Chapter Six

6. Portfolio Theory

6.1. Diversification and portfolio risk

A portfolio is a collection of financial assets. An asset’s risk and return is important in how it
affects the risk and return of the portfolio. The risk-return trade-off for a portfolio is measured by
the portfolio expected return and standard deviation, just as with individual assets.

The intention behind portfolio is, if you hold many investments:

– Through time, some will increase in value

– Through time, some will decrease in value

– It is unlikely that their values will all change in the same way

Diversification has a profound effect on portfolio return and portfolio risk. And it is a strategy
employed by investors to reduce risk. It can be also defined as a holding of many different
securities rather than just one.

Diversification of a portfolio is logically a good idea Diversification is more important now

because volatility of individual firms has increased. Investors need more stocks to adequately
diversify.

Investors will hold risky securities if higher expected returns will offset the undesirable
uncertainty. Trade-off of higher return versus risk is subjective and different for every individual

6.2. Principles of Diversification

As long as assets do not have precisely the same pattern of returns, then holding a group of
assets can reduce risk. If the returns of each security are totally independent of each other,
combining a large number of securities tends to produce the average return of the portfolio.
Diversification can substantially reduce the variability of returns without an equivalent reduction
in expected returns.

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This reduction in risk arises because worse than expected returns from one asset are offset by
better than expected returns from another. However, there is a minimum level of risk that cannot
be diversified away and that is the systematic portion.

6.2.1. Systematic Risk

 Risk factors that affect a large number of assets

 Also known as non-diversifiable risk or market risk
 Includes such things as changes in GDP, inflation, interest rates, etc.

6.2.2. Unsystematic Risk

 Risk factors that affect a limited number of assets

 Also known as unique risk and asset-specific risk
 Includes such things as labor strikes, part shortages, etc.

Diversifiable Risk

The risk that can be eliminated by combining assets into a portfolio and often considered the
same as unsystematic, unique or asset-specific risk. If we hold only one asset, or assets in the
same industry, then we are exposing ourselves to risk that we could diversify away.

Total risk = systematic risk + unsystematic risk

Mathematically we can measure total risk by using variance and standard deviation. For well
diversified portfolios, unsystematic risk is very small. Consequently, the total risk for a
diversified portfolio is essentially equivalent to the systematic risk. The portfolio theory argues
that there is a reward for bearing risk. The expected return on a risky asset depends only on that
asset’s systematic risk since unsystematic risk can be diversified away.

6.3. Why Diversification Works

Diversification is enhanced depending upon the extent to which the returns on assets “move”
together. This movement is typically measured by a statistic known as “correlation”

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Correlation: The tendency of the returns on two assets to move together. Imperfect correlation
is the key reason why diversification reduces portfolio risk as measured by the portfolio standard
deviation.

 Positively correlated assets tend to move up and down together.

 Negatively correlated assets tend to move in opposite directions.
 Zero correlation No relationship between the returns on two securities

Imperfect correlation, positive or negative, is why diversification reduces portfolio risk.

Combining securities with perfect positive correlation or high positive correlation does not
reduce risk in the portfolio. Combining two securities with zero correlation reduces the risk of
the portfolio. However, portfolio risk cannot be eliminated. Combining two securities with
perfect negative correlation could eliminate risk altogether

6.4. Portfolio Analysis

Job of a portfolio manager is to use this risk and return statistics in choosing/combining assets in
such a way that will result in minimum risk at a given level of return, also called efficient
portfolios

Select investment weights in such a manner that it results in a portfolio that has minimum risk at
a desired level of return, i.e., efficient portfolios

As we change desired level of return, our efficient combination of securities in the portfolio will
change. Therefore, we can get more than one efficient portfolio at different risk-return
combinations

Diversification is essential to the creation of an efficient investment, because it can reduce the
variability of returns around the expected return. A single asset or portfolio of assets is
considered to be efficient if no other asset or portfolio of assets offers higher expected return
with the same (or lower) risk, or lower risk with the same (or higher) expected return.

6.5. Factors Affecting Diversification Benefits

 Volatility of each individual stock

 Impact of correlations among stocks

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 • Highly correlated stocks limit diversification

6.6. Strategies for Diversifying

6.6.1. Diversification of stocks across industries

• Less risky than a portfolio of stocks all from the same industry

• Diversification is not just holding a lot of assets

• For example, if you own 50 internet stocks, you are not diversified

• However, if you own 50 stocks that span 20 different industries, then you are diversified

6.6.2. Diversification of stocks across countries

• Economic conditions tend to vary among countries

• The inclusion of assets from countries with business cycles that are not highly correlated
with our business cycle reduces the portfolio’s responsiveness to market movements.

Over long periods, internationally diversified portfolios tend to perform better (meaning that they
earn higher returns relative to the risks taken) than purely domestic portfolios. However, over
shorter periods, internationally diversified portfolios may perform better or worse than domestic
portfolios. Currency risk and political risk are unique to international investing.

Well-diversified Portfolio

There are three main things as an investor you should do, to ensure that your portfolio is
adequately diversified:

1. Your portfolio should be spread among many different investment vehicles such as cash,
stocks, bonds, mutual funds, and perhaps even some real estate.

2. Your securities should vary in risk.

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 3. Your securities should vary by industry.

The effect of lowering risk via appropriate portfolio formulation is called diversification.

With the stock markets bouncing up and down every week, individual investors clearly need a
safety net. Diversification can work this way and can prevent the entire portfolio from losing
value. Even if you hold a well-diversified portfolio, you will not eliminate all risk.

You will still be exposed to macroeconomic changes that affect most stocks and the overall stock
market. These macro risks combine to create market risk —that is, the risk that the market as a
whole will slump. Investors don’t need to worry much about the risk that they can diversify
away; they do need to worry about risk that can’t be diversified. This depends on the stock’s
sensitivity to macroeconomic conditions. The broader the diversification: the more stable the
returns and the more diffuse the risk.

6.7. Asset Allocation

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a
portfolio's assets according to an individual's goals, risk tolerance and investment horizon. Asset
allocation involves dividing (mixing) an investment portfolio among different asset categories,
such as stocks, bonds and cash are among others. And thus the choice of the fraction of funds
allocated to risky investments is the first part of the investor’s decision of asset allocation.

6.7.1. Asset Allocation Strategies (styles)

Asset allocation strategy is process through which investors decides how to allocate his/her
assets whether s/he choose a conservative, moderate, or aggressive allocation mix based on their
tolerance for risk (risk attitude).

It includes:

1. Conservative investors: make capital preservation, or safeguarding the assets they

already have, their priority. Because they aren’t willing to put any of their principal at
risk, conservative investors usually have to settle for modest returns.
2. Aggressive investors focus on investments that have potential to offer significant
growth, even if it means putting some of their principal at risk.

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 3. Moderate investors seek a middle course between protecting the assets they already
have and achieving long-term growth.
4. Contrarians buy investments that are currently out of favor with the market and avoid
investments that are currently popular.
They believe that stocks that are undervalued by the market may be poised for a rebound,
while stocks that are currently popular may be overvalued, have already peaked, or may
not be able to meet investor expectations.

6.7.3. Factors to be considered in asset allocation

There are main factors you need to take into consideration when defining your asset allocation:

1. Time horizon: Time horizon is the expected number of months, years, or decades
investors will be investing to achieve a particular financial goal.

2. Liquidity: Liquidity is defined as the ease with which an investor can convert an
investment to cash without negative impact on either capital or return.

3. Tax concerns

4. Legal and regulatory factors

 Legal restrictions on portfolio composition

 Limits on the use of material nonpublic information

5. Risk tolerance is a function of the client’s ability to bear (accept) risk and his or her
“risk attitude,” which might be considered the client’s willingness to take risk. Risk
tolerance is investors’ ability and willingness to lose some or all of original investment
in exchange for greater potential returns. As an investor your goal should always be to
improve your returns (earnings) without taking on too much risk.

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