How Diversification helps in reducing the Portfolio Risk

How Diversification helps in reducing the Portfolio Risk

Many people feel that they can also construct a portfolio on their own or manage risk on their own. This thought comes when (1) market is having a bull run and one makes money in almost all equity stocks (2) when they see return going down and feel risk has not been managed so why to invest through a professional manager.

Diversification is not just buying securities from different industries but much more than it.

This article is to make them aware how risk is managed through diversification which a normal person howsoever learned he may be, can not do the way the professional fund manager does. This article will talk on those aspects.

·        Investment process – (1) security selection based on risk –return of available investment alternatives (2) best Portfolio selection from the set of feasible portfolios.

·        Having an Optimal portfolio in any given situation. Optimal Portfolio is one which gives maximum return at a given level of portfolio risk OR has minimum risk for a given level of return.

·        As per fund mandate, Portfolio is made based on type of security. Security is selected after security analysis based on fundamental and technical factors with due emphasis on economic and industry analysis.

·        Business Cycle is forecasted:  The current state of the business cycle gets incorporated into asset prices. Fund Manager makes decisions based on future economic conditions. It is important to evaluate and also forecast changes in economic variables.

·        A strong relationship exists between the economy and the stock market.

·        Security markets reflect what is expected to go on in the economy because the value of an investment is determined by (1) its expected cash flows (2) required rate of return (i.e., the discount rate). Both gets impacted by economic situation.

·        Stock prices consistently turn before the economy does. Stock prices are forward looking. Stock prices reflect expectations of earnings, dividends, and interest rates. Stock market reacts to various leading indicators. Very important to assess, understand and analyze the trend which only a professional can do well.

·        So, what a professional manager does – (1) Analyses Economic situation and predicts probability of different economic scenario (2) Allocation of capital accordingly for best possible return (3) sector rotation (4) security selection (5) strategy and style for better performance of fund

Let’s take an example of a portfolio management in a span of time say 5 years and how diversification helps in reduction of risk.

·        Few things we need to understand in all these 5 years, economic condition might not remain the same. For some months it can be very good and some months normal and some months could be very bad (like present situation).

·        For simplicity sake and for quick understanding let’s take a portfolio with 2 securities.

·        Portfolio risk is measured by Portfolio variance of return and Portfolio Standard deviation of return.

·        Portfolio variance of return and Portfolio Standard deviation of return is less than that of individual securities ?

·        Its because of Covariance and Co-efficient of correlation.  

·        Portfolio return is weighted average of expected return of individual security but Portfolio risk is not the weighted average of expected risk of individual security but the interplay of two securities also play a role and that where diversification helps in reduction of securities.

·        Co movements or interplay between returns of securities are measured by the covariance (an absolute measure) and coefficient of correlation (a relative measure)

·        Covariance reflects the degree to which the returns of the two securities vary or change together

·        Positive covariance between 2 securities means the return of the 2 securities move in same direction (positive or negative) whereas negative covariance between 2 securities means the return of the 2 securities move in opposite direction (if positive in one then negative in another and vice versa)

·        Coefficient of correlation is simply covariance divided by product of Standard deviation of the two securities

·        Coefficient of correlation is from -1 (perfectly negatively correlated or perfect co movement in opposite direction) to +1 (perfectly positively correlated or perfect co-movement in same direction). 0 means no correlation or co movement. If Coefficient of correlation is -1 it means if return of security A is x then return of security B is -x and vice versa. Similarly, If Coefficient of correlation is +1 it means if return of security A is x then return of security B is also x and vice versa

·        For Portfolio risk we need information on weighted individual security risk and weighted co-movement between the returns of securities included in the portfolio

·        Portfolio Risk in case of 2 security is:

Variance = σ_p² = w₁²σ₁² + w₂²σ₂² + 2 w₁w₂σ₁σ₂ρ₁₂

Standard Deviation = σ_p = (w₁²σ₁² + w₂²σ₂² + 2 w₁w₂σ₁σ₂ρ₁₂)^1/2

(σ_p² is the Variance of the portfolio return, w₁ and w₂ are weights of security 1 and 2 in portfolio, σ₁² and σ₂² are the variance of return of the of individual security 1 and 2 and σ₁σ₂ρ₁₂ is the covariance of the returns on security 1 and 2)

·        Fund Manager will ensure that covariance between the two securities and Coefficient of correlation has been negative . That has helped the reduction of Portfolio Risk .

·        It’s a not possible for a normal investor to calculate these complex variables, select securities keeping them in mind and construct a portfolio to give least of Portfolio risk (Variance and Standard deviation in portfolio return)

.

Lets see a portfolio with more than 2 securities

·        In a portfolio you have many securities, may be 10, 15 , 22, ….. If there are 10 securities portfolios then it will have 10 variance and 90 covariance (10*9). If say there are 30 securities then it will have 30 variances and 870 covariances (30*29). Is it possible for a normal investor to calculate so many covariances?.

·        One thing also important to note as the nos of securities increases the impact of individual security variance (individual security risks) becomes less and impact of covariance increases in overall portfolio risk

·        Hence the Portfolio Risk (Variance) of a well-diversified portfolio is largely dependent on Covariance. The lower it is, risk gets further reduced. If it is negative that is the best situation. This is where role of diversification helps in reduction of portfolio risk

·        With more securities added in portfolio the portfolio risk keeps reducing, reaches a minimum level (not zero). For each type of portfolio there could be maximum number of securities desired to make Portfolio risk to a minimum level. Beyond that if more securities added will not help in further reduction of portfolio risk. Its not easy for a common person to know what is that maximum number of securities.

·        Portfolio total risk cannot reduce beyond a certain level because there exists systematic risk also (from economic and market factors) also along with unsystematic risk (company specific risk).

·        In an Equity fund portfolio since asset is same, they will have positive covariance. But there also diversification can be done considering the nature of business and effort is to reduce the covariance as far as possible.

Conclusion:

·        In a scenario where there are so many economic variables which impacts industries, securities and security market in different way the best way to manage risk and get optimal return is by investing through a professional Fund Management like Mutual Fund.

·        Why Mutual Fund – (1) Research is the key in Fund management (2) Top Down approach (Economy – Industry -Company) is followed methodically (3) Security selection more on fundamental factors (4) tactical allocation done more to take short term market advantage