One effective tool for investment advisors to determine the amount of diversification necessary for a portfolio is modern portfolio theory (MPT). MPT is used to determine an efficient frontier for portfolio optimization and uses diversification to achieve this goal. The efficient frontier provides a maximum return obtainable for a certain amount of risk taken.
MPT states that for a given portfolio of assets, there is an optimized combination of stocks and assets toprovide the greatest return for a given level of risk. MPT uses diversification, asset allocation, and periodic rebalancing to optimize portfolios. MPT was first created by Harry Markowitz in the 1950s, andhe eventually won a Nobel Prize for it. Further innovation ofMPT has added the calculation of Treasury bonds (T-bonds) and Treasury bills (T-bills) as a risk-free asset that shifts the efficient frontier.
MPT uses the statistical measures of correlation to determine the relationship between assets in a portfolio. The correlation coefficient is a measure of the relationship between how two assets move together andis measured on a scale from -1 to +1. A correlation coefficient of 1 represents a perfect positive relationship whereby assets move together in the same direction to the same degree. A correlation coefficient of -1 represents a perfect negative correlation between two assets, meaning they move in opposite directions from each other.
The correlation coefficient is calculated by taking the covariance of the two assets divided by the product of the standard deviation of both assets. Correlation is essentially a statistical measure of diversification. Including assets in a portfolio that have negative correlation can help to reduce the overall volatility and risk for that mix of assets.
Achieving Optimal Diversification to Reduce Unsystematic Risk
MPT shows that by combining more assets in a portfolio, diversification is increased while the standard deviation, or the volatility, of the portfolio, is reduced. However, maximum diversification is achieved with around 30 stocks in a portfolio. After that point, including more assets adds a negligible amount of diversification. Diversification is useful for reducing unsystematic risk. Unsystematic risk is the risk associated with a certain stock or sector.
For example, each stock in a portfolio has a risk associated with negative news impacting that stock. By diversifying into other stocks and sectors, the decline in one asset has less impact on the larger portfolio. However, diversification is unable to reduce systematic risk, which is the risk associated with the overall market. During times of high volatility, assets become more correlated and have a greater tendency to move in the same direction. Only more sophisticated hedging strategies can mitigate systematic risk.
There have been some criticisms of MPT over the years. One major criticism is that MPT assumes a Gaussian distribution of asset returns. Financial returns often do not follow symmetrical distributions such as the Gaussian distribution. MPT further assumes that the correlation between assets is static when in reality the degree of correlation between assets can fluctuate. The efficient frontier is subject to shifts that MPT may not accurately represent.
One effective tool for investment advisors to determine the amount of diversification necessary for a portfolio is modern portfolio theory
modern portfolio theory
Modern portfolio theory (MPT) details the comparable rates of risk and potential rewards for assets in your portfolio. According to MPT, an investor must take on a higher level of risk to achieve greater expected returns; lower risk means a lower level of expected returns.
In its most basic form, a portfolio's diversification can be measured by counting the number of assets or determining the weight of each asset. When counting the number of assets, consider the number of each type for the strategies above.
Finding your portfolio value involves first calculating the monetary value of each individual asset, then adding all of those values together. The number you get is your portfolio value.
Diversification does, however, have the potential to improve returns for whatever level of risk you choose to target. To build a diversified portfolio, you should look for investments—stocks, bonds, cash, or others—whose returns haven't historically moved in the same direction and to the same degree.
To calculate the portfolio diversity score, square each weight of the assets in the portfolio, sum up all the squared weights, and subtract the sum from 1. The resulting value represents the portfolio diversity score, with higher values indicating greater diversity.
Return on investment (ROI) is calculated by dividing the profit earned on an investment by the cost of that investment. For instance, an investment with a profit of $100 and a cost of $100 would have an ROI of 1, or 100% when expressed as a percentage.
For each asset type, multiply the number of returns by the portfolio weight. This step is illustrated by looking at “ wi ri” in the formula. Once you have this number for each asset type, add the percentages together to get the overall portfolio return.
This is a simple calculation – divide the amount invested in that asset by the total portfolio's investment amount. You can leave the answer in decimal or convert it to a percentage. 3) Assign the weights to each asset by multiplying step 1 with step 2. Remember, you have to do this calculation for each investment.
The calculation is simple enough. Simply divide each of your stock position's cash value by your total portfolio value, and then multiply by 100 to convert to a percentage. These weights tell you how dependent your portfolio's performance is on each of your individual stocks.
What Are the Rules of Thumb for Developing a Diversification Strategy? First, set aside enough money in cash and income investments to handle emergencies and near-term goals. Next, use the following rule of thumb: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds.
A classic diversified portfolio consists of a mix of approximately 60% stocks and 40% bonds. A more conservative portfolio would reverse those percentages. Investors may also consider diversifying by including other asset classes, such as futures, real estate or forex investments.
To be truly diversified, investors need to own a collection of assets with different risk drivers, which will act and react differently from each other.
A diversified portfolio should have a broad mix of investments. For years, many financial advisors recommended building a 60/40 portfolio, allocating 60% of capital to stocks and 40% to fixed-income investments such as bonds. Meanwhile, others have argued for more stock exposure, especially for younger investors.
If you are a moderate-risk investor, it's best to start with a 60-30-10 or 70-20-10 allocation. Those of you who have a 60-40 allocation can also add a touch of gold to their portfolios for better diversification. If you are conservative, then 50-40-10 or 50-30-20 is a good way to start off on your investment journey.
30/30/30/10 portfolio: This allocates 30% of your portfolio to stocks, 30% to bonds, 30% to real estate, and 10% to alternatives such as gold and other precious metals. This is a more diversified approach and helps reduce your risk even further.
Investors should also apply the 5% rule with sector funds. For example, if you wanted to diversify with specialty sectors, such as healthcare, real estate, and utilities, you would simply keep your allocation to 5% or less for each.
Diversified management investment companies have assets that fall within the 75-5-10 rule. A 75-5-10 diversified management investment company will have 75% of its assets in other issuers and cash, no more than 5% of assets in any one company, and no more than 10% ownership of any company's outstanding voting stock.
of more than 5% cannot in aggregate exceed 40% of the fund's assets. This is known as the “5/10/40” rule. There are certain exceptions for government issued securities and for index tracking funds.
First, set aside enough money in cash and income investments to handle emergencies and near-term goals. Next, use the following rule of thumb: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds. In other words, if you're 20 years old, put 80% of your assets in stocks; 20% in bonds.
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