Portfolio diversification

Portfolio diversification
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Portfolio Diversification
Portfolio investment is aimed at reaping maximum benefits. However, during this
process, the risk of making losses exists. This keeps financial experts and investors on their toes to minimize and manage risks in the guarantee of benefits. To manage risk, experts have resolved in the investment in an array of portfolios; portfolio diversification. The objective of Portfolio diversification is to have an overall positive result after the positives and negatives that arise from the different investments have been summed up. Hence, the underperformance of one investment is covered for by another investment that yields high returns. This paper seeks to discuss the dynamics of portfolio diversification.
Understanding Risk
Diversification involves in portfolios like stocks, equities, securities, and bonds. These investments have their unique technicalities, benefits, and challenges, which vary from time to time. Thus, if investors want to reap maximum benefits, they should have a deep understanding of them (Ross et al., 2010). As a result, they get to understand the magnitude and dimensions of risk that comes with investment portfolios. In investment, there is a correlation between risk and return. Often, if one opts for a low-risk investment, the yields are usually low and vice versa. In the same regard, it is worth noting that investments are affected by external forces like inflation and interest rates fluctuations.

Inflation affects the current worth of a portfolio and could result in a portfolio earning a negative interest. For bonds, the interest rates are inversely proportional to their prices for investors who intend to sell their bonds before maturity. It calls for investors to be smart in timing and decision making in regards to selling or buying (Abid et al., 2014).
Other types of risk are credit and market risk, which mainly affect bonds and stocks. The credit risk usually is determined by a company’s performance. Companies that are unstable and making losses are a no-go zone for investment. Besides being unable to pay interest to the investors, there is a possibility that investors could not receive their initial portfolio capital. This is evidence enough that without knowledge about risk and returns, investors are prone to making poor investment decisions. The ripple effect is the loss of money and the inability to speculate and adapt to changes in the ever-changing business environment (Abid et al., 2014). For the knowledgeable investors, they are well positioned to assess different portfolios, make wise decisions and maximize returns.
Reasons for portfolio diversification
Portfolio investment is a risky undertaking that requires the strategic tools that assure investors of returns while minimizing risk (Ross et al., 2010). One of the strategies is to invest in more than one portfolio while aiming at achieving a cumulative positive result. It is a strategy based on not putting all the eggs in one basket. Apart from being safe, investors are given the liberty to customize their portfolios with respect to time, amount, type and number of investments. Second, investors increase their opportunities and increase their returns. To an investor, each portfolio represents a sole business. While expounding on opportunities, portfolio diversification gives investors and experts to apply different investment styles. Investment styles are dependent on factors like risk, time, market, growth and value speculations (Abid et al., 2014).
Investors have adopted different investment styles based on their characters and goals. These techniques include Bottom-up, growth, investing, value, active and passive investing. Active investors are risk takers who live by the day while passive investors are cautious and have long-term goals. On the other hand, growth style involves investment in portfolios whose value is high and is expected to increase while value investment involves portfolios whose value is low with the hope that they will sell them at a higher price. By diversifying their portfolios, investors are flexible to adopt any investment styles to maximize returns. Lastly, the tendency of investing at home is reduced (Mroua et al., 2017). Occasionally, domestic market forces affect the performance of portfolios, which increases the risk of loss and minimizes returns. To counter these investors opt for foreign portfolios.
Shortcomings of portfolio diversification
In the quest to minimize risk through portfolio diversification, investors could end up over-diversifying. It is only realized when the losses accrued by the portfolio exceed the returns from the total investments. An increase in investments results in a decrease in risk but lowers the returns. Hence, it is essential for investors to come up with a well-balanced portfolio. Significantly, diversification could create confusion, as most of the investments would require in-depth kind of focus. This calls for a strategic kind of approach when diversifying giving more attention to portfolios with a great profit margin. Also, investments take time to mature and yield significant returns since each investment in a portfolio has its unique technicalities. This implies that time and resources should be allocated for the different components of a portfolio. As a result, investors could end up putting much effort and yield insignificant profits (Ross et al., 2009). However, at times, the negligible profits are not even yielded. Investors could end up making losses and not achieving their desired goals of their portfolios.
Optimal diversification
Optimal diversification involves the incorporation of mathematical and scientific tools to achieve maximum profits while incurring minimum risk possible. The use of technical tools is mostly found complicated by investors who do not understand various dynamics and is preferred by financial experts. To predetermine the business performance, they prefer naïve diversification, which is user-friendly. Research by DeMiguel et al. (2007), on Optimal versus Naïve Diversification; investigating the efficiency of the 1/N strategy, shows statistics is not always reliable in diversification. Instead, deep comprehension of the business environment could be more resourceful than a statistical model when it comes to portfolio diversification (Abid et al., 2014).It is worth noting that even with optimal diversification, returns are not guaranteed; Portfolio investment is an uncertain venture.
Portfolio rebalancing
Portfolios are usually composed to achieve given goals within a given period. This involves calculations to forecast the returns (Jaconetti et al., 2010). However, these speculations are adversely affected by various factors in the trading environment. To strike the appropriate balance, investors are forced to sell or buy assets, bonds, stock and other investments to adapt to changes; portfolio rebalancing. In the efforts to rebalance portfolios, two strategies are commonly used; corridor and calendar strategies. Calendar strategy involves the periodic assessment of portfolios to determine if adjustment is necessary while corridor rebalancing consists of the utilization of a percentage range to make changes on the portfolios. Rebalancing helps in the minimization of risks by ensuring that the portfolio is positioned to meet objectives (Qian, 2012). However, costs are incurred during the rebalancing of portfolios. Capital tax gains and brokerage fees are some of the expenses investors pay (Jaconetti et al., 2010). These costs are sensitive about time and nature of investment that is being rebalanced.
Annotated Bibliography
Abid, F., Leung, P. L., Mroua, M., & Wong, W. K. (2014). International Diversification versus Domestic Diversification: Mean-Variance Portfolio Optimization and Stochastic Dominance Approaches. Journal of Risk and Financial Management, 7(2), 45-66.
The risk financial management journal by Abid et al. establishes that using their PO results, at lower risk levels, local diversification strategy is dominant to international investment strategy. At higher risk level, however, the international diversification strategy dominates the local one. The authors also found that domestically diversified portfolios with smaller risk were preferred to higher risk international diversified portfolios.
Combining their experiences in business, statistics, and economics, the research is well informed and reliable. Abid et al.’s findings highlight on diversification options for investors hence being timely and appropriate in providing deeper understanding of portfolio diversification.
DeMiguel, V., Garlappi, L., & Uppal, R. (2007). Optimal versus naive diversification: How inefficient is the 1/N portfolio strategy? The review of Financial Studies, 22(5), 1915-1953.
DeMiguel, Garlappi, and Uppal’s journal set out to find out how efficient the I/N portfolio strategy is in relation to naïve and optimal diversifications. Using the U.S equity market, the authors purpose to identify an estimation of the window period sample-based-mean variance would need to outperform the I/N benchmark and the number of assets per portfolio needed.
The authors provide a table of asset allocation models that aid better understanding of the derivation of optimal diversification strategies. The results are significant to the current research as they reveal that to attain optimal diversification, the strategy selected one has to consider the assets being included and the window period for maximum returns.
Jaconetti, C. M., Kinniry, F. M., & Zilbering, Y. (2010). Best practices for portfoliorebalancing. Vanguard Research, July.
In their article, Jaconetti, Kinniry, and Zilbering find out that the main reason behind portfolio rebalancing is to minimize the risk of asset allocation as opposed to maximizing returns. Investors, therefore, go for a rebalancing strategy that reflects on their willingness to take risk. In time different assets produce varying returns hence the need for rebalancing.
With thoughtfulness of the importance of investors risk tolerance, time horizon, and financial goals in asset allocation, the authors incorporate these three factors in their investigation. As experienced financial risk analysts, the authors caution potential investors that the performance shown by their findings may not be the same as that of the future. The authors provide a deeper understanding of how to choose a rebalancing strategy and the benefits of rebalancing hence the information is essential when analyzing portfolio rebalancing.
Mroua, M., Abid, F., & Wong, W. K. (2017). Optimal diversification, stochastic dominance, and sampling error. American Journal of Business, 32(1), 58-79. Retrieved from http://search.proquest.com.ezproxy.
The American business journal establish that reducing sampling error raises dominance relationships in several different portfolios. Portfolio relationships alterations from sampling errors impact investment decisions. Mroua, Abid, and Wong found that risk-averse investors had no preference between diversification tactics. The authors conclude that for U.S. investors who are risk-averse, stochastic diversification in domestic and a number of international markets including Europe, Australia, and the Far East have better risk returns.
A paper presents a new idea of stochastic measurement of portfolio investment returns that combines the concept of portfolio re-sampling and stochastic portfolio optimization to investigate optimal option between local and foreign diversification methods. The data will be reliable in assessing optimal diversification.
Qian, E. (2012). Diversification return and leveraged portfolios. Journal of Portfolio Management, 38(4), 14-25, 8. Retrieved from http://search.proquest.com.ezproxy.
Qian in his journal seeks to analyze the essential relationship between portfolio rebalancing and portfolio dynamics. Using long-only, long-short, and leveraged portfolios, the author analyses the effectiveness of the mean-reverting strategy and diversification returns thereon. Qian also looks at risk partly portfolios breaking them down into two parts namely: positive and negative diversification returns on the rebalancing of given assets.
Qian ‘s methods of investigation are forthcoming complementing them with his vast knowledge in finance and experience in institutional investments. His information is useful in the current study as it points out some of the factors that may impact portfolio rebalancing.
Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2009). Corporate Finance Core Principles & Applications. McGraw-Hill. New York, NY
In their book, Westerfield, Jaffe, and Jordan point out the need of investors having deeper understanding of risk to maximize returns from their investments. The authors assert that every investment is a risk and portfolio diversification is one of the ways that investors protect themselves from losing a lot of money. The authors also establish that high-risk investments often have high returns and vice versa.
The authors provide useful information on reasons for portfolio diversification and why investors may opt for high risk investments as compared to lower risk ones and vice versa. Through clearly presented materials and a well-articulated design and concise examples, the authors present key financial concepts in a way that is easily comprehensible by a wide range of audience.
References
Abid, F., Leung, P. L., Mroua, M., & Wong, W. K. (2014). International Diversification versus Domestic Diversification: Mean-Variance Portfolio Optimization and Stochastic Dominance Approaches. Journal of Risk and Financial Management, 7(2), 45-66.
DeMiguel, V., Garlappi, L., & Uppal, R. (2007). Optimal versus naive diversification: How inefficient is the 1/N portfolio strategy? The review of Financial Studies, 22(5), 1915-1953.
Jaconetti, C. M., Kinniry, F. M., & Zilbering, Y. (2010). Best practices for portfoliorebalancing. Vanguard Research, July.
Mroua, M., Abid, F., & Wong, W. K. (2017). Optimal diversification, stochastic dominance, and sampling error. American Journal of Business, 32(1), 58-79. Retrieved from http://search.proquest.com.ezproxy.
Qian, E. (2012). Diversification return and leveraged portfolios. Journal of Portfolio Management, 38(4), 14-25, 8. Retrieved from http://search.proquest.com.ezproxy.
Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2009). Corporate Finance Core Principles & Applications. McGraw-Hill. New York, NY.