Last week, we had discussed the importance of money management and the necessity to diversify one’s portfolio through asset allocation.
Nobel laureate Harry Markowitz in his modern portfolio theory says one should realise that though different asset classes have different risk-return profiles, they may be correlated.
Hence, by holding assets that have little or low correlation among themselves, an investor can reduce risk and optimise return.
Diversification into various asset classes may reduce the overall portfolio risk, but it also lowers the return. It is also seen that diversification can reduce the portfolio risk to a certain extent.
However, further diversification only reduces the return and not the risk.
This is because there are systemic and non-systemic risks to any investment.
Systemic risks are beyond the control of an individual investor, for example, the movement in interest rates or market swings.
Non-systemic risks are associated with individual security or an investment instrument.
Diversification can reduce only the non-systemic risks.
Thus, too much of diversification is not good for a portfolio. It can tell upon your return as different asset classes are subjected to varied systematic risks.
Set your objective
Diversification should be done in accordance with your risk-taking ability — that is how much loss you can bear — and the return objective. One should not chase maximum returns, which remains elusive.
The purpose of an investment portfolio is to help you achieve financial goals comfortably without taking much risks.
Before planning an investment portfolio, you should determine your financial goals, that is how much you would require and when.
One approach could be to target each financial goal separately and construct separate portfolios for each of them, given the investment horizon for each financial goal.
The other approach could be to construct one investment portfolio targeting all the financial goals together.
You will have to start by deducing the minimum rate of return that you need to get, given your monthly (or annual) savings that you are going to invest.
Markowtiz’s theory of portfolio selection considers the standard deviation of returns as the measure of risk associated with an asset.
Standard deviation determines the deviation of actual returns from their mean value.
But while talking about investment risks, what worries most is the negative return or loss of investment.
It may often be the case that an investor will want a minimum return while taking risks in an investment, (otherwise he would put the money in risk-free instruments, such as bank deposits).
For the sake of simplicity, let us assume that this minimum return is equal to the bank fixed deposit rate.
Then we should consider the bank fixed deposit rate instead of the mean return value of the asset in question while calculating its standard deviation.
Given the minimum return rate (bank fixed deposit rate in our example), an investor will be concerned only about the negative deviations in actual returns from this value — positive deviations could be considered as zero while calculating the standard deviation.
The standard deviation will then give a true measure of the intensity of loss that an investor may have to suffer by investing in that particular asset.
While the standard deviation measures the average loss intensity, the probability of suffering actual losses (from investing in the asset) is given by the percentage of occasions the asset has given a negative return in the past.
However, the average intensity and the probability of suffering a loss diminish as the investment horizon increases.
For example, the average intensity and probability of loss will be higher for annual returns (of an asset) and it will be lower if you consider three-year or five-year rolling average returns.
If we apply the method we have just discussed to assess how prone an asset is to risk, one may find that assets which otherwise appeared highly volatile (high standard deviation) is not at all that risky. After all gains from investment don’t worry investors, losses do.
What an investor needs to do is to switch his investment to other assets in the portfolio whenever the actual return from one asset exceeds the target.
This will protect one’s investment in case the price of the asset in question eventually declines — you are protected to the extent to which you have shifted to other asset classes.
Too much of diversification is self-defeating. What is important is to maintain a fine balance of risk and return.