Diversification. Chris Gan; For educational use only

Similar documents
Does Portfolio Theory Work During Financial Crises?

(Modern Portfolio Theory Review)

J B GUPTA CLASSES , Copyright: Dr JB Gupta. Chapter 4 RISK AND RETURN.

FNCE 5610, Personal Finance H Guy Williams, 2009

Analysis INTRODUCTION OBJECTIVES

Which Investment Option Would You Choose?

Archana Khetan 05/09/ MAFA (CA Final) - Portfolio Management

IBM 401(k) Plus Plan. Individual Fund Flyer Conservative Fund

CHAPTER 5: ANSWERS TO CONCEPTS IN REVIEW

Chapter 5: Answers to Concepts in Review

Risk and Return and Portfolio Theory

Risk and Return. CA Final Paper 2 Strategic Financial Management Chapter 7. Dr. Amit Bagga Phd.,FCA,AICWA,Mcom.

FIN 6160 Investment Theory. Lecture 7-10

SKYBRIDGEVIEWS Why Investors Should Allocate To Hedge Funds

Diversification. Finance 100

Models of Asset Pricing

Answers to Concepts in Review

Research Note Hancock Agricultural Investment Group

Portfolio Theory and Diversification

FINC 430 TA Session 7 Risk and Return Solutions. Marco Sammon

21-1. Background. Issues. CHAPTER 19 Globalization and International Investing

Financial Analysis The Price of Risk. Skema Business School. Portfolio Management 1.

Fact Sheet User Guide

Wealth Strategies. Asset Allocation: The Building Blocks of a Sound Investment Portfolio.

Technical Guide. Issue: forecasting a successful outcome with cash flow modelling. To us there are no foreign markets. TM

NATIONWIDE ASSET ALLOCATION INVESTMENT PROCESS

Advanced Financial Modeling. Unit 2

Fundamentals of Investing for Retirement Income. Understanding Investment Risk and Return

Building an Investment Strategy

Staying Ahead of the Investment Curve

Modern Portfolio Theory -Markowitz Model

Economics 483. Midterm Exam. 1. Consider the following monthly data for Microsoft stock over the period December 1995 through December 1996:

Mathematics in Finance

Sample Reports for The Expert Allocator by Investment Technologies

EG, Ch. 12: International Diversification

Modern Portfolio Theory

Efficient Frontier and Asset Allocation

Tactical Growth ETF. Investor Presentation N ORTHC OAST I NVESTMENT A DVISORY T EAM NORTHCOASTAM. COM

Risk and Return - Capital Market Theory. Chapter 8

Chapter 5. Asset Allocation - 1. Modern Portfolio Concepts

Motif Capital Horizon Models: A robust asset allocation framework

2017 Kerns Capital Management, Inc. July 2017 Investor Presentation

F 9 STANDING COMMITTEES. B. Finance, Audit & Facilities Committee. Consolidated Endowment Fund Asset Allocation Review

Direxion/Wilshire Dynamic Asset Allocation Models Asset Management Tools Designed to Enhance Investment Flexibility

White Paper Alternative Investments: Incorporating a Turnkey Solution

Port(A,B) is a combination of two stocks, A and B, with standard deviations A and B. A,B = correlation (A,B) = 0.

Equity Volatility and Covered Call Writing

Invesco Diversified Dividend Fund. Building a solid foundation

Manager Comparison Report June 28, Report Created on: July 25, 2013

Next Generation Fund of Funds Optimization

Essential Performance Metrics to Evaluate and Interpret Investment Returns. Wealth Management Services

Principles of Finance Risk and Return. Instructor: Xiaomeng Lu

ECO 317 Economics of Uncertainty Fall Term 2009 Tuesday October 6 Portfolio Allocation Mean-Variance Approach

Return and Risk: The Capital-Asset Pricing Model (CAPM)

Performance Supplement. The IBM 401(k) Plus Plan Investment Results

R02 Portfolio Construction and Management

The Spiffy Guide to Finance

University 18 Lessons Financial Management. Unit 12: Return, Risk and Shareholder Value

Module 6 Portfolio risk and return

Interest Rate Risk Basics Measuring & Managing Earnings & Value at Risk

Investment In Bursa Malaysia Between Returns And Risks

The mean-variance portfolio choice framework and its generalizations

Purpose Driven Investing

Portfolio Management

An Introduction to Dynamic Overlay

Important Information about Structured Products

PortfolioConstructionACaseStudyonHighMarketCapitalizationStocksinBangladesh

OPTIMAL RISKY PORTFOLIOS- ASSET ALLOCATIONS. BKM Ch 7

Morningstar Investment Services

The purpose of this paper is to briefly review some key tools used in the. The Basics of Performance Reporting An Investor s Guide

The Investment Profile Page User s Guide

MBA III Semester Supplementary Examinations May 2018 INVESTMENT & PORTFOLIO MANAGEMENT (For students admitted in 2014, 2015 & 2016 only)

ECONOMIA DEGLI INTERMEDIARI FINANZIARI AVANZATA MODULO ASSET MANAGEMENT LECTURE 6

Chapter 13 Return, Risk, and Security Market Line

Portfolio Management

Lecture 10-12: CAPM.

Destinations INVESTOR GUIDE. Multi-asset class solutions to meet a range of investor needs. Dynamic portfolios constructed from mutual funds

K&S EXXONMOBIL 401(k) Savings Plan Investment Process

SDMR Finance (2) Olivier Brandouy. University of Paris 1, Panthéon-Sorbonne, IAE (Sorbonne Graduate Business School)

COPYRIGHTED MATERIAL. Portfolio Selection CHAPTER 1. JWPR026-Fabozzi c01 June 22, :54

Vanguard Global Capital Markets Model

Voya Life Companies Asset Allocation Solutions

Precious Metals Critical Diversifier

Direct Foreign Investment (DFI)

Mutual Fund Directors Forum Evaluation of Fund Performance Information Keil Fiduciary Strategies LLC

Leverage Aversion, Efficient Frontiers, and the Efficient Region*

Solutions to questions in Chapter 8 except those in PS4. The minimum-variance portfolio is found by applying the formula:

Behavioral Finance 1-1. Chapter 2 Asset Pricing, Market Efficiency and Agency Relationships

Demystifying the Role of Alternative Investments in a Diversified Investment Portfolio

Portfolio Allocation Models. for Lincoln Financial Group s Variable Life Insurance Products

BUILDING INVESTMENT PORTFOLIOS WITH AN INNOVATIVE APPROACH

THE REWARDS OF MULTI-ASSET CLASS INVESTING

Alternative Investments: Incorporating a Turnkey Solution

Risk and Return - Capital Market Theory. Chapter 8

Asset Allocation in the 21 st Century

International Finance. Estimation Error. Campbell R. Harvey Duke University, NBER and Investment Strategy Advisor, Man Group, plc.

Chapters 21 & 22 Modern Portfolio Theory. Equilibrium Asset Pricing

Chapter 8. Portfolio Selection. Learning Objectives. INVESTMENTS: Analysis and Management Second Canadian Edition

Historical Performance and characteristic of Mutual Fund

A Study on Importance of Portfolio - Combination of Risky Assets And Risk Free Assets

Transcription:

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