Portfolio Diversification: It's Impact on Investor Risk Reduction

Introduction

Investing in a market, it is should be expected that there are present risk. Most of the investors are aware of the portfolio diversification but did not set much attention on it. Slowly, as they approach in the action to reduce the volatility or uncertainty in the investments or portfolio then, it is advisable to need more than one security. But in the means of achieving the risk reduction, having this option is not enough.

Portfolio Diversification

Diversification is one of the most important tenets of modern finance and from this concept was promoted by Prof. Harry Markowitz in 1952. The introduction of Modern Portfolio Theory (MPT) which is also called “portfolio theory” or portfolio management theory” became a sophisticated approach in investment (CTA, 2004). It is advised that investors should not only hold a portfolio of investments, but with the relationship or correlation of different investments should also be considered when building a portfolio. The value of diversification underlies in the simple explanation – as the number of stocks in the portfolio increases, there will be a reduction in the risk associated with the stocks, and the overall risk of the portfolio should more closely match the systematic risk of the market (Rzepczynski, 2003).

The modern portfolio theory was utilized by the investors in enhancing the performance and risk reduction benefits of diversification in non-correlated investments. Most of the investors recognized the risk reduction benefits of managed the future as if in the form of investments - the higher the ratio or the return on investment, the lower the risk. In addition, the diversification reduces volatility more efficiently. Many investors diversified their portfolios in different investments such as individual stocks, mutual funds, bonds, and international stocks. According to the portfolio theory, the proper diversification is in different asset classes that move independently from one another (CTA, 2004; USF, 2007).

Investor Risk Reduction: Two Firms in Traded Stocks

Upon the examination of the two firms that are traded on stock exchange, one is identified as domestically investing while the other is engaged in internationally investment. Companies that have portfolios of both international and domestic stocks reduce average portfolio risk as much as 30% more than the domestic portfolios alone. This is because the domestic portfolios provide little additional risk reduction. And diversifying internationally extends the boundaries of domestic equity mutual funds. International securities make a strong contribution to portfolio efficiency and the country allocations play a much larger role than investment style in the international fund performance. Therefore, by adding international stocks to domestic portfolios, the risk can be reduced much more rapidly than by adding domestic stocks. In all cases, international diversification provided a better and quicker reduction in risk, even for a portfolio with a limited number of securities. The mutual funds provide opportunities for investors to diversify, and ideally, investors seek a higher return on their investment but at lower risk (Alvares and Boldin, 2006).

The idea of combining more investments that are not perfectly correlated to form a portfolio, the risk of the said portfolio can be reduced. Investors must recognize the relationship of the investment for the reason the theory states that if there is a small relationship among the various investment included in a portfolio, the greater of reduction of risk or diversification. The rate of return of an investment considers the fact that there are some total risks associated with the investment that can be diversified (USF, 2007).

Optimal Portfolio

Having the opportunity of the investor to measure the efficiency of the portfolio diversification, then the investor or portfolio manager can identify the specific optimal portfolio. If the investors can have the capability to analyze the classical plug-in methods for the estimations of the optimal portfolio, then they can derive to the mean-variance theory. Moreover, the idea of the optimal portfolio is concern with the investing in the universe of the riskless asset, which is also in the form of combining the different investment that can be diversified and reduce the risk (CTA, 2004; Kan and Zhou, 2005; USF, 2007).

Conclusion

The lack of diversification among the investing leaders led them to the under-representation of managed futures. Investors with small holdings on investment are expected to lead diversified but if there are larger portfolios, the investment will have better superior skills at diversifying portfolio risk than smaller investors. In this fact, the international portfolio is more effective in reducing the risk than the domestic portfolio. The only diversification value comes from the number of stocks in the portfolio. Therefore, if there is greater diversification provided many equity and bond investments may serve as diversification enhancer.

References:

Alvares, B., & Boldin, R., 2006. Mutual Equity Fund Portfolios: Risk Reduction through Global Diversification. [Online] Available at: http://www.ekf.vsb.cz/shared/uploadedfiles/cul33/Robert.Boldin1.pdf. [Accessed 27 Jan 2010].

CTA, 2004. Modern Portfolio Theory: Dynamic Diversification for Today’s Investor, Commodity Trading Advisors. [Online] Available at: http://www.cta.visionlp.com/pdf/gen/MPT_01062004_online.pdf. [Accessed 27 Jan 2010].

Kan, R., & Zhou, G., 2005. Optimal Portfolio Choice with Parameter Uncertainty [Online] Available at: http://www.rotman.utoronto.ca/~kan/papers/erisk8.pdf. [Accessed 27 Jan 2010].

Rzepczynski, M., (Pres. & CIO) 2003. Portfolio Diversification, Investors Just Don’t Seem to Have Enough. (John W. Henry & Company, Inc.) JWH Journal, Vol. 1, No. 1. [Online] Available at: http://www.jwh.com/Documents/JWHJournal_2003.pdf. [Accessed 27 Jan 2010].

USF, 2007. Risk and Rates of Return, University of South Florida. [Online] Available at: http://www.coba.usf.edu/departments/finance/faculty/besley/notes/risk.pdf. [Accessed 27 Jan 2010].