Investment Diversification

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The phrase "don't put all your eggs in one basket" has been wise advice to investors for centuries and the logic is soundly based.

By diversifying your investment across a number of different asset classes can reduce volatility as well as enhance overall returns.

The key to getting a balanced portfolio is to spread your investments in a number of different areas which are uncorrelated to each other.

For example, with rising interest rates shares may go down but if you have an exposure to fixed interest investments such as a bond portfolio these will have a tendency to rise, thus smoothing the equity curve.

The theory of diversification was refined into what has now become a common buzz word throughout the investment community

Modern Portfolio Theory

The theory was originated by Harry Markowitz for which he won the Nobel Prize in the early 1950's.

While investors before then knew intuitively that it was smart to diversify as we stated at the start of this page Markowitz was the first to attempt to quantify risk and demonstrate quantitatively why and how diversification can reduce risk and enhance the reward of a portfolio of assets.

He established the idea of an "efficient portfolio".

An efficient portfolio is one which has the lowest attainable portfolio risk for a given level of expected overall return (or on the other hand the largest expected return for a given level of risk).

The process for establishing an optimal of assets in a portfolio generally uses several measures for each asset to be used in the portfolio of assets studied:

Asset Allocation

Asset allocation is defined as the allocation of funds to each asset class.

This is really the most important point to keep in mind to optimize the best risk reward.

Each asset class will of course have different levels of return and risk.

They also behave differently in relation to other asset classes and this is critical in the theory and is a reflection of our example given earlier on the affect of interest rates on bonds and stocks.

At the time one asset class is increasing in value, another will be decreasing or, at least, not increasing as much and vice versa.

The measure used for this is referred to as the correlation coefficient.

Correlation Coefficient

Correlation coefficient is the measure of the degree two assets classes' move together.

The value of the correlation coefficient ranges from -1 to +1.

For example assets which have a correlation coefficient of -1 are negatively correlated.

For a value of +1 they are positively correlated. I.e. Their values move simultaneously in the same direction and magnitude.

A correlation coefficient of 0 indicates there is no relationship at all between the asset classes.

All assets have some positive correlation, although it can of course be very minor.

Returns

Total return is a measure of the combined overall capital gain from an investment.

This is then typically shown as a percentage over a given time period

Standard Deviation of Returns

This denotes the risk.

Standard Deviation of (historical) returns is the most common measure of the risk and is a statistical measure which measures the variability of returns (about the mean or average).

The higher the standard deviation, the more uncertain the outcome over any given period of time will be.

Standard deviation enables investors to quantify the risk of different types of investment and compare them to one another.

Optimal Portfolio return to risk

By comparing the returns and standard deviation of returns (to denote the risk) correlation coefficients data, investors can study a number of portfolio strategies to target varying levels of return.

Each of the portfolios studied will reflect the least amount of risk achievable from the various asset classes included.

These are referred to as optimal portfolios.

The investor can then construct a portfolio to reflect his risk tolerance and a target growth to reflect his investment objectives.

Does the theory work?

Many people swear by modern portfolio theory and others with the uncertainty in investment performance feel that past performance does not tend to reflect future performance and it is of little use.

Whatever your view it is sound advice to balance a portfolio in terms to reduce to target the highest possible returns with lowest downside risk and as yet Modern Portfolio Theory is still the best way of doing this.

It does of course have its limitations, but so do most investment theories and chances are, if you use it you will get a far more balanced portfolio than if you don't.