One effective tool for investment advisors to determine the amount of diversification necessary for a portfolio is modern portfolio theory (MPT). MPT is used to determine an efficient frontier for portfolio optimization and uses diversification to achieve this goal. The efficient frontier provides a maximum return obtainable for a certain amount of risk taken.
MPT states that for a given portfolio of assets, there is an optimized combination of stocks and assets toprovide the greatest return for a given level of risk. MPT uses diversification, asset allocation, and periodic rebalancing to optimize portfolios. MPT was first created by Harry Markowitz in the 1950s, andhe eventually won a Nobel Prize for it. Further innovation ofMPT has added the calculation of Treasury bonds (T-bonds) and Treasury bills (T-bills) as a risk-free asset that shifts the efficient frontier.
MPT uses the statistical measures of correlation to determine the relationship between assets in a portfolio. The correlation coefficient is a measure of the relationship between how two assets move together andis measured on a scale from -1 to +1. A correlation coefficient of 1 represents a perfect positive relationship whereby assets move together in the same direction to the same degree. A correlation coefficient of -1 represents a perfect negative correlation between two assets, meaning they move in opposite directions from each other.
The correlation coefficient is calculated by taking the covariance of the two assets divided by the product of the standard deviation of both assets. Correlation is essentially a statistical measure of diversification. Including assets in a portfolio that have negative correlation can help to reduce the overall volatility and risk for that mix of assets.
Achieving Optimal Diversification to Reduce Unsystematic Risk
MPT shows that by combining more assets in a portfolio, diversification is increased while the standard deviation, or the volatility, of the portfolio, is reduced. However, maximum diversification is achieved with around 30 stocks in a portfolio. After that point, including more assets adds a negligible amount of diversification. Diversification is useful for reducing unsystematic risk. Unsystematic risk is the risk associated with a certain stock or sector.
For example, each stock in a portfolio has a risk associated with negative news impacting that stock. By diversifying into other stocks and sectors, the decline in one asset has less impact on the larger portfolio. However, diversification is unable to reduce systematic risk, which is the risk associated with the overall market. During times of high volatility, assets become more correlated and have a greater tendency to move in the same direction. Only more sophisticated hedging strategies can mitigate systematic risk.
There have been some criticisms of MPT over the years. One major criticism is that MPT assumes a Gaussian distribution of asset returns. Financial returns often do not follow symmetrical distributions such as the Gaussian distribution. MPT further assumes that the correlation between assets is static when in reality the degree of correlation between assets can fluctuate. The efficient frontier is subject to shifts that MPT may not accurately represent.
One effective tool for investment advisors to determine the amount of diversification necessary for a portfolio is modern portfolio theory
modern portfolio theory
The modern portfolio theory (MPT) is a practical method for selecting investments in order to maximize their overall returns within an acceptable level of risk. This mathematical framework is used to build a portfolio of investments that maximize the amount of expected return for the collective given level of risk.
Correlation analysis plays a pivotal role in assessing the diversification of a portfolio. Correlation measures the degree to which the prices or returns of two or more assets move in relation to each other.
In its most basic form, a portfolio's diversification can be measured by counting the number of assets or determining the weight of each asset. When counting the number of assets, consider the number of each type for the strategies above.
As a general rule of thumb, most investors would peg a sufficiently diversified portfolio as one that holds 20 to 30 investments across various stock market sectors. However, others favor keeping a larger number of stocks, especially if they're riskier growth stocks.
The correlation coefficient is calculated by taking the covariance of the two assets divided by the product of the standard deviation of both assets. Correlation is essentially a statistical measure of diversification.
There are three popular performance measurement tools that assist with portfolio evaluations—the Treynor, Sharpe, and Jensen ratios. Portfolio returns are only part of the story—without evaluating risk-adjusted returns, an investor cannot possibly see the whole investment picture.
What Are the Rules of Thumb for Developing a Diversification Strategy? First, set aside enough money in cash and income investments to handle emergencies and near-term goals. Next, use the following rule of thumb: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds.
It is one way to balance risk and reward in your investment portfolio by diversifying your assets. Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited.
Financial planners say it is difficult to put a cap on the number of schemes in an investor's portfolio, as investors increasingly use mutual funds to meet both long-term and short-term goals. However, they feel investors should restrict themselves to 10 schemes, as a higher number is difficult to monitor and manage.
To be truly diversified, investors need to own a collection of assets with different risk drivers, which will act and react differently from each other.
A classic diversified portfolio consists of a mix of approximately 60% stocks and 40% bonds. A more conservative portfolio would reverse those percentages. Investors may also consider diversifying by including other asset classes, such as futures, real estate or forex investments.
If you are a moderate-risk investor, it's best to start with a 60-30-10 or 70-20-10 allocation. Those of you who have a 60-40 allocation can also add a touch of gold to their portfolios for better diversification. If you are conservative, then 50-40-10 or 50-30-20 is a good way to start off on your investment journey.
Portfolio weight is calculated by dividing the stock value by the total portfolio value and multiplying this amount by 100 to get a percentage. For example, the portfolio weight of an asset worth $10,000 from a total portfolio worth $100,000 has a weight of 10%.
Finding your portfolio value involves first calculating the monetary value of each individual asset, then adding all of those values together. The number you get is your portfolio value.
The portfolio turnover ratio can be calculated using a very simple method. You can take the minimum of either bought stock or sold stocks under a fund and divide them by the average Assets Under Management (AUM). The number you get is the Portfolio Turnover Ratio of that particular fund.
Attractiveness of Industries. The company needs to assess if the industries it is diversifying into are attractive in terms of market demand and revenues. ...
“Diversification score (leaf)” calculates the diversification score based on the lowest level. The default diversification score, uses the “leaf” method with the portfolio grouped so that the lowest level is positions. For the same portfolio, the leaf method will always produce a higher diversification score.
That diversification could be across different asset classes or using different investment styles within a particular asset class, often called factors. A factor looks for stocks which share similar characteristics and behave the same way during different points in the macro-economic cycle.
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