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Thoughts on the benefits of share market diversification
Dr Frank Shostak
It is accepted by the practitioners of this way of thinking that risk is associated with the degree of dispersion of returns around the average of returns. Thus a security whose returns are not expected to deviate significantly from its historical average is termed as a low risk. A security whose returns are volatile from year to year is regarded as risky. The MPT assumes that investors are risk averse and they want high guaranteed returns. To comply with this assumption the MPT tells investors how to combine stocks in their portfolios to give them the least possible risk, consistent with the return they seek. The MPT shows that if an investor wants to reduce investment risk he must practice diversification. Consider the following example:
Let us assume that on average, half of the time the weather is cold and half it is warm. According to the table investment in activity A will yield 20 per cent return in cold weather and in warm weather will produce a loss of 10 per cent. On average the return by investing in A will be 5 per cent. The same outcome will be obtained with regard to investment in activity B. The MPT then suggests that if investor will diversify and will invest one dollar in A and one dollar in B then he will be guaranteed, regardless of weather conditions, 5 per cent return. Thus in warm weather one dollar invested in B will produce 20 per cent return, while one dollar invested in A will produce 10 per cent loss. Investors total return on two dollars invested in A and B will be 5 per cent. Exactly the same result will be obtained for cold weather conditions.
This example thus illustrates that regardless of weather conditions through the magic of diversification one can obtain risk free 5 per cent return on investment. This must be contrasted with the fact that two activities A and B are highly risky investments. The reason being because the frequency of a cold or a warm season in a particular year cannot be always ascertained. All that we know is that on average over a prolonged period half of the time the weather is cold and half it is warm.
This however, doesn't mean that every year it will be so. This example shows that as long as activities are affected differently by given factors there is a place for diversification which will eliminate risk. The basic idea of MPT then is that portfolios of volatile stocks i.e. risky stocks can be combined together and this in turn will lead to the reduction of the overall risk.
The guiding principle for combining stocks is that each stock represents activities which are affected by given factors differently. These differences once combined supposedly will cancel each other thereby removing the total risk. This is, according to MPT not exactly so. The theory indicates that the risk of various stocks must be broken into two parts. The first part is associated with the tendency of returns on a stock to move in the same direction as the general market. The other part of the risk results from factors peculiar to a particular company. The first part of the risk is labelled systematic risk while the second part unsystematic.
Through diversification, it is argued, only unsystematic risk is eliminated, the systematic risk however, cannot be removed through diversification. Consequently it is held that a return on any stock or portfolio will be always related to the systematic risk i.e. the higher the systematic risk the higher the return. The systematic risk of stocks captures therefore the reaction of individual stocks to general market movements. Some stocks tend to be sensitive to market movements while other stocks display a lesser sensitivity.
The relative sensitivity to market moves is estimated by means of statistical methods and is popularly known as beta. In this regard beta is the numerical description of systematic risk. If a stock has a beta of 2 it means that on average it swings twice as much as the market. Thus if the market goes up 10 per cent the stock tends to rise 20 per cent. If however, the stock has a beta of 0.5 per cent then it tends to be more stable than the market.
Does it all make sense?
This way of thinking gives the impression that there is a difference between investing in the stock market and investing in a business. However, the stock market doesn't have a "life of its own". The success or a failure of investment in stocks depends ultimately on the same factors that determine success or failure of any business. Consequently an investment in stocks should be regarded as investment in business as such and not in stocks.
By becoming an investor in a business an individual has exercised an entrepreneurial activity. In other words he has committed his capital with a view to supply the most urgent needs of consumers. Meaning that for an entrepreneur the ultimate criterion for investing his capital is to employ it in those activities which will produce goods and services that are on the highest priority list of consumers.
It is this striving to satisfy the most urgent needs of consumers that produces profits and it is this alone that guides entrepreneurs. The entrepreneurs focus and main consideration while investing his capital is to secure the highest possible profits, not to minimise risk as the MPT suggests. If entrepreneurs strived after what they considered to be the safest investment while neglecting consumers wishes this would render the entire investment unsafe.
What determines the size of entrepreneurs return on their investment is not how much risk they assume but whether they comply with consumers wishes. The fact that entrepreneurs appear to be practicing diversification by investing in various businesses over time doesn't mean that they do so in order to reduce their investment risk. They diversify in order to boost their chances of earning profits.
Now, the moment the consideration of investment is not securing the highest profit possible but rather reducing the risk then all kind of strange decisions could emerge. For instance, deliberately choosing an investment which offers a negative return if in the framework of the MPT it will reduce the overall portfolio risk. However, no sane investor deliberately chooses a bad investment. It is only the emergence of conditions not properly forecasted by the investor entrepreneur that leads to a bad investment.
The focus on diversification of portfolio in order to reduce risk for a given return can lead to the opposite results. Having a large number of stocks in the portfolio might leave little time to analyse these stocks and understand their fundamentals. This in turn could raise the likelihood of putting too much money in bad investments. In fact this way of conducting business would not be an entrepreneurial investment but rather gambling.
One of the most successful stock market investors, Warren Buffett, argues that investor's financial success is in direct proportion to the degree to which he understands investment. This understanding according to Buffett is what separates investors with a business consideration from gamblers who merely buy stocks. Buffett says that investors are better served if they concentrate on locating a few spectacular investments rather than jumping from one mediocre idea to another. In other words, according to Buffett, it is a mistake to think that one limits the risk by spreading between companies about which one knows very little.
Furthermore, the employment of sophisticated mathematics and probabilities in compliance with the modern portfolio theory misses he entire point of an investor-entrepreneur activity. Entrepreneurial actions cannot be captured by means of probabilities for such probabilities cannot be established. Mathematics and statistical methods are only suitable in analysing objects or insurable risk but not human beings in general and entrepreneurs in particular.
Frank Shostak is a former professor of economics who now works as an economist for M. F. Global.
BrookesNews.Com
Monday 22 March 2010
According to the popular view stock market prices move in response to unexpected information. Since the unexpected cannot be known, otherwise it would not be called unexpected, it implies that individual's chances to anticipate general direction of the market are as good as anybody else's chances. It is thus suggested that since the future direction of the stock market cannot be known, the only way of earning above average return is to assume greater risk. This way of thinking is known as the modern portfolio theory (MPT). The MPT views risk as the chance that expected security returns will not materialise.
Cold weather 20%
Warm weather -10%