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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

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Who Cares About Regulations?

October 17, 2010 Leave a comment

American journalist Mignon McLaughlin once said that we humans are “…all born brave, trusting and greedy, and most of us remain greedy”. This has some truth to it, even if at certain levels of greed. For the most part though, the majority of individuals have control over their ‘greed’ (for a lack of a better word) by adhering to certain censorship codes, whether be it: religion, morals, ethics, social norms, etc. That doesn’t mean though, that there does not exist individuals who allow greed to consume them, and guide their decisions. With all the dangers surrounding the decisions taken by such individuals, perhaps the most of which, are those that have negative effects on other individuals. If we project such dangers onto the financial industry, then greedy decisions maybe referred to as systematic risk; “the unscrupulous actions of a few market participants could undermine public confidence in the entire financial system” (Levy and Post, p.896, 2005).

Given the potential fragility of financial markets, due to vulnerability from information asymmetry, agency problem, and transaction costs, lies the importance of regulating them. Regulations sometimes are viewed as tools, or deterrents, that “address systemic risk” (Schapiro, 2010). The main issue with financial markets is that incentives are misaligned on the “micro-level;  which [could result] in numerous potential conflicts of interest” (Kumpan, 2009). Regulations of financial markets are especially important in our current times, as when “financial institutions get bigger, markets move faster and investments grow more complex” (Schapiro, 2010), introducing potential cracks that ill-guided individuals may exploit. But one must not latch onto such negative view of regulations, as the main reason they are put there is to bring along with them added benefits to the financial industry; regulations are not closed doors. They attempt to align interests, effectively promoting for more efficient markets. They may also act as springboards in promoting more connected and expanded markets. The net effect is further industry stablility and stronger economies.

In deciding how much regulation should be put in place, one has to understand the reasons behind regulating the financial industry, and the implications that may be brought along with it. The benefits have been discussed above; which simply boil down to providing a better market platform that offers stability, efficient movement of capital and potential of growth. Many authors coined the term economic safety in describing such benefits. But “economic safety is more elusive than military safety …. too much safety undermines the very stability that safeguards promise” (Amity, 2010). Issues that should be taken into account when deciding on the level of regulation to be put in place, include:
> Available infrastructure: would a country’s given financial market infrastructure support such regulations? Whether the the answer is a yes or a no, how much will it cost to have such regulations put in place?

> Acceptability of local financial market: do such regulations actually benefit the players in a given financial market? [the point of these regulations in the first place is to benefit such users of the financial market — not burden them with no added benefits]

> Foreign investors: Given the interconnectedness of international financial markets, as a result of globalization trends, any regulation put in place by a specific country’s financial market could bare effects on other international markets. Thus, when drafting such regulations, financial market synergies along with foreign investors must be take into account; else the regulations would solve a specific issue while introducing more problematic issues.

> Market transparency and efficiency: the effect of such regulations on the market’s transparency and efficiency.

> Culture: on a more non-financial level, the regulations have to take into account social and cultural norms. These regulations, and the authorities who issue them, may find themselves in the spotlight, if for example, foreign investors are favoured over what is socially acceptable.

> … and many more issues

The degree of how much regulation should be put in place may seem like an simple task; one can argue that it borrows a page from the it ‘costs versus benefits’ theme. At the end of the day, there must exist certain goals and objectives for a given country’s financial industry; much like the goals and objective of companies. Regulations should promote and facilitate the achievement of such goals. For the most part, this is true, but what is different here is that the both internal and external environment that the financial industry interacts with is ever changing. And this change is a result of many variables, a lot of which are unknown territory for us: for example, our interpretation of the financial industry with advancements in technology, our definition of incentives, our understanding of ethics, etc.

“… it is managements’ job to organise, manage and control their businesses in a way which meets a set of high level principles … to safeguard the interest … and secure the safety and fairness of [financial] markets” (Tiner, 2005). Regulations are there to make sure that happens.

— Youssef Aboul-Naja