In this series of articles I would like to turn my attention first to the application of some fundamental aspects of portfolio planning, though with adva nced application, and then look at the features of the main types of asset class which may be used within the various investment strategies.
Combining concepts and strategies
It is a fundamental concept of investment theory that risk and reward go hand in hand. If an investor wants to reduce or avoid risk in his portfolio, so the theory goes, he must invest in low-risk assets.
But, given the choice, almost everybody wants to invest in low-risk assets. So this pushes up the price of those assets or reduces the pressure on the provider of those assets to pay attractive returns.
Either way, low-risk assets almost invariably come with low (or comparatively low) returns. Only those who take risks with their investment can expect, we have traditionally been led to believe (with justification), above average investment rewards.
This leaves us in a quand ary when planning a portfolio as to where the balance lies between an acceptably low level of risk and an acceptably high level of investment return.
However, in this article I look at those investment strategies which seek to yield high levels of portfolio return, usually associated only with high-risk investments, by combining a series of high-risk/high-reward individual investments in such a way as to create a low-risk profile for the overall portfolio.
The best of both worlds –
a portfolio offering high
returns with low risk?
Perhaps. This is not simply a theoretical and unachievable aim but, as you will see throughout these articles, a practical and workable strategy which will add value to any investment portfolio. The strategy builds upon three main principles, developing the concept of volatility:
Correlation strategy, and
The definition of an efficient frontier.
Diversification and correlation
If all of an investor's money rests in
shares in just one company on the stockmarket – for example, Barclays Bank – then the value of his portfolio (which cannot really be called a portfolio, with no diversification) relies completely on the behaviour of Bar clays Bank's share price.
Diversification would, as can clearly be appreciated even with no technical knowledge of portfolio planning, reduce the level of his portfolio risk. He should sell some of his Bar clays' shares and buy a mixture of other shares.
Can we quantify the reduction in risk, within the portfolio, of diversification?
To some extent, yes. There is a mathematical investment concept, in this connection, called portfolio size and residual risk, a summary of which appears in the table on the right.
You can see that this is not a rocket science concept. It suggests that diversifying between, say, two investments within the portfolio (portfolio science) will reduce the overall risk (residual risk) to 50 per cent of what it would have been had the entire portfolio been invested in just one investment. Spreading the portfolio between four assets reduces residual risk to 25 per cent, and so on.
Whether or not we agree with the strict mathematics behind this concept we can, I am sure, generally agree with the underlying theory. Or can we?
When might portfolio diversification not work?
Or, to be more precise, in what circumstances, might diversification not reduce the overall risk profile of the portfolio as much as we would hope?
Suppose the investor, currently with all his portfolio in Barclays Bank shares, accepts a suggestion that diversification can reduce portfolio risk and sells, say, 80 per cent of his Barclays' shares.
He then decides to invest the proceeds as follows: 20 per cent remains invested in Barclays, 20 per cent Lloyds TSB Bank, 20 per cent Abbey National Bank, 20 per cent Royal Bank of Scotland and 20 per cent Halifax Bank. Has he reduced the level of risk in his portfolio?
Not really. He has reduced the risk of Barclays shares doing particularly badly but clearly he has not reduced the risk of high-street banks, as a sector, performing badly. If Barclays Bank shares fare badly, it will usually be because of adverse sentiment to the whole of the banking sector.
This might be because of interest rate movements, regulatory threats to an important profit-earning part of their business or any other sector-specific considerations which might affect the demand for shares in this sector.
The poor performance might, of course, relate specifically to Barclays' shares (perhaps having made a particularly unsuccessful foray into ownership of an American bank) but usually the trend in the Barclays' share price will reflect the trend in bank share prices generally.
Of course, the share prices of any two banks have not always mirrored each other but, for the largest part of the time, the trend in their share price performance has been very close. This similarity in performance, in portfolio planning terminology, leads to an assessment that the two shares have been what is termed highly correlated.
Diversification between equity sectors in the UK
How great would have been the reduction in risk of the portfolio if the investor had diversified away from Barclays 50 per cent to Lloyds TSB? Not much. What happens to Barclays share price generally also happens to Lloyds TSB and vice versa of course.
This is not only true of the banking sector but also of most other stockmarket sectors. The share price of one water board could be expected to mirror closely the share price of most of the other water boards, not least because of the pressures (or otherwise) from Ofwat, their regulator. Many other examples can be identified in other sectors.
So diversification away from sha res in Barclays to shares in other high-street banks avoids the specific risk in Barclays but it does not avoid the risk of the high-street banking sector performing badly.
Diversification between different sectors could then achieve a greater reduction in portfolio risk. The inv estor might decide, therefore, to direct the proceeds of his Barclays Bank share sales into, say, a company from the chemicals sector, one from the building sector, one from the retail sector and so on.
But does diversification between sectors satisfactorily remove or substantially reduce the overall risk profile of his portfolio? Not really. It removes the specific Barclays Bank share price risk and even the banking sector risk but it does not remove the more general risk of the UK stockmarket as a whole.
Although different sectors within the UK equity market frequently move in different directions at any particular point in time, nonetheless a sustained upward trend in UK share prices might generally be expected to tend to benefit the majority of shares across all the sectors (and conversely a sustained downward trend tends to hit the vast majority of shares). This is not necessarily the case.
An illustration of these points is seen in the Financial Times index of a number of sectors within UK equities over a one-year period to the end of 1999. Information and technology shares rose by 435 per cent, software and computing services rose by 131 per cent and mining shares rose by 126 per cent.
On the other hand, food producers and processors lost 28 per cent, personal care and household products lost 28 per cent and tobacco fell by 31 per cent. These are particularly interesting statistics to bear in mind when we look, in later articles, at the reversal of fortunes of these sectors throughout last year.
So far, I have looked at diversification away from a particular share and away from over-reliance on one sector within the UK equity market. I will develop this theme further next week when I look at diversification between companies of different sizes within different countries and then diversification away from the equity market entirely.