Importance of Diversification in Portfolio Theory and Its Role in Formulating Practical Investment Strategies

Introduction to Financial Markets (2016 – 2017) [SS2-SEM2]

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1600 Words

20/FEB/2017

Topic: Explain the importance of diversification in Portfolio Theory and its role in formulating practical investment strategies.

“But divide your investments among many places,

For you do not know what risks might lie ahead.”

 Ecclesiastes 11:2 NLT

Introduction. If investors could tell that one significant security would produce excessive returns over the next 10-30 years, they would place all their funds into that one security and expect a wonderful outcome. Unfortunately, this is not the case in a reality, as all types of investment activity are associated with significant risks. Diversification is arguably the best way to protect investors from such risks. There is a general consensus that the more diversification investors can achieve, the better it will serve in eliminating the risks. The era of globalisation opened many doors for investors to invest internationally. Now investors can significantly reduce the risk within their portfolios by implementing international diversification strategies.

The aim of this essay is to explain the importance of diversification in Portfolio Theory, and its role in formulating practical investment strategies.

Background. The diversification of the investment portfolio is defined by the distribution of funds between various investment targets. The idea of such method is not ‘to place all your eggs into one basket’, so that if a basket falls, a person would not lose all of their eggs at once. If applied to investments, it means that investors should avoid investing all their funds in a single type of security, regardless of how profitable it may appear. Instead, investors should invest into different securities, so that they could avoid serious financial losses in the event of falling prices of one or more of their securities.

There are 3 types of portfolio diversifications – simple, across industries, and diversification according to Markowitz.

1. Simple diversification is an instinctive division of funds between different securities, without any serious preliminary analysis. One type of simple diversification is called naïve or 1/N and can be traced back to the 4th century’s Rabbi Issac Bar Aha’s quote from Talmud, “One should always divide his wealth into three parts: [investing] a third in land, a third in merchandise, and [keeping] a third ready to hand.” (Aha, 4th Century) The principle behind such strategy is to equally invest into three non-related securities or industries.  

2. Diversification across industries is a division of funds between different industries. The principle of such diversification is to avoid any deflection of the portfolio towards securities of one particular industry as any industry is prone to an unexpected turn of events. For example, the fall in oil prices may lead to a simultaneous drop in the share prices of all oil companies. Investing all available funds in oil companies in this case would lead to excessive losses. The same applies to companies of a one geographical region. The fall in prices of that region companies’ shares would be due to a political instability, strikes, or even a natural disasters.

3. Diversification according to Markowitz takes into account three things: the expected rate of return, standard deviation for each share and covariance between stocks. If this information is available, then it is possible to define a set of "efficient portfolios" (Figure 1).

[pic 1]

Figure 1.

Markowitz proceeded from the assumption that the majority of investors try to avoid the risk, if it is not offset by higher income investments. For a given expected return most investors will prefer the portfolio, which will provide a minimum deviation from the expected value (Markowitz, 1952). Therefore the risk was defined as uncertainty or the ability of the expected results to differ materially, as measured means of standard deviation.

According to the interpretation Markowitz, a portfolio C (Figure 1) is suboptimal or ineffective because it could provide higher risk with lower expected return. Whereas, portfolio B on the other hand, could provide the same level of expected return with a lower risk. While portfolio D at the same degree of risk could provide higher expected return. Thus, all
efficient portfolios should be based on the EF curve, which is often called the "efficient frontier" of Markowitz.

There are two types of risks – systematic and unsystematic (Figure 2). Together they represent the total risk of the portfolio.

[pic 2]

Figure 2.

Systematic risk – a form of risk that affects all securities of the portfolio. It is considered non-diversifiable. For example, events such as war, interest rates, unemployment levels, exchange rates or gross national product levels are considered to be systematic risk factors.

Unsystematic risk, on the other hand, is is considered diversifiable and comprises special risk that is unrelated to other risks and only affects certain securities or assets. For example examples, firm's credit rating, undesirable press reports about a business, or a strikes.

From the Figure 2, we conclude that the total risk of the portfolio is reduced with its growing number of securities as Sharpe (1964) has pointed out that diversification can reduce the unsystematic risk.

International Diversification. International diversification of the portfolio can drastically reduce the risk (Solnik, 1974). This is possible due to unsynchronised movements in securities prices in different foreign countries as studies of (Grubel, 1968) and (Sarnat, 1970) have shown. That is, due to changes in prices on one securities exchange not dependent on changes in prices on another country’s securities exchange, investors can use it to their advantage in offsetting their losses. Regarding the return, with the same number of securities, a portfolio that is diversified internationally would be half as risky as a diversified portfolio of U.S. securities as well as 1/10th as risky as a usual security (Solnik, 1974). Furthermore, international diversification strategy also produce a lower risk than diversification across industries (Solnik, 1974). However, some more recent studies have shown that due to increased co-movement in major market share indices, the international diversification advantages began to decrease (Login, 1995). Statman and Scheid (2005) revealed that, for the past twenty years, co-movement between the returns of a US portfolio and an international portfolio raised from 0.35 to 0.86. Goetzmann and Rouwenhorst (2005) argue that raise in co-movement happens due to the free flow of capital across international borders. In other words, the increased capital market integration followed by higher co-movement of prices between the markets. International diversification, if done correctly, is a very working strategy and can help investors in managing their risks.