Efficient Diversification in Portfolio Risk Management

1.1    Portfolio and Portfolio Risk

In finance, investments assets of an investor (personal or institutional) are held in what is known as ‘portfolio’. Therefore, a portfolio could be defined as a collection or combination of investment assets held by an individual or an institution.

The desire of any investor is to reap returns from such investment. On the other hand there is the possibility to record financial losses. The chance of recording financial losses from investment is known as ‘risk’. Risk could affect the expected returns. It is therefore possible for the investment portfolio to be affected by risk, if the portfolio is not properly managed.

An investment portfolio can be affected by two major forms of risks, which are the sources of portfolio risks:

·         Systematic risk

·         Unsystematic risk

Systematic risk is associated with market forces and general economic conditions (such as the business cycle, the inflation rate, interest rate, exchange rate and so forth) which affect all firms and companies. Because these are not predictable with certainty, they affect a company’s rate of returns.

Unsystematic risk is firm-specific and is caused by factors that affect a particular company without noticeably affecting other firms. These factors affect the company’s rate of returns.

These form the total risks that a portfolio could be exposed to, thus→

·         Total Risk = Systematic Risk + Unsystematic Risk

Risk is always associated with return.

Given these, a risk-averse investor (an investor that avoids risks) will always want to avoid risk and seek for an investment portfolio that has minimum level of risk. Such investor can achieve this through diversification.

1.2 The Meaning of Diversification

Diversification is:

·         the process of spreading a portfolio over many investments in order to avoid excessive exposure to any one source of risk.

·         It is a process of combining securities in a portfolio.

·         It is meant to reduce total risk without sacrificing portfolio return.

·         It entails investment of funds in more than one risky asset with the basic objective of risk reduction.

By implication, for diversification to hold, investment of funds should be in more than one risky asset and the basic objective should be risk reduction.

It is important for diversification to be efficient. An efficient diversification will result into an efficient portfolio. An efficient portfolio will reflect a combination of investment assets which provides:

·         highest possible expected return for a given level of risk; or

·         lowest risk for a given level of expected return.

This is the principle of efficient diversification.

At this point, we have to note that it is impossible to eliminate or reduce all risks through diversification. We cannot eliminate or reduce systematic risk because, it is attributable to market forces and economic conditions and it affects all firms. However, in practical sense, we can eliminate or reduce unsystematic risks through diversification because it is a company-specific risk. Therefore, the risk that remains even after diversification is the systematic risk (the market risk).

In practice, what an investor would do is:

·         to select investment weights and use the available risk and return statistics in choosing/combining investment assets in such a way that will result in an efficient portfolio → (minimum risk at a given level of return or maximum return at a given level of risk).

·         He should be able in such a manner that it results in a portfolio that has minimum risk at a desired level of return.

Illustration:

If you invest half of your risky portfolio in an oil company, say BP and leaving the other half in a computer manufacturing company, say HP, what happens to the portfolio risk if oil prices increase, and when computer prices fall?

·         Increases in oil price will increase BP’s return. This will go on to increase the investor’s return on investment.

·         A fall in computer prices reduces HP’s revenue. This will go on to reduce investor’s return on investment.

The two effects are offsetting which stabilises portfolio return.

Armed with risk and return statistical information, the investor should consider the combination of assets that will reduce/eliminate portfolio risk for a desire level of return.

If we want to sustain the efficiency of diversification → as the desired levels of return and risk change, the efficient combination of investment assets in the portfolio will change. Consequently, → it is possible to have more than one efficient portfolio at different risk-return combinations.

This leads to the concept of efficient frontier which is about the locus of points in risk-return space having the maximum return at each risk level or the least possible risk at each level of desired return. It presents a set of portfolios that have the maximum return for every given level of risk or the minimum risk for a given level of return.