This paper contains a critical analysis
of the statement: “The concept of efficient diversification implies that for an
investor wishing to efficiently assume risk in their investment portfolio; the
risky part of the portfolio should consist of weighted proportions of all
possible risky assets.”The rationale for diversification of stock portfolios
has been explained at length with the examination of the fact on whether or not
it is necessary to include all the stocks in order to reflect on the lowest
levels of risk obtainable. The paper then goes on to explain why the concept of
diversification may not always yield the expected result in relation to the
frequency with which investors are capable of efficiently diversifying their
portfolios. A preliminary look at the findings brings some level of concurrence
with the base argument in the sense that the addition of more stocks to a
portfolio contributes to a reduction of the portfolio’s riskiness. However,
these additions come at a cost and it reaches a point where the risk reduction
may not be commensurate with the risk reduction rates.
The statement- “The concept of efficient
diversification implies that for an investor wishing to efficiently assume risk
in their investment portfolio; the risky part of the portfolio should consist
of weighted proportions of all possible risky assets” can best be explained by
understanding the concept of portfolio diversification, its importance and the
knowledge of how risk is effectively minimised.
The statement above implies that it is
necessary to include all the stocks available in order to drive down the
riskiness of a portfolio to the lowest possible level. This may be the case
where the diversification is not efficiently done.
Diversification refers to the practice
of allocating risks to a wide range of stocks normally sourced from different
types of financial instruments, industries, and business categories (Shawky and
David, 2005). Diversification works in the following manner: where a certain
circumstance leads to the lowering of the incomes in one company, the same
circumstance may lead to the improvement in the profitability of another
(Shawky and David, 2005). A classic example is the diversification using stocks
in agricultural sector and in the manufacturing sectors. When there is a price
surge in the agricultural raw materials, the manufacturing companies have to
contend with diminished incomes. However, this effect is neutralised by the
gains in profitability by the producers of these raw materials. A stock
portfolio containing both stock categories may therefore suffer minimum effects
due to such a circumstance. Diversification does not constitute a guarantee
against loss: it merely reduces the risk of suffering such losses.
As analysts would concur, the portfolio
risk is at its lowest when all the stocks have been included (Rubinstein, 2002).
However, investors rarely factor in the total number of stocks in their
portfolios for a number of reasons. To start with, they may not have the kind
of resources required to acquire reasonable amounts of stocks across the entire
index. More importantly, the additional costs of transaction may not
necessarily justify the gains to be obtained in form of the risk reduction to
the entire portfolio. According to some analysts, the transaction cost for most
stocks range between 1% and 1.5% of the value of the securities (Considine,
2008). Most observers agree that the riskiness of portfolios tend to reduce
dramatically as the investors diversify their stock ranges from 1 to 10
(Considine, 2008). Reasonable reductions are also experienced as the
diversification grows from 10 to 30 stocks (Rubinstein, 2002). Beyond that, it
starts uneconomical to pursue further diversification as the cost of doing so
is often higher than the targeted gains in terms of risk reduction. Since risk
minimisation through extensive diversification is often too costly, the concept
of efficient diversification is increasingly being employed.
Indeed, it is not uncommon to find small
stock portfolios whose riskiness is lower than the riskiness of portfolios with
a much larger number of stocks (Wang and Yang, 2011). The secret behind such
disparities is: efficient diversification. When seeking to lower the riskiness
of their portfolios, investors must avoid the practice of diversification for
the sake of it. The riskiness of the stocks being considered must be weighed
carefully with company and market characteristics put under consideration (Wang
and Yang, 2011). When diversification is efficient, the portfolio’s riskiness
can be lowered substantially without having to include more stocks. The
statement “The concept of efficient diversification implies that for an
investor wishing to efficiently assume risk in their investment portfolio; the
risky part of the portfolio should consist of weighted proportions of all
possible risky assets” is right as far as calculation of a portfolio’s
riskiness using the weighted proportions of the stocks therein are concerned.
It may also be correct in its implication that the larger the number of stocks
in a portfolio, the lower the riskiness of the portfolio. However, the
statement fails to appreciate the role of efficiency in diversification. A
proper analysis of stock characteristics, market volatility and impact of the
business cycles may substantially help an investor to create portfolios with
lower risks despite the low number of stocks involved (Strongin, Petsch and
Sharenow, 2007). For instance, where two stocks bear the same characteristics,
it may not be beneficial to include both in a portfolio unless the investor may
be in possession of information that may make such stocks beneficial to their
portfolios. For this efficiency to be achieved, the investor must be adequately
informed about the goings on in the market as well as the happenings in the
organisations in question. The stability of corporate governance practices, the
innovativeness of the organisations, and the level of market rivalry the
businesses face are among the factors to be considered when evaluating the
riskiness of a stock (Wang and Yang, 2011).
Varied opinions have been expressed on
different forums on the ability of investors to efficiently diversify their
portfolios. Efficiency in the diversification of portfolios is in most cases a
function of the amount of knowledge held by investors. Financial knowledge and
general knowledge on the happenings in the markets and in the companies is the
prerequisite for efficient diversification (Wang and Yang, 2011). For such
efficiency to be achieved there must be free flow of information which must be
obtainable at little or no cost. This is however not the case in most
instances. The level of diversification by most investors is rarely at its
optimum.
As analysts would observe, most
investors tend to exaggerate their financial literacy levels tending to project
themselves as more knowledgeable than they actually are (Cart, 2005). They make
decisions on investment in the belief that such decisions are good for the risk
reduction of their portfolios when the reality may be much different. Those
that acknowledge their deficiency in the knowledge of finance and the market
operations tend to enlist the help of professional stock brokers whose level of
knowledge in the stock markets may be considered superior to theirs (Wang and
Yang, 2011). However, most stock brokers may not function to the optimum as
they may have to obtain permission from their principals from time to time; and
this permission may either delay or their requests summarily declined.
Moreover, however knowledgeable such agents may be, they may not have the
capacity to obtain all the relevant information necessary for their decision
making in good time and even where such information is received, there may be
errors of judgment that may compromise the efficiency with which their
diversification are achieved.
Most people and indeed most investors,
tend to think of themselves as rational beings whose decisions are purely
driven be logic and reason. However, the reality is different. Most investors
tend to base their investment decisions on sentiments that have little to do
with the riskiness of the stocks (Strongin, Petsch and Sharenow, 2007). For
instance, it is not uncommon to find a good number of investors making their investment
decisions based on the recommendations of trusted colleagues. Several surveys
have shown that the power of recommendation is alive and strong in the
investment markets with many stocks being purchased on this basis. Personal
feelings of investors towards organisations also influence the investment
decisions. It is indeed rare to find investors purchasing stocks of companies
which they find distasteful. In fact, less than 5% of all investors admit to
having bought stocks despite their strong resentment for the organisations
owning the stocks (Considine, 2008). Personal sentiments are a strong factor in
influencing investment decisions and this is perhaps the basis for the massive
investments made by companies in public relations and social responsibility
programs with the generation of positive investor sentiments as one of their
goals.
The reaction of the markets to
incidental happenings in organisations is also proof of the fact that investors
are rarely rational and therefore not capable of conducting efficient portfolio
diversification. It is indeed very common to find the trading on stocks decline
or increase based on the temporary good or bad performance of organisations
(Considine, 2008). These changes occur despite the fact that the fundamentals
remain largely in place implying that the organisation’s mid and long term
performance may not behave much to do with the observed incidents. For
instance, where rumours start to spread about the well being of an
organisation, it is common to see investors being panic stricken and rushing to
dispose off their stocks. The contrary happens when good sentiments are spread
and these decisions are made without much analysis of the fundamentals that are
used to assess the riskiness of the stocks and their possible contribution to
the riskiness of the investors’ stock portfolios.
Diversification of stocks is necessary
in order to ensure that the investors are exposed to as little risk as
possible. As a general rule, the more stocks that a portfolio contains, the
lower the riskiness of such a portfolio. However, when the diversification is
done efficiently, it is possible to minimise such risks without having to
invest in a vast number of stocks. Efficient diversification is helpful in
eliminating unnecessary costs while helping investors to keep their portfolio
risks at the bare minimum. However, this efficiency may be hard to achieve in
view of the fact that investors mostly lack the rationality needed to achieve
it.
References
Cart, M., 2005. Do investors make rational or
emotional decisions? Financial Advisor
Magazine, May Issue
Considine,G., 2008. What is Diversification Worth? (Online) Available at:
http://www.quantext.com/DiversificationPremium.pdf (Accessed 5 November 2011)
Rubinstein, M., 2002. Markowitz’s Portfolio
Selection: A fifty-year retrospective. The
Journal of Finance, LVII (3)
Shawky, H.A., David, M.S., 2005. Optimal Number of
Stock Holdings in Mutual Funds Based on Market Performance. Financial Review, 40, pp. 481-495
Strongin, S., Petsch, M., Sharenow, G., 2007.
Beating benchmarks: a stockpicker’s Reality. Journal of Portfolio Management, 26, pp. 11-27
Wang, G.Y., Yang, Y., 2011. Portfolio Diversification and Optimal Stock Holdings- A Study of Taiwan
Equity Funds. (Online) Available at:
http://ibacnet.org/bai2007/proceedings/Papers/2007BAI7603.pdf (Accessed 5
November 2011)
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