Reduction Of Portfolio Risk Through Diversification 2i4c1u

REDUCTION OF PORTFOLIO RISK THROUGH DIVERSIFICATION

CHAPTER-1 INTRODUCTION Diversified portfolios greatly reduce risk while smoothing investment returns by including many securities across a wide range of industries. This allows investors to participate in a wide variety of investment opportunities while reducing the risk of large losses due to any one security. Diversification is an investment strategy in which you spread your investment dollars among different sectors, industries, and securities within a number of asset classes.A well-diversified stock portfolio, for example, might include small-, medium-, and large-cap domestic stocks, stocks in six or more sectors or industries, and international stocks. The goal is to protect the value of your overall portfolio in case a single security or market sector takes a serious down turn. Diversification can help insulate your portfolio against market and management risks without significantly reducing the level of return you want. But finding the diversification mix that's right for your portfolio depends on your age, your assets, your tolerance for risk, and your investment goals. A risk management investment strategy in which a wide variety of investments are mixed within a portfolio; the rationale is that a portfolio of different investments will, on average, yield higher returns and pose a lower risk than any individual investment within the portfolio. Diversification strives to smooth out unsystematic risk in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not correlated. The main purpose of diversification is to lessen risk. For example, if someone has 20 percent of her portfolio invested in XYZ stock, she stands to lose a significant percentage of her 1


portfolio value if XYZ declines. However, if the investor diversifies by investing in other stocks and leaves only 5 percent of her portfolio in XYZ, she will lose a much smaller percentage of portfolio value in the event of a decline.

1.1 DEFINITION

AND

MEANING

OF

PORTFOLIO

AND

PORTFOLIO DIVERSIFICATION DEFINITION OF PORTFOLIO A collection of

investments all owned by the same individual or organization. These

investments often include stocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earn interest; and mutual funds, which are essentially

pools of money from many investors that are invested by professionals

or according to indices.

MEANING OF PORTFOLIO A portfolio refers to a collection of investment tools such as stocks, shares, mutual funds, bonds, cash and so on depending on the investor’s income, budget and convenient time frame

PORTFOLIO DIVERSIFICATION A risk management technique that mixes a wide variety of investments within a portfolio. The

rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

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Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

MEANING Portfolio diversification is the means by which investors minimize or eliminate their exposure to company-specific risk, minimize or reduce systematic risk and moderate the short-term effects of individual asset class performance on portfolio value. In a well-conceived portfolio, this can be accomplished at a minimal cost in of expected return. Such a portfolio would be considered to be a well-diversified. Although the concepts relevant to portfolio diversification are customarily explained with respect to the stock markets, the same underlying principals apply to all types of investments. For example, corporate bonds have specific risk that can be diversified away in the same manner as that of stocks.

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CHAPTER-2 PORTFOLIO RISK AND TYPES OF PORTFOLIO RISK Portfolio risk is the possibility that an investment portfolio may not achieve its objectives. There are a number of factors that contribute to portfolio risk, and while you are able to minimize them, you will never be able to fully eliminate them. With the markets moving up and down like a Six Flags roller coaster, is there anything you can do to stomach the risk? Have you carefully considered the various risks that are associated

with

each

investment

you

make?

The fact is, many people either have no desire or no knowledge about how to protect themselves from unneeded risk. In this tutorial, we'll introduce you to risk and give you a good foundation to understand the relationship between return and risk Different individuals will have different tolerances for risk. Tolerance is not static, it will change as your life does. As you grow older tolerance will usually shrink as more and more obligations

come

up,

including

retirement.

There are several different types of risks involved in financial transactions. I hope we've helped shed some light on these risks. Achieving the right balance between risk and return will ensure that you achieve your financial goals while allowing you to get a good night's rest

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Types Of Portfolio Risk

Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio. It is virtually impossible to protect yourself against this type of risk.



Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only

way

to

protect

yourself

from

unsystematic

risk.

Now that we've determined the fundamental types of risk, let's look at more specific types of risk, particularly when we talk about stocks and bonds. 

Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates.



Country Risk - Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds,

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options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit. 

Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreignexchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of America and invest in some Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American dollar.



Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks.



Political Risk - Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment.



Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the the day-to-day fluctuations in a stock's price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behaviour, or "temperament", of your investment rather than the reason for this behaviour

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CHAPTER-3 IMPORTANCE ,NEEDS, ADVANTAGES AND DISADVANTGES OF DIVERSIFICATION IN REDUCTION OF PORTFOLIO RISK 3.1IMPORTANCE OF DIVERSIFICATION:Diversification is not a new concept. We should that investing is an art form, not a knee-jerk reaction, so the time to practice disciplined investing with a diversified portfolio is before diversification becomes a necessity. By the time an average investor “reacts” to the market, 80% of the damage is done. Here, more than most places, a good offense is your best defense and in general, a well-diversified portfolio combined with an investment horizon of three to five years can weather most storms. 1. Spread the WealthEquities are wonderful, but don’t put all of your investment in one stock or one sector. Create your own virtual mutual fund by investing in a handful of companies you know, trust, and perhaps even use in your day-to-day life. People will argue that investing in what you know will leave the average investor too heavily retail-oriented, but knowing a company or using its goods and services can be a healthy and wholesome approach to this sector. 2. Consider Index or Bond FundsConsider adding index funds or fixed-income funds to the mix. Investing in securities that track various indexes make a wonderful long-term diversification investment for your

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portfolio. By adding some fixed-income solutions, you are further hedging your portfolio against market volatility and uncertainty. 3. Keep BuildingAdd to your investments on a regular basis. Lump-sum investing may be a sucker’s bet. If you have $10,000 to invest, use dollar-cost averaging. This approach is used to smooth out the peaks and valleys created by market volatility: you invest money on a regular basis into a specified portfolio of stocks or funds. 4. Know When to Get OutBuying and holding and dollar-cost averaging are sound strategies, but just because you have your investments on autopilot does not mean you should ignore the forces at work. Stay current with your investment and remain in tune with overall market conditions. Know what is happening to the companies you invest in.

5. Keep a Watchful Eye on CommissionsIf you are not the trading type, understand what you are getting for the fees you are paying. Some firms charge a monthly fee, while others charge transactional fees. Be cognizant of what you are paying and what you are getting for it. , the cheapest choice is not always the best.

3.2 NEEDS OF THE DIVERSIFICATION:The portfolio should be spread among many different investment vehicles such as cash, stocks, bonds, mutual funds, and perhaps even some real estate. The securities should vary in risk. You’re not restricted to picking only blue chip stocks. In fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains

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offset losses in other areas. Keep in mind that this doesn’t mean that you need to jump into high-risk investments such as penny stocks. The securities should vary by industry, minimizing unsystematic risk to small groups of companies. Another question people always ask is how many stocks they should buy to reduce the risk of their portfolio. The portfolio theory tells us that after 10-12 diversified stocks, you are very close to optimal diversification. This doesn’t mean buying 12 internet or tech stocks will give you optimal diversification. Instead, you need to buy stocks of different sizes and from various industries. If we invest in a single security, our return will depend solely on that security; if that security flops, our entire return will be severely affected. Clearly, held by itself, the single security is highly risky. If we add nine other unrelated securities to that single security portfolio, the possible outcome changes Þ if that security flops, our entire return won’t be as badly hurt. By diversifying our investments, we can substantially reduce the risk of the single security. Diversification substantially reduces the risk with little impact on potential returns. The key involves investing in categories or securities that are dissimilar.

3.3

ADVANTAGES

AND

DISADVANTAGES

OF

PORFOLIO

DIVERSIFICATION Diversification of investment means selecting multiple asset classes or investing in the different asset categories. It is a popular technique employed by most investors to lower risk and increase the chances of good returns. Unfolding your investment in different areas develops a risk-proof portfolio, which means if one investment fails, another will balance it out.

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Diversified portfolio has certain built-in risks. For example, stocks could be fickle in the short term. Even though you have carefully diversified your portfolio, there is always a percent chance of investors undergoing losses due to emergency conditions. Some of these factors include commodities meltdown, global financial crises, socio-political condition and others. A diversified portfolio is having a collection of financial instruments carefully spread in different industries, fields and ensures minimal attachment or effects against each other. Diversification of portfolios had allowed investors to gain more profit and lessen the impact of their losses. However, there are also some disadvantages to a diversified portfolio. ADVANTAGES-

The advantage of diversification is that it broadens your exposure to market swings. The principle is that one sector (or stock) may devalue, but not all sectors will devalue. In the long term, most sectors tend to experience growth, so the total portfolio value of a diversified should gradually grow. A diversified portfolio works by investing in different areas of industries where one industry cannot affect another industry should it have minimal to negative market activity. With diversification, investors lower the risk value of their assets and portfolio. Most diversified portfolios work well with long-term investors to outlast economic storms.

1.Asset ChoicesWhen your holdings are widely diversified, you can spread them out over widely divergent forms of assets, including securities such as stocks and bonds, commodities such as oil and minerals, real estate and cash. Each of these assets exhibits different strengths and weaknesses in of risk and profitability. Maintaining holdings in all of these areas helps to create a stable portfolio that will increase in value over the long term. 10


2.Lower MaintenanceInvestments require a certain amount of care and attention to keep them performing well. If you are playing high-stakes games with your assets and moving them around through risky ventures, you will probably be spending a fair amount of time watching the markets and dodging financial bullets. A diversified portfolio is less exciting and more stable. Once you have your investments settled into a wide variety of stocks and securities, they can remain there for extended periods without requiring a lot of maintenance. This frees up your time to pursue other matters and reduces the market stress that may lead to burnout. 3.RiskPortfolio diversification tends to reduce your long-term risk. Anytime you hold an investment, you risk losing its value. For example, if you purchase a share of stock for $50 and end up selling it for $35, you incur a loss. Now imagine that you own two shares of stock. You purchase one stock for $50 and end up selling it for $35. The second stock costs $10 and you sell it for $25. In this example, you eliminate your loss through diversification. Most diversified portfolios do not achieve complete elimination of loss -- only reductions in its potential. 4.Higher ReturnsA diversified portfolio could result in higher returns. Between January 1, 2001 and November 30th, 2011, the Standard and Poor's 500 Fund Index returned a 1.4 percent gain. Investors with diversified portfolios returned an average 5.4 percent gain during the same time period, according to "USA Today." A larger percentage of bonds were in the diversified portfolios. Higher returns from diversification tend to be seen with longer periods of time. Diversification does not always increase returns in the short term, however. If the overall health of the investment market is poor, diversification may still result in a negative return.

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5.AdjustmentsAn advantage of diversification is that you can adjust your investment mix. A more risky, growth-oriented strategy makes more sense when you're young. You have more time to tolerate ups and downs in the market. A growth-oriented diversification strategy for 20- to 30year-olds might consist of 90 percent stocks and 10 percent bonds, according to USA Today. If your diversification strategy is more advanced, you might invest heavily in the stocks of small and emerging U.S.-based companies. 6.BalanceBehavioral portfolio theory states that investments either protect from loss or provide highgrowth potential. According to the theory, your portfolio represents a pyramid when you diversify. A diversified portfolio has a higher percentage of low-risk, income and value investments. At the top of the portfolio pyramid is a lower percentage of "blend" and growth funds. "Blend" funds are a combination of high-risk and risk-averse investments. Portfolio diversification allows you to achieve more than one financial goal. The income and value investments can provide you with stability and regular payments. Blend and growth funds can help you increase your wealth. Of course, any of these can incur risk; positive returns are never guaranteed. DISADVANTAGES-

The disadvantage of diversification is that a portfolio focused on a single sector or stock can have some super growth, naturally this comes with increased risk. Another disadvantage is that diversification can be difficult for small investors. (It doesn't need to be, but it can be.

A diversified portfolio spreads assets “too thinly”. When risk is lower, this also means the gain is lower. An investor also lessens the chance of having growth from industry booms 12


because they have less investment on such fields. While diversified portfolios do not easily shake with daily market fluctuations, they also guarantee lower returns and profit for the investor. 1. Reduces QualityThere are only so many quality companies and even less that are priced at levels that provide a margin of safety. The more stocks you put into your portfolio the less concentrated your portfolio will be in the best opportunities. 2. Too ComplicatedMany investors include so many assets in their portfolio they don’t really understand what’s in them. Diversification in investing is important,but keep your portfolio simple enough that you can stay on top of your investments. 3. IndexingIf you have too many assets in your portfolio it essentially becomes an index fund. If you want an index fund, buy an index fund; don’t waste transaction fees on purchasing numerous assets that morph into an index fund. The more stocks you own the more correlated your portfolio will be to market returns. While ive management or indexing might work in bull markets it does not work well in flat or bear markets. Most indices are skewed toward stocks that have already risen and underweight stocks that have fallen, and may be at bargain prices.

4. Market Risk-

13


Before you buy an index fund be sure you understand how the mathematics of portfolio volatility lowers your portfolio performance. Few investors ever achieve even close to “average” returns because of volatility caused by market risk. 5. Below Average ReturnsIndexing and over diversification are disadvantages of diversification because quality suffers when you own inferior investments along with good investments. Below average returns result from transaction fees or mutual fund expenses. In addition to portfolio volatility lowering returns, many investors let their emotions cause them to buy high and sell low. 6. Bad Investment VehiclesMost investors, who over diversified use investment vehicles such as index funds, or even worse, actively traded mutual funds. Actively managed mutual funds trade in and out of stocks and have a tendency to focus on short term trading instead of value. Studies show these funds underperform market indices in the long run.

CHAPTER-4 14


PRINCIPLES, COMPONENTS AND TOOLS OF DIVERSIFICATION PRINCIPLES OF DIVERSIFICATION:NOT PUTTING ALL THE EGGS INTO BASKET It has been said that diversification is the secret sauce of asset allocation. Diversification seems so obvious and so easy–”Don’t put all your eggs in one basket.” Investment professionals suggest that you invest in a portfolio of non-correlated assets, which in simple refers to securities that generally do not change in price and direction at the same time. The idea here is that owning a portfolio of non-correlated assets allows an investor to reduce volatility and achieve better long-term risk-adjusted performance. In the first two segments of this series on asset allocation we established that constructing the optimum portfolio depends on measuring risk, forecasting returns and calculating correlation. We explained the importance of replacing normal distributions with non-normal distributions in an effort to better understand the probability and severity of extreme events. We also discussed how GARCH analysis can improve an investment forecasting model the way Doppler radar improves weather forecasting, as it places more emphasis on recent data and takes into the way in which the data has been changing. Diversity is a pretty general concept meaning simply a lack of similarity. When we want to speak technically with more precise language we use the statistical correlation and dependence, which describe and measure similarity. Correlation describes how pairs of securities act in relationship to each other over some period of time; if you can predict the change in one based on the change in the other, you have demonstrated dependence. As investors, we know that owning a portfolio of highly correlated assets does little to cushion the impact of down markets and we are told by our investment advisors that that owning non-

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correlated or negatively correlated assets will protect us from market crashes and dampen our losses in bear markets. One problem with correlation is the stubborn unwillingness of securities to remain at a fixed level of correlation over time. In fact, the daily noise reflects real variations in behavior. You will often see negatively correlated securities become highly positively correlated, especially during market crashes and major market rebounds. Seasoned professionals often remark, “The only thing that goes up in a down market is correlation!” In other words, the common pitfall of using correlation to do portfolio optimization is assuming that correlation is fixed and can be determined from long-term averages. Just as we pointed out in the discussion of risk and return forecasting, the long-term average value is quite often not indicative of future results.

COMPONENTS OF A DIVERSIFIED PORTFOLIO:A diversified portfolio is a collection of asset classes. Asset classes refer to distinctly different types of securities such as stocks, bonds, commodities, international investments, cash and real estate. The purpose of the diversified portfolio should be to offer maximum return while minimizing the overall risk of the portfolio. 1.Asset Classes Make a Diversified PortfolioCommon asset classes are stocks, bonds, commodities and currencies. Asset classes are a unique group of stocks that have common properties. Stocks and preferred stocks can be considered different classes but they are not as diversified as a combination of stocks and foreign currencies.

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2.Diversify Within Each Asset ClassOwning a stock portfolio is better than owning a single stock. Owning a stock and bond fund adds another new asset class. Adding a third asset class, commodity exchange traded funds, further spreads risk and smoothes returns. 3.Diversified Portfolio is a Core Principle of InvestingInvesting is not being smarter than the market. It is about riding the market trends as profitably as possible under a variety of circumstances. Diversified portfolios help ride out market uncertainty. 4.Indices are Diversified PortfoliosYou can buy an index fund of stocks, bonds, or other asset classes that is a proportionate sample of all the securities in that index. Exchange traded funds are low cost replicas of many asset classes. Purchased together, a cost-effective diversified portfolio of many asset classes can be assembled. 5.The Alternatives to a Diversified PortfolioOwning securities that are very similar or highly correlated provides irregular returns and high risk. Investors suddenly needing to convert their asset to cash at inopportune times will have no choice but to accept the current market price

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TOOLS OF PORTFOLIO DIVERSIFICATION:As an investor, you are well advised to spread your money among a number of instruments. This way, you don't risk putting all your eggs in one basket. Even if you lose money on one investment, you could make up the loss in another. Diversifying among and within asset classes is a way to create a healthy portfolio, as is investing in mutual funds.

1.Diversifying Among Asset ClassesThere are a number of asset classes for investors to choose from. You could invest in stocks or bonds, the two best known classes. You could also choose real estate or commodities. How about precious metals? Each asset class has its own risks and rewards. When stocks do well, bonds may not. Your diversification will prevent your portfolio from going down all at once. 2.Diversifying Within Asset ClassesEven if your portfolio is made up of a number of asset classes, you may not be adequately diversified within them. If you have a number of stock holdings, they should be in companies operating in different industries. If you have exposure to just one industry, you will lose money if that industry does not do well. Also, spread your investments among established companies, which are less likely to default, and startups, which come with a higher level of risk. 3.Mutual FundsConsidering that it is difficult for an individual investor to buy a large number of stocks and bonds on a limited budget, a mutual fund is a good option as a portfolio diversification tool. A fund invests the money in many individual stocks and could also give you access to

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investments you may not be able to buy on your own. You could buy a stock fund that gives you exposure to different industries and even different countries. Be aware, though, that you should have diversity in your mutual fund choices as well. There are also mutual funds that invest in bonds of different companies. There are mutual funds that invest in alternative investments such as commodities, precious metals and real estate. These are typically run by managers with expertise in those sectors

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CHAPTER-5 TYPES OF DIVERSIFICATION AND ITS BENEFITS FOR REDDUCTION OF PORTFOLIO RISK Diversification can be used with many types of investments, and it allows the investor to still earn a profit, or limit her losses, even if one investment performs badly. For example, a farmer can grow corn, soybeans and wheat, so if a corn beetle eats all of the corn in the farmer's field, the farmer still has soybeans and wheat available to sell. 1.Geographical DiversificationGeographical diversification protects an investor from problems in the local market. For example, a restaurant owner may build restaurants in Pasadena, San Diego and San Jose. If many companies in San Jose lay off their employees, reducing the number of customers at the San Jose restaurant, the restaurant owner can still collect revenue from his Pasadena and San Diego restaurants. 2.Cross-sector DiversificationCross-sector diversification protects an investor if one type of company's sales decline. A business conglomerate can own unrelated businesses, such as a pencil factory, a potato farm and a motorcycle dealership. If customers decide to purchase pens instead of pencils, the conglomerate does not have all of its resources invested in the pencil factory. 3.Intra-sector Diversification-

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An investor can purchase multiple types of investments in the same sector. For example, a real estate developer can build condominiums in one development, single-family houses in another and apartments in a third. A real estate investment trust obtains funds from many investors, so it can afford to purchase several types of real estate, which is difficult for a homeowner who can only pay the mortgage on a single house. 4.TaxesDiversification may provide tax benefits. If the pencil factory doesn't sell enough pencils in one year to earn a profit, the conglomerate reports a loss for the pencil factory, which reduces the amount of income taxes it has to pay that year on its successful potato farm and motorcycle dealership. 5.Seasonal DiversificationDiversification can improve the cash flow of a seasonal business. Many customers want to purchase pumpkins right before Halloween, but demand will be lower during the rest of the year. The pumpkin farmer can grow another crop that he can sell in the spring, such as apples, so he doesn't have to wait until Halloween to have cash available.

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CHAPTER-6 STEPS AND LEVELS OF DIVERSIFICATION In traditional portfolio theory, there are three levels or steps to Diversifying: capital allocation, asset allocation, and security selection. Capital allocation is diversifying your capital between risky and riskless investments. A “riskless” asset is the short-term (less than ninety-day) U.S. Treasury bill. Because it has such a short time to maturity, it won’t be much affected by interest rate changes, and it is probably impossible for the U.S. government to become insolvent—go bankrupt—and have to default on its debt within such a short time. The capital allocation decision is the first diversification decision. It determines the portfolio’s overall exposure to risk, or the proportion of the portfolio that is invested in risky assets. That, in turn, will determine the portfolio’s level of return. The second diversification decision is asset allocation, deciding which asset classes, and therefore which risks and which markets, to invest in. Asset allocations are specified in of the percentage of the portfolio’s total value that will be invested in each asset class. To maintain the desired allocation, the percentages are adjusted periodically as asset values change.

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Figure 12.11 "Proposed Asset Allocation"shows an asset allocation for an investor’s portfolio. Figure 12.11 Proposed Asset Allocation

Asset allocation is based on the expected returns and relative risk of each asset class and how it will contribute to the return and risk of the portfolio as a whole. If the asset classes you choose are truly diverse, then the portfolio’s risk can be lower than the sum of the assets’ risks. One example of an asset allocation strategy is life cycle investing—changing your asset allocation as you age. When you retire, for example, and forgo income from working, you

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become dependent on income from your investments. As you approach retirement age, therefore, you typically shift your asset allocation to less risky asset classes to protect the value of your investments. Security selection is the third step in diversification, choosing individual investments within each asset class. Here is the chance to achieve industry or sector and company diversification. For example, if you decided to include corporate stock in your portfolio (asset allocation), you decide which corporation’s stock to invest in. Choosing corporations in different industries, or companies of different sizes or ages, will diversify your stock holdings. You will have less risk than if you invested in just one corporation’s stock. Diversification is not defined by the number of investments but by their different characteristics and performance

LEVELS OF DIVERSIFICATION. Investment Strategies Capital allocation decides the amount of overall risk in the portfolio; asset allocation tries to maximize the return you can get for that amount of risk. Security selection further diversifies within each asset class. Figure 12.12 "Levels of Diversification" demonstrates the three levels of diversification.

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Just as life cycle investing is a strategy for asset allocation, investing in index funds is a strategy for security selection. Indexes are a way of measuring the performance of an entire asset class by measuring returns for a portfolio containing all the investments in that asset class. Essentially, the index becomes a benchmark for the asset class, a standard against which any specific investment in that asset class can be measured. An index fund is an investment that holds the same securities as the index, so it provides a way for you to invest in an entire asset class without having to select particular securities. For example, if you invest in the S&P 500 Index fund, you are investing in the five hundred largest corporations in the United States—the asset class of large corporations. There are indexes and index funds for most asset classes. By investing in an index, you are achieving the most diversification possible for that asset class without having to make individual investments, that is, without having to make any security selection decisions. This strategy of bying the security selection decision is called ive management. It also has the advantage of saving transaction costs (broker’s fees) because you can invest in the entire index through only one transaction rather than the many transactions that picking investments would require.

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In contrast, making security selection decisions to maximize returns and minimize risks is called active management. Investors who favour active management feel that the advantages of picking specific investments, after careful research and analysis, are worth the added transaction costs. Actively managed portfolios may achieve diversification based on the quality, rather than the quantity, of securities selected. Also, asset allocation can be actively managed through the strategy of market timing— shifting the asset allocation in anticipation of economic shifts or market volatility. For example, if you forecast a period of higher inflation, you would reduce allocation in fixedrate bonds or debt instruments, because inflation erodes the value of the fixed repayments. Until the inflation es, you would shift your allocation so that more of your portfolio is in stocks, say, and less in bonds. It is rare, however, for active investors or investment managers to achieve superior results over time. More commonly, an investment manager is unable to achieve consistently better returns within an asset class than the returns of the ively managed index.

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CHAPTER-7 TECHNIQUES OF DIVERSIFICATION FOR REDUCTION OF RISK Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories.It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true, and how to accomplish diversification in your portfolio.

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Efficient financial management combines safety of principal, alongside opportunities for growth. Diversified investment portfolios are designed to neutralize economic volatility and provide for steady returns amidst numerous economic scenarios. Still, all financial transactions

carry

distinct

risks.

1.IdentificationDiversification relates to asset allocation strategy that combines varying levels of stocks, bonds and cash within one investment portfolio. Commodities, real estate and derivatives are alternative investments that increase diversification. 2.BenefitsDiversification is intended to manage the wild fluctuations in price associated with the stock market and individual investments. Furthermore, diversification allows for higher returns over inflation than certificates of deposit and bonds.

3.ConsiderationsProper diversification strategies are dynamic, and vary according to your personal risk tolerance and time frame towards particular goals. For example, savers approaching retirement will favor portfolios that feature larger proportions of bonds. Conversely, young savers prefer to invest for growth---with higher weightings for stocks.

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4.MisconceptionsSimply owning several different stocks and bonds does not equate to perfect diversification. Investments should cover multiple industries and geography, so that different portions of the portfolio are profitable at each point during the economic cycle. 5.RisksDiversification cannot counter systemic risk. Systemic risk describes the collapse of the entire financial system.

CHAPTER-8 PORTFOLIO RISK AND ITS DIVERSIFICATION 8.1PORTFOLIO RISK AND DIVERSIFICATION

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Whether it is investing, driving, or just walking down the street, everyone exposes themselves to risk. Your personality and lifestyle play a big role in how much risk you are comfortably able to take on. If you invest in stocks and have trouble sleeping at night, you are probably taking

on

too

much

risk.

Risk is defined as the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment.

Those of us who work hard for every penny we earn have a harder time parting with money. Therefore, people with less disposable income tend to be, by necessity, more risk averse. On the other end of the spectrum, day traders feel if they aren't making dozens of trades a day there

is

a

problem.

These

people

are

risk

lovers.

When investing in stocks, bonds, or any investment instrument, there is a lot more risk than you'd think. In the next section, we'll take a look at the different kind of risk that often threaten investors' returns. 8.2 THE PORTFOLIO RISK REWARD TRADE -OFF The risk-return tradeoff could easily be called the iron stomach test. Deciding what amount of risk you can take on is one of the most important investment decision you will make. The risk-return tradeoff is the balance an investor must decide on between the desire for the lowest possible risk for the highest possible returns. to keep in mind that low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty

(high

risk)

are

associated

with

high

potential

returns.

The risk-free rate of return is usually signified by the quoted yield of "U.S. Government

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Securities" because the government very rarely defaults on loans. Let's suppose that the riskfree rate is currently 6%. Therefore, for virtually no risk, an investor can earn 6% per year on his or her money. But who wants 6% when index funds are averaging 12-14.5% per year? that index funds don't return 14.5% every year, instead they return -5% one year and 25% the next and so on. In other words, in order to receive this higher return, investors much also take on considerably

more

risk.

The following chart shows an example of the risk/return tradeoff for investing. A higher standard deviation means a higher risk:

Diversifying The Portfolio To Reduce The RiskWith the stock markets bouncing up and down 5% every week, individual investors clearly need a safety net. Diversification can work this way and can prevent your entire portfolio from

losing

value.

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. Still, most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping you reach your long-range financial goals while minimizing your risk. Keep in mind, however that no matter how much diversification you do, it can never reduce risk down to zero.

CHAPTER-9 PROBLEMS WITH PORTFOLIO DIVERSIFICATION

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Simply put, diversification is not putting all your eggs in one basket; it is spreading your assets across multiple investment vehicles to reduce risk while trying to maximize return. The term diversification is used interchangeably with asset allocation, although asset allocation pertains to having various classes of assets in your portfolio (stocks, bonds, commodities), while diversification refers to having several securities within the same class, such as several stocks in a stock portfolio. Portfolio diversification is supposed to protect you on the downside, but as the 2007-2008 bear market demonstrated, it does not, with many diversified portfolios losing 50 percent or more. There are several problems with diversification as it is practiced in 2010.

1.Partial ProtectionDiversification provides partial protection against non-systemic risks. For example, any stock you buy can go down to zero at any time for any reason, but if you buy two stocks, you reduce your risk by 50 percent while your return may remain the same or even improve (if the second stock does better). Your risks are further reduced when you increase your portfolio to five stocks, but after about 20 stocks, your risk and return approach the market, meaning your portfolio will mirror the market on both the downside and the upside. 2.Over-diversificationBasic assets allocation calls for your portfolio to hold several classes of assets with limited correlation, i.e., assets that do not move in the same direction--for example, stocks, bonds and commodities. Even if each of those assets is risky, the assets' non-correlated moves can make your portfolio more stable overall. But many investors go beyond that and diversify within each class of assets for "further protection." For example, they can hold government bonds, 33


corporate bonds, short-term bonds, intermediate term bonds and foreign bonds, which provides little protection, because when interest rates rise, all bonds decline. 3.Below Market ReturnsIf you spread your assets across every conceivable asset class and fund, you effectively invest in the market as a whole, so your return is going to be the market return minus management fees and expenses. 4.ConfusionSome financial advisers use diversification as a selling point, making it sound overly complicated and academic. Every quarter or so you are supposed to "rebalance" your portfolio by making sure, for example, that you have precisely 14 percent in investment quality intermediate term corporate bonds. Those "precise" targets provide no protection or edge and only confuse. 5.Opportunity CostIn any market, some assets or sectors outperform while others lag. For example, Chinese stocks, commodities or junk bonds can take the lead at different times. The key to superior returns is to move into the outperforming assets while avoiding laggards. If instead you spread your assets across the board in the expectation that one day (or one year) you will "capture" those returns, you incur tremendous opportunity costs by keeping your money in assets that may go nowhere or even decline for years while limiting your exposure to the leading sectors by maintaining some "scientific" percentage allocation.

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MEASURING PORTFOLIO DIVERSIFICATION:In the market place, diversification reduces risk and provides protection against extreme events by ensuring that one is not overly exposed to individual occurrences. We argue that diversification is best measured by characteristics of the combined portfolio of assets and introduce a measure based on the information entropy of the probability distribution for the final portfolio asset value. For Gaussian assets the measure is a logarithmic function of the variance and combining independent Gaussian assets of equal variance adds an amount to the diversification. The advantages of this measure include that it naturally extends to any type of distribution and that it takes all moments into . Furthermore, it can be used in cases of undefined weights (zero-cost assets) or moments. We present examples which apply this measure to derivative overlays. 1. They are not a function of the allocation to the additional investment. 2. The sum of the diversification benefit and the return benefit equals the overall benefit. 3. The return benefit always equals the difference between the expected return of the additional investment and that of the existing portfolio, which makes common sense. 4. All benefits, including the diversification benefit, are measured in return . Since these are expected returns, they are meaningful only when a risk reference is provided. (Indeed, all benefits are expressed at the risk level of the existing portfolio.) 5. And lastly, when an infinitesimal amount of the additional investment is included in the existing portfolio, the marginal benefits can be calculated per unit of allocation, making it possible to compare the benefits across investments in a consistent fashion.

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CHAPTER-10 CONCLUSION For asset investments, diversification is an effective tool in reducing the risk of investments in stocks, bonds, and other securities. Utilizing the correlation structure among the assets, idiosyncratic risk can be reduced or even eliminated. For businesses, diversification is a strategic decision. It is vital for a firm’s long-term value creation to identify and manage growth opportunities. Diversification is an important way to manage these opportunities well, reducing risk and ensuring success. To be more specific, while international investments make systematic risk to lower, other kinds of risk, such as transaction costs, tax rates, greater resources, foreign exchange risk and possible information disadvantages, are created. Investors are unable to allocate, fully understand and at the same time handle these risks and many times are driven to the choice of a regional (non-international) diversified portfolio. Portfolio diversification in the stock market consists of not only investing in multiple stocks, but investing in stocks representing different sectors of the market. A portfolio that focuses only on one sector, such as technology, is not diversified even if capital is spread over several stocks. This is because the stocks are subject to the same factors and will likely be highly correlated. Instead, someone holding technology stocks could diversify by investing in other sectors, such as pharmaceuticals, real estate and retail. The truest form of diversification is investment in multiple markets such as stocks, bonds, commodities and real estate. The percentage of portfolio value dedicated to each market is entirely up to the investor and varies widely. For example, one investor may have a portfolio 36


consisting of 80 percent stocks and 20 percent bonds, while another investor may have 50 percent in stocks, 40 percent in commodities and 10 percent in bonds.

CHAPTER-11 BIBLIOGRAPHY ARTICLES & REFERENCES Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V., “Fundamentals of Investment, 3rd Edition, Pearson Education. Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P. “ Investments”, 6th Edition,  Tata McGraw-Hill.

Bhole, L.M., and Mahakud, J. (2009), Financial institutions and

markets.5th Edition, Tata McGraw Hill (India). Fisher D.E. and Jordan R.J., “Security Analysis and Portfolio Management”, 4th  Edition., Prentice-Hall. Jones, Charles, P., “Investment Analysis and Management”, 9th Edition, John  Wiley and Sons. Prasanna, C., “Investment Analysis and Portfolio Management”, 3rd Edition, Tata  McGraw-Hill. Reilly, Frank. and Brown, Keith, “Investment Analysis  & Portfolio Management”, 7th Edition, Thomson South-Western.

WEBSITES www,portfoliomgmt.com www.economictimes.com

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