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Understanding Investment Diversification

October 24, 2010 1 comment

“Diversification is a time-honored investment principle” (Gibson, 2004). Early documentation of diversification may be traced back as far as 1200 BC, where the Jewish Talmud preached that “every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve” (Gibson, 2004). People have recognized, from an early stage, the benefits of risk spreading brought upon by diversification; even if that was at an intuitive level. And as the world continues to take on varying forms, as a result of changes brought upon by one generation inheriting it from the next, part of what remains constant across time, is that “investors want high returns, [all the while not incurring] risk in securing those returns” (Gibson, 2004).

But why do investors want returns in the first place? And what risks are they trying to avoid? In answering these questions, we must first establish that when investing in any asset, an investor is taking on a certain level of risk. This degree of risk, may be divided into two parts: systematic and non-systematic. The systematic portion is association with market risk, and is ingrained in each asset; meaning it cannot be diversified away. As for the unsystematic risk portion, this type of risk is asset specific. Unsystematic risk is the amount of possible deviation between the expected and actual return on an asset. The higher the possible deviation, the higher the unsystematic risk. As a result of the risk investors take when giving up their capital to invest in a given asset, they expect to be compensated. Naturally, the higher the associated risk, the higher the compensation; or in other words, the expected returns.

Diversification, refers to the selection and investing in various assets, so as to spread the risks associated with investing in each asset. Since each asset inherently contains the same market risks, that is systematic risk, then diversification “could be conceptualized as a reduction in unsystematic risk” (Hight, 2010). The selection criteria for the assets when achieving diversification, includes [but not limited to]:
– Geographic location [i.e. different international markets]
– Industry [i.e different industry types]
– Asset type [i.e. Bonds, stocks, treasury bills, etc].
– The relationship between the returns of the different assets [also known as correlation]

So up until this point, we have determined that:
> Any type of asset bares some form of risk [systematic and non-systematic]
> Investors, whom are giving up their capital to invest in assets, want returns to be compensated for the risk they are baring. Preferably, the investors want as high a return as possible; and as low a risk as possible.
> What diversification does effectively is spread an investor’s capital across a portfolio of assets, reducing the “risks that bear no compensation” (Wagner and Lau, 1971). Generally, the “more securities in a portfolio, the greater the likelihood that sufficient good fortune will appear to balance off the bad fortune” (Sharpe, 1995). This gives the investor the benefit of higher predictability when if comes to the expected return on investment. Diversification facilities for less investment volatility.

But so far, this discussion has only tackled diversification from a very theoretical point of view. In the real world, certain impediments exist, as to lessen the benefits gained from diversification. Such hurdles include:

> Markets are not as uniform as mathematical formulas make them to be: the diversification process relies on formulas and probabilities [such as the quadratic formula and normal distribution] that provide good approximations of the expected asset returns. Also, these formulas rely on data input that is based on sample historical data; as it would be too costly and difficult to take into account all of the historical data. Thus, given that formulas are not exact, and the underlying data is only a partial set, a lot of estimation error is introduced.
> Returns are not symmetric: what diversification aims to achieve, is to create a portfolio of assets, where the correlation between the different assets is low; as when one asset goes down, the other goes up. But “paradoxically, [the correlations of] well-diversified portfolios… tend to increase during crisis situations, reducing the effectiveness of diversification when it is needed most” (Levy and Post, p.237, 2005).
> The diversification effect has become less due to globalization: lower costs in information and capital accessibility, has had the effect of increasing the correlation between the various markets. This dampened the diversification effect, as “economic events in one part of the world affect markets on the other side of the globe” (Gibson, 2004)
> Limited possibility sets due to regulations: investors may have to adhere to certain rules and regulations when it comes to investing; for example: a set percentage limit in investing in a given asset type,  or investing in only environmentally friendly companies. Such restrictions, whether enforced or voluntary, end up reducing the diversification effect as the number of investment options [the possibility set] shrinks.
> Market timing: a lot of underlying variables in the diversification formulas must be ‘tweaked’ to reflect the best diversification strategy. But such tweaking is highly dependent on the market conditions, and thus timing is crucial. Yet, since we still do not have a way to tell how future events may unfold, market timing is at best a guess-timate!
> The human factor: steering away from all the mathematics and number crunching, there are some human elements that cannot be capturing by formulas, such as: what defines an acceptable risk level? what defines an acceptable return for a given risk level? etc. Each person may answer these questions different, and as such, a given diversification strategy/formula may not apply to everyone.

Warren Buffett once said, “diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing”. But then again, diversification does have some merits, so as long as its effectiveness is not over estimated. It has been proven that as more assets are included in the diversified portfolio, the marginal benefits diminish quickly. Thus wide-diversification is essentially harmful to the investor. This theme extends to all types of investments, regardless of the underlying asset. For example, in the real estate business, “marginal risk reduction from expanding into more cities diminishes quickly, making the choice of staying geographically concentrated a sensible portfolio strategy” (Ping and Roulac, 2007).  Effectively, it might be best if one utilizes a more focus-diversified strategy.

— Youssef Aboul-Naja

Working Capital: Benefits of the Money Market

March 14, 2010 Leave a comment

In the Beginning: The Balance Sheet

It all starts, when a couple of entities decide to pool their resources together to generate more resources. They do so by creating a company; and they inject it with their pooled resources [known as equity] along with some long-term debt; the combination of equity and long-term debt consitutes the company’s capital strucutre. The company then converts this capital “into assets [and operates it] to earn economic returns by fulfilling customer needs” (Groth and Anderson, 1997).

Thus, we have established that a company has assets financed through equity and long-term debt. The company’s assets are made up of current assets [which are more liquid: in the sense that they can be converted into cash more readily] and fixed assets [which are more illiquid assets: such as factories]. Like wise,  part of the longer-term debt will be short-term (or current liabilities), to enable day to day financing operations. Therefore, we conclude that current and fixed assets are financed with current liabilities, long-term debt and equity; which are the constitutes of the balance sheet. This is captured in the below formula:

Current Assets + Fixed Assets = Current Liabilities + Long-term Debt + Equity   (equation 1)

Working Capital: What Is That?

In a nutshell, “working capital is the [difference] between current assets and current liabilities” (Pass and Pike, 1987). Current liabilities represents the debts or obligations that must be paid by the company within the duration of one year; whereas, current assets are those assets that will be converted into cash within one year. Therefore, working capital represents the supposed excess cash on hand “to continue business operations” (Needles and Powers, 2004, p.259). The importance of this quantity is that it gages a company’s liquidity; the availability of cash to continue operations and meeting debt obligations.

Ideal World View: Working Capital

In an ideal world, the management of a company would be able to identify all the debt obligations it shall incur in the upcoming year. By knowing such information, management would match the current liabilities with the same amount of current assets; effectively having a net working capital of zero. Referring back to (equation 1) from the previous section, since current assets and current liabilities are equal, they can be dropped from the equation. Therefore, in an ideal world, fixed assets (which have a longer nature of usability) would be financed by long-term debt and equity. So we notice that, there is a matching of the “maturity dates of the assets with the liabilities” (Pass and Pike, 1987). This ideal world view is best captured in the below diagram:


Real World View: Working Capital & Money Markets

Though the ideal world view conceptually makes sense, it is flawed for two reasons. The first of which is that it is very hard to predict with certainty the debt obligations for the upcoming year. The second, and more important issue, is that “current assets cannot be expected to drop to zero … [as] long-term rising level of sales will result in some permanent investment in current assets” (Ross et al., 2008, p.755). This permanent investment in current assets comes partially in the form of accounts receivables, inventories, accruals, etc. Therefore, the real world view diagram will look something like:

A company will want to maintain a working capital such that it would minimize the sum of the carrying and shortage costs; it would do so by “minimizing the amount of funds tied up in current assets” (Filbeck and Krueger, 2005). Why a company would do so, is because short-term debt is much cheaper than long-term debt &/or equity, especially since working capital is financed by their of the latter two.  But if a company wants to maintain a set working capital, its must be able to predict accurately future inflow/outflows of transactions (cash); which as previously discussed, not possible. Thus a company might have, at anytime, a bit more or less cash relative to the optimal capital structures, running costs up; as depicted in the below diagram:

(Pass and Pike, 1987)

That’s were the role of the Money Market (MM) comes in. If a company has excess cash, it would invest it in the MM. Likewise, if it requires additional money, it would obtain it from the MM; which is short-term in nature, meaning cheaper than long-term debt or equity. In that regards, the more developed the MM of a given country, the easier it is for companies to obtain short-term finances, and maintain a working capital that would result in the least amount of costs.

~ Youssef Aboul-Naja

Capital Budgeting, Real Options, & Bending Grass

February 28, 2010 3 comments

Trees, no matter how well rooted they are, topple over from gusts of winds due to their inflexibility. But Confucius noted that “when the wind blows, the grass bends”. Thus, adaptability to the surrounding environment, plays a big role in survival. Against such backdrop, do I put into perspective the topic of Real Options; and how that aids management in better project selection; making them more adaptable.

Companies are established to generate wealth to its stakeholders. In doing so, a company must be working towards a vision; which is synonymous to the company’s central theme. By working towards their vision, companies take on and execute various projects. But since a company’s main object is to maximize the wealth of its stakeholders, management must have a way [or a tool] to help them select the most profitable projects. This is where Capital Budgeting comes into play.

In a nutshell, capital budgeting is the process of “making and managing expenditures on long-lived assets” (Ross et. al, 2008, p.2). Management must determine the cash inflows and outflows of a given project to determine its suitability relative to:

  • How the cash flows affect the stakeholders’ overall wealth
  • How the cash flows measure against the cash flows of other potential projects that management could undertake instead

Given that companies have limited funds (or fund sources), management must select those projects that create the most financial benefit to the shareholders.

But the process of selecting projects is not as trivial as portrayed above. A company exists in a complex environment, whereby a lot of factors are interconnected and in play. In fact, market environments are so complex, that they are semi-deterministic; they cannot be modeled with 100% accuracy, yet they are not chaotic. Thus uncertainty complicates the project selection process, as future cash inflows and outflows are only known with a given degree of accuracy.

In solving the project selection problem, various investment decision tools have been devised to assist managers; most prominent of which are:

  • Net Present Value (NPV): whereby the future cash inflows and outflows are discounted back to present money and all added up. The project with the highest NPV value will be the clear winner, as it maximizes shareholder’s wealth.
  • Internal Rate of Return (IRR): the IRR is the rate were a project does not contribute any gains or losses to the shareholders’ wealth – thus management would be indifferent about executing it. With this tool, managers compare the rate of return of a given project against its IRR to determine its level of profitability. The project that produces that highest profitability is selected.
  • Payback Period: Projects are determined on how quickly the cash inflows payback the initial investment [cash outflow]. The fastest project is selected.

Though this is by no means an exhaustive list, each method has its short comings. These methods were “designed for relatively stable environments… As a result, business strategy … turn out to be flawed because something outside their control doesn’t go as planned” (Trigeorgis et al., 2007). What was need is another method, that accounts for uncertainty and management’s ability to respond to future events; thus the method of Real Options came about.

“At its core, the real option perspective is like other theories of investment in that it is concerned with identifying the factors that influence the investor’s threshold —the point at which investors choose whether to invest or not” (Miller and Flota, 2002). What the real options method did differently, is that it introduced the concept of “the possibility of contingent decisions” (Amram and Kulatilaka, 1999). The method was a bit more chaotic compared to other methods, in the sense that it was more reflective of reality. Thus it accounted for situations of project expansion, contraction, abandonment, timing of events, and “sequential [growth] options [of other projects]” (Wyant, 2009). By explicitly accounting for the future flexibility inherent in capital investment opportunities, the real option method would better portray the real financial effect of a given project on shareholders’ wealth.

The main benefits of the real options method is that it facilities for better planning and in taking strategic decisions. Other methods might be too conservative in analyzing the benefits of a project, which would result in its rejection. The reason why the other methods suffer from such consevatism, is because they commit project decisions at the beginning stages, which results in “sacrificing flexibility and increasing exposure to … uncertainties of new markets” (Miller and Flota, 2002). Therefore with the real options method, better strategic modeling is conducted, which results in flexible project variability, a more informed management and lower costs [cash flows].

At my current place of employment, a financial leasing company, we constantly use the real options method. Since our funds are limited, we are selective with the clients we are willing to finance. In determining the risk profile of the client, we attach probabilities to our future relationship directions with the client: increase/decrease/or cap the exposure, perform repossession in the event of a payment defaults, file a lawsuit, etc. Based on such analysis, we are able “to better quantify the value of each contingency” (Trigeorgis et al., 2007) and effectively better handle our client base and overall company risk and returns.

~ Youssef Aboul-Naja