Diversification
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
Diversify Another way of saying Don t put ALL your Eggs in One Basket
Diversification- across asset classes, regions & style Markets move in CYCLES 4
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
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: 15 20 years Internal Distribution Only 6
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: 28-40 yrs Suggested portfolio: HLG Bond (50%), HLG Penny Stock (30%), HLG Dividend (20%) Internal Distribution Only 7
Performance vs. Custom benchmark KLIBOR/KLCI 50 (MP) Bond/Div/Penny_New (MP) 32.5 Percentage Growth Total Return, Tax Default, In LC 30.0 27.5 25.0 22.5 20.0 31.3 Percentage Growth 17.5 15.0 12.5 10.0 28.2 7.5 5.0 2.5 0.0-2.5 07/2005 10/2005 01/2006 04/2006 07/2006 10/2006 01/2007 04/2007 2 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
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 - 0.28 0.39 Dividend 0.28 - Penny Stock 0.39 0.87 - 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
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 = 5.64. Internal Distribution Only 10
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
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%
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
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
Returns & risk of portfolios Portfolio Returns: ER p = (12% x 0.6) + (5% x 0.4) = 7.2 + 2% = 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
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 0.07 2 ) + (0.4 2 x 0.03 2 ) +[ 2 x (0.4 x 0.6) x 0.07 x 0.03 x 0.27] 16
These are the formulaes if you are interested in the details 17
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 1991 18