Portfolio Diversification

Portfolio Diversification

Surname 4 title Portfolio Diversificationname Of Studentname Of Profes

Surname 4 Title: Portfolio diversification Name of Student: Name of Professor: Affiliation/School: Date: Assume you are considering a portfolio containing two assets, L and M. Asset L will represent 40% of the dollar value of the portfolio, and asset M will account for the other 60%. The projected returns over the next six years, 2018–2023, for each of these assets are summarized in the following table.

1. Use an Excel spreadsheet to calculate the projected portfolio return, rp , for each of the six years.

2. Use an Excel spreadsheet to calculate the average portfolio return, rp , over the six-year period.

3. Use an Excel spreadsheet to calculate the standard deviation of expected portfolio returns, sp , over the six-year period.

4. How would you characterize the correlation of returns of the assets L and M?

There is a strong negative correlation of -0.96395 between returns of asset L and M as returns of asset L is increasing with time while returns of asset M is decreasing with time.

5. Discuss any benefits of diversification achieved through creation of the portfolio. Diversification of portfolio helps reduce the overall risk. Having assets with negative or low positive correlation results in overall higher returns as while one portfolio is not performing well it will be compensated by the other that is performing well cancelling out the risk. Year Asset L Asset M Portfolio returns % 20% 17.600% % 18% 16.400% % 16% 16.000% % 14% 15.200% % 12% 14.000% % 10% 13.600% Average portfolio Returns = 15.467% Standard Deviation Of Expected Portfolio returns = 1.511% Correlation = -0.96395 Diversification of assets and liabilities Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The idea behind this technique has proven that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so the positive performance of some investments neutralizes the negative performance of others. Therefore, the benefits of diversification hold only if the securities in the portfolio are not perfectly correlated. Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Investing in more securities yields further diversification benefits, albeit at a drastically smaller rate.

Further diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments gives an investor a small cushion of protection against losses due to an American economic downturn. Most non-institutional investors have a limited investment budget and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification.

In our case the portfolio consists of two assets that re negatively correlated, meaning as the projected returns of asset L increases those of asset M reduces during the same period of time. Asset L performs better whereas asset M performance is dismay but through the diversification of the portfolio and having assets with negative or low positive correlation results in overall higher returns, as while one portfolio is not performing well it will be compensated by the other that is performing well cancelling out the risk. Diversification alone is not enough to manage downside risk, rather academic research in dynamic portfolio theory suggests the three complementary techniques of diversification, hedging, and insurance can be used together to design customized investment solutions, that ultimately separate assets into performance seeking portfolios and liability hedging portfolios, according to EDHEC’s Felix Goltz and Stoyan Stoyanov.

Diversification allows investors to obtain the best risk/return tradeoff in normal market conditions. It is often mistakenly believed that diversification can also provide explicit protection from extreme risks if, rather than variance, a downside risk measure is used. Although diversification may make extreme portfolio losses less likely, it does not provide a guarantee that such losses will not occur. The reason is that the correlation of assets tends to spike in market crashes, making diversification inefficient. Nonetheless, two other methods, hedging and insurance, can be used to manage downside risk.

While diversification is used to construct portfolios achieving the highest risk-adjusted returns, hedging is done to shed risk that cannot be diversified away. In fact, the theory of optimal asset/liability management (ALM) indicates that efficient capital allocation involves two portfolios — a performance-seeking portfolio (PSP) constructed through diversification, and a liability-hedging portfolio (LHP) used to deal with the variability of the stream of liabilities arising from different sources, mainly interest rates and inflation. LHPs can be designed in various ways. Cash flow matching is a popular technique that, through investments in suitable bonds, attempts to ensure a perfect static match between the cash flows from the portfolio of assets and the commitments in the liabilities.

Although the technique is simple, a big problem is finding bonds with the proper duration, a major challenge above all in the corporate bond sector. Approaches to hedging inflation include investing in cash instruments such as Treasury inflation-protected securities (TIPS) or derivatives such as inflation swaps. A problem with this approach is the very low real performance of inflation-protected securities; for this reason, other asset classes have also been considered. Although research is ongoing, empirical studies indicate that stocks, commodities, and real estate can offer protection from inflation at lower cost. From an ALM perspective, hedging is done to protect long-term liability needs.

It can also reduce downside risk — the equity risk in an equity portfolio, for example, can be reduced trivially by increasing the weight of the cash component, leading to a limited downside risk but also to limited upside potential. The right approach to limiting downside risk while maintaining access to the upside potential is risk-controlled investing (RCI), a form of insurance. Like any other form of insurance, it comes at a certain cost. Dynamic asset allocation theory suggests that downside risk constraints, or asset value floors, can be implemented through an optimal state-dependent weighting of the PSP component depending on the size of the risk budget. In this way, risk exposure can be adjusted in an optimal manner, allowing at the same time the highest possible exposure to the upside potential of the PSP component within the imposed risk constraints.

The framework is flexible and can accommodate such floors as capital guarantees, maximum drawdowns, and rolling performance floors. The floor can also be benchmark-relative, indicating that the LHP can be adopted as a benchmark. In this way, risk-controlled investing can be done in an ALM context and provide a guarantee that the value of the assets will remain above a multiple of the value of the liabilities at any time until the horizon. As mentioned above, diversification alone is not an appropriate means of controlling downside risk. However, well-diversified portfolios are a crucial ingredient in such insurance strategies because an attractive risk/reward ratio makes it possible to lower the cost of insurance.

References

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