Portfolio management
and diversification
This section provides a general overview of the principles associated with portfolio management and investment so as to establish a foundation with which to assess the remainder of the study.
The relationship between risk and return
The relationship between risk and return is at the core of any financial decision. The greater the level of risk assumed by investors, the greater the expected or anticipated rate of return required in order to compensate investors for the higher level of risk.
The lack of diversification opportunities caused by the Foreign Property Rule increases the level of risk while at the same time limiting the possible rates of return. It effectively distorts the relationship between risk and return that is fundamental to any investment decision.
Types of return
There are two types of return available to investors: income and capital appreciation. The first type of return refers to annual or periodic income (i.e., dividends) distributed to investors. The size of the income is directly related to the size of the total investment. For instance, dividends are paid on a per-share basis and thus the more shares an investor owns, the greater the amount of dividend income earned. The two key characteristics of periodic income are that it is based on an underlying investment and it is paid regularly over a specified time period.10
The second type of return refers to the appreciation or depreciation of the investment itself--capital gains and losses. Capital gains and losses refer to the difference between the beginning or purchase value of an investment (asset) and the ending or sale price of the investment. Unlike income, capital gains and losses are not regular payments; they are realized only at the time of disposition or sale.
Understanding risk
Risk refers to a situation in which the likelihood of the outcome of an event is unknown or not known with certainty.
The are a number of sources of risk but almost all can be placed in one of four categories.
- general economic risk due to the possibility that a particular jurisdiction will experience economic stagnation or recession;
- inflation / deflation risk due to the uncertainty regarding pricing policies, financing costs, the costs of labour and materials, and the relationship between inflation and effective tax rates;
-
firm and issue-specific risk:
- business risk due to the general market within which the firm operates;
- financial risk due to the amount of financing provided by creditors and the level of fixed financial costs;
- issue-specific risk due to the types of securities, and any provisions attached to them, that the firm uses to finance its operations;
- international risk due to competition from foreign operations in the domestic market and the domestic firm's competitors in foreign markets. (Canadian Securities Institute 1993)
Correlation analysis
Much of portfolio diversification is aimed at reducing the level of risk in a portfolio without sacrificing the rates of return. Reduction of risk is analyzed using the correlation value of the assets included in a portfolio. A correlation is a measure of the degree to which two variables are linearly related, that is, the extent to which they move together.
The range of possible correlation values is positive 1 to negative 1. A correlation of positive 1 indicates a perfectly positive correlation, meaning that the two assets move in unison. For instance, if the value of asset A increased by 10 percent, and was perfectly positively correlated with asset B, then the value of asset B would also increase by 10 percent.
A correlation greater than 0 but less than 1 (figure 10a) indicates a positive, although less than perfectly positive relationship between the assets. A positive correlation means that the two assets generally move in the same direction but to different extents and at different times. If asset A increased in value by 10 percent, the value of asset B would also increase but to a different extent, possibly by 5 or 15 percent.
Source: Davis and Pinches 1988:122
A correlation of negative 1 indicates a perfectly negative relationship, meaning that the two assets move in exactly the opposite direction. If asset A's value increased 10 percent, the value of asset B would decrease by 10 percent, assuming the two assets were perfectly negatively correlated.
A correlation of less than 0 but greater than negative 1 (figure 10b) indicates a negative relationship, although not perfectly negative. If the value of asset A increased 10 percent, then the value of asset B would decline, but by less or more than 10 percent.
Source: Davis and Pinches 1988:122
Finally, a correlation of 0 (figure 10c) indicates the absence of any relationship between the two assets. The absence of a correlation indicates that the two assets move independently of one another.
Source: Davis and Pinches 1988:122
In practice, it is extremely difficult to find stocks that are negatively correlated. Most stocks are positively correlated, although not perfectly so. That is, most stocks tend to move up and down together to some degree.
Systematic and unsystematic risk
There are two types of risk in portfolio management: systematic and unsystematic risk.
Unsystematic risk is sometimes also referred to as company-specific risk. It relates to particular risks and events that affect a particular company such as strikes, product development, and other occurrences unique to a firm. Within a portfolio, unsystematic risk is the risk that the price of a specific security, or a group of securities, will change to a different degree or in a different direction from the market as a whole.
Unsystematic risk can be reduced by holding a variety of securities such that a negative event affecting one or two securities does not affect the overall portfolio to any great extent. Table 13 summarizes the ways in which a portfolio manager can reduce both systematic and unsystematic risk.
Table 13: Methods of diversifying an investment portfolio to reduce risk
Systematic Risk
Unsystematic Risk
- Diversify Fixed Income Securities by
-
issuer's credit rating: mix of corporate and
government bonds -
securities features: preferred vs. participating,
retractable vs. convertible, etc. - Diversify Equities by
Source: Canadian Securities Institute 1993: table 16, 399.
Systematic risk is often referred to as market risk. It includes general economic conditions, the impact of monetary and fiscal policies, inflation, and other events that affect all firms in an industry or country. It is essentially the risk of being in a particular capital market.
Systematic risk can be reduced by investing in different asset groups (see table 13). It can also be managed within each component of the portfolio.
Risk measurement: beta analysis
Risk is calculated, in general, as the probability of a particular event occurring. Risk within a diversified portfolio is usually measured by how the returns of specific assets move, or are correlated with, the returns of the portfolio as a whole. To measure the risk of a diversified portfolio, the returns of the portfolio are measured against the returns of a broad indicator, such as the Toronto Stock Exchange 300 Composite Index in Canada, or the Standard & Poor 500 Index in the United States.
Beta analysis is a particular measure of risk. It refers to the amount of risk between portfolios and the broader market, such as the TSE 300. Figure 11 depicts the returns of two portfolios as well as the market as a whole, as measured by a broad indicator such as the TSE 300 Composite Index. The dashed line in between the two solid lines represents the market return over time. The market beta value is 1.00. A beta (b) of 1.00 indicates perfectly correlated movement with the market. A portfolio whose beta value was 1.00 would have the same risk as the market, indicated by the dashed line in figure 11.
Figure 11: Beta, Volatility, and Returns
Source: Davis and Pinches 1988: 136
Beta values in excess of 1.00 indicate more volatility and thus greater risk than is present in the broader market: the risky or aggressive portfolio earns higher rates of returns in the up cycle than does the broader market but also yields significantly lower returns during the down phase.
Alternatively, betas values of less than 1.00 indicate less volatility and therefore have less risk than is present in the broader market. The conservative portfolio does not yield as high a return as the market during the up phase but also does not lose as much of its value during the down phase.
Thus, we see a direct relationship between the expected rates of return from the three portfolios of investments and the level of risk, or volatility associated with each portfolio. Table 14 presents further illustrations of the use of beta values in understanding risk and returns.
The closer a beta value is to 1.00, the closer the returns of the underlying asset mirror the returns of the broader market. In the examples provided in table 14, Dofasco, a Hamilton-based steel company comes the closest to mirroring the returns of the market.
Alternatively, Bell Canada, a central Canadian telecommunications company maintains the lowest beta value, indicating a lower rate of return but also a lower rate of volatility, i.e. less risk.
Placer Dome, on the other hand, exhibits a much higher beta value (1.44) than any of the other firms, indicating that its fluctuations are significantly higher than those experienced by the broader market.
To reiterate, beta values are an approximate method by which to compare a portfolio and its investment returns relative to a broad market index of performance.
Security Market Line: a conceptual tool
Another method of examining the relationship between risk and return is the Security Market Line (SML), a conceptual tool that aids in the understanding of the relationship between risk and rates of return presented in the previous section.
Figure 12 depicts the relationship between the required rate of return (vertical axis) and the expected level of volatility, or risk (horizontal axis). The level of required return increases as one moves along the SML. That is, as the level of risk, or volatility, increases, so does the required rate of return. It is important to understand that the intercept between the SML and the vertical axis is the point of risk-free return; that is, the intercept represents a point at which the rate of return has zero volatility (risk), or a 100 percent probability of occurrence.
Figure 12: Security Market Line Illustrating Risk and Return
Source: Davis and Pinches 1988: 140
The Security Market Line (SML) slopes positively outward from this point of intersection, indicating a positive relationship between risk, or volatility, and the required rate of return; as risk increases, so does the required rate of return.
An example will further clarify the relationship presented in figure 12. Let us examine the relationship between corporate bonds and blue-chip common shares. The SML depicted in figure 12 indicates that blue-chip common shares are inherently more risky and thus require a greater rate of return than corporate bonds. There are a number of factors that contribute to making common shares more risky than bonds: these include the fact that owners of bonds have priority claims on both the income and assets of the firm, bonds have a fixed duration, and payment of income is guaranteed. Common shareholders, on the other hand, are subordinate in their claims for both income and the assets of a company and have no guarantee of either dividends or the appreciation of their shares. The increased risk associated with holding common shares is offset by the higher anticipated rate of return.
Management of investment portfolios
The relationship between risk and return is the foundation of investment. Higher levels of risk, or volatility, result in higher expected rates of return. Central to this concept is the matching of individual tolerance for risk with appropriate investments. There are a variety of factors that are assessed in constructing an individual portfolio, all of which are analyzed in order to match the investor's tolerance of risk with the investment portfolio. The following lists the main considerations in constructing an investment portfolio:
-
personal data: age, marital status, health,
number of dependants, etc. - net worth or family budget
- tax position
- investment knowledge
- unacceptable risks
- risk tolerance
- time horizon
These factors are assessed in formulating a reasonable estimate of risk tolerance and investment objectives. There are essentially three separate but not mutually exclusive objectives in portfolio management: income, growth, and safety. There are also secondary considerations such as taxes and liquidity (marketability) that may affect the precise nature of the portfolio.
Of particular importance in the construction of the portfolio is the individual's age. Figure 13 presents the life-cycle theory of investment objectives. In general, there is a propensity for individuals to assume greater levels of risk, regardless of their particular level of risk tolerance, during the early phases of saving and investment. When they are older, investors are less willing to assume risk, as safety and income considerations become paramount. The framework provided by the life-cycle theory of investment objectives provides a rough outline of how the age of an individual will affect the particular construction of a portfolio.
Portfolio management is basically about considering all of the constituent aspects of investing--the risk/reward relationship, the life-cycle investment objective, portfolio diversification, and risk management--and creating a cohesive investment plan for an individual investor. Specifically, portfolio management entails the matching of an investor's risk tolerance and life-cycle profile with a specific portfolio mix. It also involves the composite structure of the particular portfolio mix utilized. Again, based on the risk tolerance and life-cycle of the investor, coupled with general principles of diversification, the portfolio manager crafts specific investment selections within each component of the portfolio.
Let us use an example to illustrate the portfolio management process. An individual with an average income, at age 35, begins a portfolio. The portfolio management process would first assess the investor's risk tolerance. Next, given the investor's age, a life-cycle profile is constructed indicating that growth is the primary objective, with tax minimization as a strong secondary objective. From this data, a general portfolio mix is then constructed with approximately 35 percent to 50 percent equity, 35 percent to 50 percent fixed-income, and approximately 10 percent cash or cash equivalents.
The construction of the general portfolio mix is relatively easy compared to the complexities associated with formulating a specific investment strategy; that is, choosing specific instruments such as stocks and bonds for inclusion in the portfolio. For instance, what cash and cash equivalents should be purchased? Should they all be denominated in Canadian dollars?
More vexing are the investment questions relating to the fixed income and equity sections of the portfolio. What mix of government and corporate bonds should be used? What specific level of bonds should be purchased relative to equities? Should any foreign-denominated bonds be included? To what extent should blue-chip and established companies form the bulk of the equity portfolio? How large a position should be taken in growth companies? How much of the equity portfolio should be invested in foreign equities?
Many of these particular questions are answered using the same data, namely risk tolerance, life-cycle, and income, that were used to construct the general portfolio mix. However, diversification is of paramount importance to the portfolio manager. Diversification is a unique situation for investors in that it offers the possibility of a "win-win" situation: higher rates of return coupled with lower risk. Diversification reduces both systematic and unsystematic risk by spreading the investment pool over a large number of varied assets.
Diversification of investment portfolios
Diversification of the investment portfolio is brought about by purchasing more than one asset in a way that protects the investor from adverse movements in any one particular asset, industry, currency, country, or region. Portfolio diversification is essentially aimed at reducing risk in a portfolio of investments. Diversification is basically a process of investing in more than one asset, where the assets do not move proportionately in the same direction at the same time. Table 15 is a summary of the diversification strategies listed in table 13. There are a host of diversification strategies. The Foreign Property Rule, however, inhibits the ability of investors to adequately diversify their portfolios.
Table 15: Summary of diversification strategies
-
type of asset:
- cash,
- fixed income,
- equity
-
term to maturity:
- short,
- medium
- long
- geographic region: different regions and countries
-
issuer's credit rating: mix of
- corporate and
- government bonds
-
securities features:
- preferred vs. participating,
- retractable vs. convertible
-
degree of risk:
- conservative,
- growth,
- venture, and
- speculative stocks
- industries: different industries
- currency: different countries that use separate currencies
-
broad economic sectors:
- regulated,
- interest-sensitive,
- mature,
- growth.
Source: Canadian Securities Institute 1993: table 16, 399.
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