk attached to one asset in the portfolio could be reduced with minimal impact on the overall returns of the portfolio. Diversification of assets doesn’t guarantee profitability for the portfolio held by an investor nor does it prevent losses but seeks to safeguard investments from being wiped out by price fluctuations. According to the findings of Rode (2000) investors are naïve enough to analyze whether the assets they hold are positively correlated and implement a well-diversified portfolio. Merton (1987) summarizes that search monitoring and search cost inhibit investors from investing in a diversified portfolio. The false impression among investors that by thoroughly studying a handful firms and investing on them will minimize the risk. Huberman (2001) suggests that investors invest on those stocks which they are familiar with hence creating an illusion of over-confidence. The illusion created will prevent from holding a well-diversified portfolio. According to research studies on systemic risk the impact which have on diversification benefits of portfolio risk has shown that even with a minimal probability of occurrence, systemic risk can significantly reduce the diversification benefits. Gains achieved through diversification of portfolio results from volatility in the market, growth achieved by careful and targeted rebalancing of portfolio. In nutshell the gains attributed to a portfolio does not necessarily result from diversification but out of market forces which sometimes turns out to be favorable for an investor. Diversified portfolio safeguards the investment of an investor from adverse market conditions which might wipe out the investment. In the long run ownership of diversified portfolio is the best strategy for any investor since it guarantees moderate volatility and achieves assured returns. Diversification of a portfolio therefore according to some researchers is one of the main objectives and this involves putting resources in more than one company, asset or country. Portfolio diversification enhances liquidity for any opportunities that come up for the investor to seize. Portfolio management can be easily converted into liquid cash on short notice to facilitate quick investment. Management of portfolio involves flexibility. The underlying assets should be easily marketed and traded in the stock market. This will enable the stock holder to switch investment easily without any hiccups. Investors therefore seek to invest on active securities which can be easily traded. With foreign investments risk of a portfolio can be reduced with minimum sacrifice on return. This can only be made possible when an investor is presented with numerous set of choices. Portfolio variance can be achieved by combining a portfolio assets which is less than perfectly correlated. Portfolio assets found in the same country tend to have strong co-movement in the same direction. Foreign country assets can exhibit positive correlation with domestic assets but this might not be strong to influence the market risk. Portfolio investment will always guarantee any investor of real appreciation in value. This happens after taking into consideration inflation which can erode the purchasing power of any investor. Portfolio investment will lead to growth of capital. Reinvestment of the difference in capital gains from asset gain will ultimately lead to growth in capital of the investor. Returns from portfolio invested is always guaranteed since the yields from diversified portfolio compensates for the foregone investment out of the choice of good portfolio. The returns is therefore consistent. As a result of deliberate investment in specific set of assets an investor can be able to avoid taxes. Such arrangement will drastically reduce tax owed to the government. The arrangement as such should be within the law. Comparison between marginal cost and marginal benefit should be done in order to determine the optimal level of diversification. Unsystematic risk could be eliminated by holding 10 or 100 stocks but this does not imply the other risk factors are incorporated. It is possible that with limited diversification marginal cost could be rising faster than marginal benefits Diversified asset classes sometimes have unexpected high correlations in the underlying assets. The risk factors existing therefore might lead to investor being exposed to potential losses. The same was exhibited in the recent market downturn despite the fact that the investors had diversified their portfolio. A set of portfolios can be constructed to form an efficient frontier that gives the highest level of return with reduced risk. Given expected return of 10% for domestic asset and Standard deviation of 0.18, whereas the foreign asset expected return being 4.75% with standard deviation of 0.365. The resultant correlation of the assets is 0.148. The efficient frontier is: Point C is a point of representation for foreign assets of a portfolio and point A represents a portfolio dominated by domestic assets. The efficient frontier therefore is a line from point A to point C which represents minimum variance. The points along the line represents the highest return given the market risk. The domestic efficient frontier lies lower than the global efficient frontier. The implication is that investment in international portfolio yields higher return than investment in domestic portfolio. This demonstrates that there is higher return and less risk when an investor adds foreign portfolio in domestic assets. The scenario actually encourages investors to diversify their investment opportunities. This is due to the fact that international stock are not perfectly correlated. The choice of a specific international market to invest in should be based on forecasting rather than past performance. This is because past performance analysis can be too unreliable to bank on as past experiences among investors have shown. The dominance of global efficient frontier over domestic efficient frontier. International diversification results in addition or destruction value of a portfolio investments remains to be a point of contention. Finance theorists infers that diversifying in international portfolio can minimize risk and generate portfolio benefits for investors out of the correlations which are imperfect at stock markets among countries. On the other hand, diversification in international portfolio can also diminish stock value since there is high transaction costs involved · The benefits accruing from investing internationally have been overemphasized because of ever increasing integration of international markets hence becoming more correlated. The correlation argument against international diversification is gathering momentum since the benefits from diversification is becoming more difficult to realize. Both domestic and foreign markets are exposed to the same risks due to interrelatedness. Also restrictions from individual governments inhibit international investment. Insufficient or lack of information for potential investors may lead to poor investment hence resulting in heavy losses. Also some kind of risks cannot be diversified since it cuts across all regions and sectors. In general world market is experiencing upward trend in terms of correlation coupled with periods of high volatility which can be attributed to governments deregulating the market, surge in multinational corporations as well as increase in free trade agreements all of which facilitates easy movement of capital which includes financial assets. Portfolio managers for a long time struggled to manage risk by diversifying asset classes. The design of equity portfolios has been designed in a way to avoid overconcentration, considering regions, economic policy or market capitalization; while at the same time bond portfo­lios have been constructed in such a way to avoid similar maturity period. In general all facets of risks has been considered in coming up with optimal portfolio mix. Diversification benefits accruing out of traditional portfo­lios has not yielded any tangible benefits since globalization has increased correlation in all asset classes. This trend has resulted in diminished the efficacy of diversification practices which cushion portfolio volatility in the world markets. Diversification by investors can be a tool which is powerful, giving a framework that can be used in investment management, while at the same time encouraging occasional portfolio rebalancing. Market conditions prevailing over a couple of years ago have forced investors to come up with new approaches which seeks to tackle risk aversion among investors. On that note, new investment strategies presents new approach to minimizing portfolio volatility in the world which is increasingly becoming correlated. Therefore it is paramount to monitor conditions in the market in order to come up with right asset mix according to investor’s circumstances which always remain dynamic and there is need for frequent portfolio rebalancing towards achieving optimal point. Diversification therefore remains to be a key strategy to every investor since the benefits outweigh the demerits. References 1. Almgren R, C Thum, E Hauptmann and H Li, 2005 Equity market impact Risk July, Pg 57-62 2. Bender, J., Briand, R., Nielsen, F. “Portfolio of Risk Premia: A New Approach to Diversification.” Journal of Portfolio Management, Winter 2010, Vol. 36, No. 2. 3. Coval, Joshua, Tyler Shumway (2005) Do Behavioral Biases Affect Prices? // Journal of Finance, 2005, 60, p.1-34. 4. Heaton, John, and Deborah Lucas, 2000, Portfolio choice and asset prices: the importance of entrepreneurial risk, Journal of Finance 55, 1163—1198. 5. Huberman, Gur, 2001, Familiarity breeds investment, Review of Financial Studies 14, 659—680. 6. Goetzmann, William N., Lingfeng Li, and K. Geert Rouwenhorst, 2001, Long-term global. 7. Litterman R and J Scheinkman 1991, Common factors affecting bond returns Journal of Fixed Income 1, pages 54–61 8. Market correlations, Working Paper International Center for Finance, Yale School of Management, May 2001. 9. Merton, Robert C., 1987, A simple model of capital market equilibrium with incomplete information, Journal of Finance 42, 483—510. 10. Rode, David, 2000, Portfolio choice and perceived diversification, Working Paper. Department of Social and Decision Sciences, Carnegie Mellon University. Read More