Diversification. Chris Gan; For educational use only

Transcription

1 Diversification

2 What is diversification Returns from financial assets display random volatility; and with risk being one of the main factor affecting returns on investments, it is important that portfolio risks be reduced through diversification. MPT*: it is possible to reduce portfolio risk without giving up returns, By broadly diversifying into different asset classes, which are less than perfectly correlated Hence, diversify across: Asset Classes, Sectors, Regions/Countries, and Styles * Modern Portfolio Theory: Markowitz, Modigliani & Miller, etc 2

3 Diversify Another way of saying Don t put ALL your Eggs in One Basket

4 Diversification- across asset classes, regions & style Markets move in CYCLES 4

5 Example of Diversification (Asset Class) A Diversified Portfolio Offers: Portfolio with lower volatility & relatively high returns Lower Volatility Better Performance in downturn Minimizes risk 5

6 Example of diversifying portfolio Objective: to provide investors who wish to save for their children tertiary education needs Focus: consistent return, with long term capital appreciation, inflation-adjusted. Maturity: years Internal Distribution Only 6

7 Portfolio expected returns & risk Features of funds: Established track record of performance Expected return (between 8-10% pa) Moderate volatility (risk) Capital preservation moderate. Target group for this fund: yrs Suggested portfolio: HLG Bond (50%), HLG Penny Stock (30%), HLG Dividend (20%) Internal Distribution Only 7

8 Performance vs. Custom benchmark KLIBOR/KLCI 50 (MP) Bond/Div/Penny_New (MP) 32.5 Percentage Growth Total Return, Tax Default, In LC Percentage Growth / / / / / / / / Years From 31/05/2005 To 31/05/2007 User may have modified the original chart and axis titles provided by Lipper. Annualized returns over 2 years (to 31 May 2007): 14.6% p.a, s.d: 1.93 (higher vs. retirement portfolio) Internal Distribution Only 8

9 Correlation between funds in portfolio Portfolio allocation: HLG Bond: 50% HLG Dividend: 20% HLG Penny Stock: 30% Correlation matrix: 2 yrs (Lipper) Correlation Bond Dividend Penny Bond Dividend Penny Stock To increase diversification benefit, aim is to add assets into the portfolio which are less than perfectly, positively correlated. An art and a science how many funds, % allocation etc. Internal Distribution Only 9

10 Determining assets to include Low correlation between HLG Bond (conservative) and more aggressive Dividend and Penny Stock Dividend and Penny Stock highly correlated 0.87 (expected); both equities, & dividend should be less volatile. But below 1. HLG Bond- provides steady& consistent income HLG Dividend: provides some income & cap growth (secondary). HLG Penny stock: aggressive fund, provides capital growth via small caps stocks upside kicker Over 2 yrs, annualized return = 14.6% with s.d of 1.93 (low). Sharpe = Internal Distribution Only 10

11 Diversification Aim to build an efficient portfolio Assume normal distribution & using expected return, s.d, and covariance to develop. Combining diff. assets with diff. return/risks Shifting the efficient frontier same risk but with higher returns. Key: Add less than perfectly correlated assets to portfolio. The only free lunch in finance. Same price but more value. 11

12 In simple terms Diversification: getting higher returns per unit of risk taken, by building a well diversified or efficient portfolio. Typical asset allocation Commodities 5% Properties 15% Bonds 20% Alt. Inv 10% Cash 10% Stocks 40%

13 Efficient Portfolios R e t u r n X A B By adding new assets, with correlations less than perfect, the portfolio efficiency improves. Portfolios on Curve A is more efficient than Curve B. Portfolio X = higher returns for the same level of market risk (beta) Beta ß 13

14 Combining 2 portfolios We can also combine 2 or more portfolios Example: 2 portfolios. Portfolio A: consists of different stocks. ER = 12%, s.d = 7% Portfolio B: consists of different bonds. ER = 5%, s.d.= 3% (ER = expected returns, s.d.= std deviation) But let s take a 60: 40, static, balanced portfolio (Portfolio A: Portfolio B) Assume that the risk profile of individual investors are the same. 14

15 Returns & risk of portfolios Portfolio Returns: ER p = (12% x 0.6) + (5% x 0.4) = % = 9.2% Portfolio Risk: s.d (stocks) = 7%, & s.d (bonds) = 3% but the sd (portfolio) is not 5.4% (i.e. (0. 6 x 7%) + (0.4 x 3%)) S.d p should be lower than 5.4% due to less than perfect correlation between bonds and stocks. Assume correlation between stocks & bonds = 0.27 If stocks go up/down by 1%, then bonds should go up/down by only 0.27% 15

16 Correlations Hence, s.d p = 4.5%* which is lower than 5.4% Lower than s.d for stocks alone of 7%, The magic is less than perfect correlation, between bonds & stocks. Diversification: the only free lunch in investments. Getting higher returns for taking on same level of risks. Basis of Modern portfolio theory (MPT) * Sd 2 = (0.6 2 x ) + (0.4 2 x ) +[ 2 x (0.4 x 0.6) x 0.07 x 0.03 x 0.27] 16

17 These are the formulaes if you are interested in the details 17

18 What s Asset Allocation? Process of deciding how to distribute investors wealth among diff. countries & asset classes for investment purposes. Key to long term portfolio performance. Approximately 90% of success depends on asset allocation, only 10% on security selection. Asset Allocation Market t iming 2% Ot hers Security selection 2% 5% Asset Allocation 91% Reference: Financial Analyst Journal, May-June