- Published on
Investment - Risk and Portfolio Diversification
An investment policy statement (IPS) captures information about a customer and the client’s needs. The IPS provides as a reference to what is demanded of and what is acceptable in the investment portfolio. The IPS helps guide asset allocation — that is, which asset classes and how much of each asset class should be included in the investor’s portfolio.
Academic research have suggested that asset allocation is the most important factor of portfolio return. Most investors — both individual and institutional — keep a broad range of investments rather than a portfolio concentrated in just a few investments. A fundamental reason for this diversity is the need to manage risk, which is congruent with the aphorism to not ‘put all your eggs in one basket’.
Systematic Risk, Specific Risk, and Diversification
How well investment risk is managed is a crucial factor of the success of investment management. Risk occurs when there is uncertainty, implying that a variety of outcomes are possible from a single scenario or activity.
In financial terminology, risk is the potential that the actual realised return on an investment will be something other than the return originally predicted on the investment. There will be instances when the return fails to match an investor’s expectations and times when the return exceeds expectations. Fluctuations in the prices and values of investments (capital gains and losses) represent the risk of investing. Income (e.g., dividends and interest) may also differ from what was expected.
Most investors seek larger returns and reduced risks. That is, people desire better outcomes and more certainty, all other things being equal. The trade-off between risk and return is a key issue in investment management. Typically, the larger the risk of an investment, the higher the expected return; the lower the risk, the lower the expected return.
Systematic and Specific Risk
The returns on investments, such as equities, bonds, and real estate, will be affected by overall economic conditions. Returns will also be affected by issues that are specific to the particular investment.
Systematic risk
The risk caused by general economic conditions is characterized as systemic or market risk since the danger emanates from the wider economic system. For example, if the economy enters a recession, many companies will notice a fall in their revenues and profits.
Specific risk
Risk that is distinctive to a certain firm or investment is variously termed as specific, idiosyncratic, non-systematic, or unsystematic risk. Examples include the positive share price response when a company releases a successful new product (e.g., the Apple iPad) or the negative response to the news that a promising new treatment has failed in trials.
The distinction between systemic and specific risk is essential because the two categories of risk have different implications for investors. Investors can lower specific risk by holding a number of different securities in their portfolios. Holding a variety of securities that are not associated diversifies away specific risk. The amount to which two asset classes (or securities) move together is indicated by the statistical measure of correlation.The stronger the correlation between the returns on asset classes (or securities), the more comparable their price movements will be.
Investors cannot diversify away systematic risk. They can do nothing to minimize systematic risk because all investments will be influenced to some extent by systematic risk — for instance, a recession. Diversifying an equity portfolio by adding alternative forms of investments, such as real estate, will not eliminate systematic risk because rents and real estate values are affected by the same broad economic variables as the stock market.
Because systematic risk cannot be avoided or spread away and because risk is undesirable, investors have to be compensated for taking on systematic risk. More exposure to systemic risk tends to be associated with higher predicted returns over the long run.
Portfolio theory implies that taking on more specific risk does not necessarily lead to higher returns on average because specific risk can be diversified away. But some investors may try to locate shares that they think to outperform (to produce higher returns than predicted based on their risk) and invest in them rather than diversifying. In the process, investors take on specific risk; if they turn out to be correct, they may get a bigger return as a result of taking on more risk.
Diversification
Diversification is one of the most important aspects of investing. When assets and/or asset classes with varied characteristics are mixed in a portfolio, the overall level of risk is often lowered.
Mathematically, a portfolio that combines two assets has an expected return that is the weighted average of the returns on the individual assets. Provided that the two assets are less than completely linked, the risk of the portfolio (measured by the standard deviation of returns) will be smaller than the weighted average of the risk of the two assets individually. Overall, this indicates the risk–return trade-off, which is a key issue for investors, is better for a portfolio of assets than for individual assets.
Most investors have more than two securities in their portfolios. Adding more assets to a portfolio will lower risk through diversification, although eventually the additional benefits begin to lessen. The exhibit below demonstrates the degrees of risk — total, particular, and systematic — for portfolios of shares picked at random from all of the shares in the US market.
Specific risk is decreased by merging additional shares, but as the portfolio moves beyond 30 shares, the incremental risk reduction becomes minimal and the accompanying trading expenses may outweigh any incremental advantage of risk reduction. The display illustrates the ideas of unique risk and diversification. Specific risk is highest at the left side of the exhibit (one share) and lowest at the right side of the display since much of the specific risk is spread away.
Portfolio Risk
The display assumes randomly picked shares. But there is the potential for higher risk reduction when shares with low correlation with each other are chosen.
Combining diverse asset classes can also boost diversification and lower a portfolio’s risk by minimizing specific risk. For example, an investor can combine assets in multiple stock and bond markets with investments in real estate and commodities to lower the overall risk of a portfolio.
An investment policy statement (IPS) captures information about a customer and the client’s needs. The IPS provides as a reference to what is demanded of and what is acceptable in the investment portfolio. The IPS helps guide asset allocation — that is, which asset classes and how much of each asset class should be included in the investor’s portfolio.
Academic research have suggested that asset allocation is the most important factor of portfolio return. Most investors — both individual and institutional — keep a broad range of investments rather than a portfolio concentrated in just a few investments. A fundamental reason for this diversity is the need to manage risk, which is congruent with the aphorism to not ‘put all your eggs in one basket’.
Systematic Risk, Specific Risk, and Diversification
How well investment risk is managed is a crucial factor of the success of investment management. Risk occurs when there is uncertainty, implying that a variety of outcomes are possible from a single scenario or activity.
In financial terminology, risk is the potential that the actual realised return on an investment will be something other than the return originally predicted on the investment. There will be instances when the return fails to match an investor’s expectations and times when the return exceeds expectations. Fluctuations in the prices and values of investments (capital gains and losses) represent the risk of investing. Income (e.g., dividends and interest) may also differ from what was expected.
Most investors seek larger returns and reduced risks. That is, people desire better outcomes and more certainty, all other things being equal. The trade-off between risk and return is a key issue in investment management. Typically, the larger the risk of an investment, the higher the expected return; the lower the risk, the lower the expected return.
Systematic and Specific Risk
The returns on investments, such as equities, bonds, and real estate, will be affected by overall economic conditions. Returns will also be affected by issues that are specific to the particular investment.
Systematic risk
The risk caused by general economic conditions is characterized as systemic or market risk since the danger emanates from the wider economic system. For example, if the economy enters a recession, many companies will notice a fall in their revenues and profits.
Specific risk
Risk that is distinctive to a certain firm or investment is variously termed as specific, idiosyncratic, non-systematic, or unsystematic risk. Examples include the positive share price response when a company releases a successful new product (e.g., the Apple iPad) or the negative response to the news that a promising new treatment has failed in trials.
The distinction between systemic and specific risk is essential because the two categories of risk have different implications for investors. Investors can lower specific risk by holding a number of different securities in their portfolios. Holding a variety of securities that are not associated diversifies away specific risk. The amount to which two asset classes (or securities) move together is indicated by the statistical measure of correlation.The stronger the correlation between the returns on asset classes (or securities), the more comparable their price movements will be.
Investors cannot diversify away systematic risk. They can do nothing to minimize systematic risk because all investments will be influenced to some extent by systematic risk — for instance, a recession. Diversifying an equity portfolio by adding alternative forms of investments, such as real estate, will not eliminate systematic risk because rents and real estate values are affected by the same broad economic variables as the stock market.
Because systematic risk cannot be avoided or spread away and because risk is undesirable, investors have to be compensated for taking on systematic risk. More exposure to systemic risk tends to be associated with higher predicted returns over the long run.
Portfolio theory implies that taking on more specific risk does not necessarily lead to higher returns on average because specific risk can be diversified away. But some investors may try to locate shares that they think to outperform (to produce higher returns than predicted based on their risk) and invest in them rather than diversifying. In the process, investors take on specific risk; if they turn out to be correct, they may get a bigger return as a result of taking on more risk.
Diversification
Diversification is one of the most important aspects of investing. When assets and/or asset classes with varied characteristics are mixed in a portfolio, the overall level of risk is often lowered.
Mathematically, a portfolio that combines two assets has an expected return that is the weighted average of the returns on the individual assets. Provided that the two assets are less than completely linked, the risk of the portfolio (measured by the standard deviation of returns) will be smaller than the weighted average of the risk of the two assets individually. Overall, this indicates the risk–return trade-off, which is a key issue for investors, is better for a portfolio of assets than for individual assets.
Most investors have more than two securities in their portfolios. Adding more assets to a portfolio will lower risk through diversification, although eventually the additional benefits begin to lessen. The exhibit below demonstrates the degrees of risk — total, particular, and systematic — for portfolios of shares picked at random from all of the shares in the US market.
Specific risk is decreased by merging additional shares, but as the portfolio moves beyond 30 shares, the incremental risk reduction becomes minimal and the accompanying trading expenses may outweigh any incremental advantage of risk reduction. The display illustrates the ideas of unique risk and diversification. Specific risk is highest at the left side of the exhibit (one share) and lowest at the right side of the display since much of the specific risk is spread away.
Portfolio Risk
The display assumes randomly picked shares. But there is the potential for higher risk reduction when shares with low correlation with each other are chosen.
Combining diverse asset classes can also boost diversification and lower a portfolio’s risk by minimizing specific risk. For example, an investor can combine assets in multiple stock and bond markets with investments in real estate and commodities to lower the overall risk of a portfolio.
0 Comments