Is There an Increased Demand for Risk Diversification?

Portfolio Theory Model and Risk Diversification

Is There an Increased Demand for Risk Diversification?

In recent lectures we learnt about risk diversification through the use of Portfolio Theory and other combinations of investment.  These evaluate the levels between the risk and return of investing in the stock market to determine the most efficient portfolio.  I am interested in researching further into this topic and have used this opportunity to broaden my knowledge.

Late last year it was announced in the Financial Times that, James Agnew, the chairman of corporate broking at Deutsche Bank is set to leave his role and returning to his roots at KPMG (Financial Times, 2014).  KPMG are continuing their expansion into investment banking as they diversify beyond their traditional auditing background, is there a growing demand for this service as an increasing number of people wish to create a portfolio of investments to reduce their risk? I believe there could be.

The portfolio theory model was developed my Markowitz in 1952, the basic idea behind this theory builds on the concept that investors can reduce their risk by holding a portfolio and diversifying their investment. Portfolio theory manages the risk versus the returns received, by constructing a portfolio it aims to optimise their returns, yet minimise the risk being taken.  This concept has undergone much development since Markowitz’s initial framework (Baker & Filbeck, 2013).

The fundamental point about portfolio theory states that if an investor were to invest all their money in one company’s shares then the risk being taken is likely to be extremely high.  By adding a second, in hindsight, this should reduce the risk, given the companies are not perfectly positively correlated (Arnold, 2013). Further research into portfolio theory demonstrates the total risk (variance) is the sum of the systematic or market risk and non-market, unsystematic risk.  Unsystematic risk can is also referred to as diversifiable risk as this can be reduced or even eliminated by holding a sufficiently large portfolio. Investors must be aware that by producing a portfolio of investments they can only reduce the unsystematic risks, systematic risks are unavoidable and it is the risk of playing the game. Investors must accept that market risk comes as part of investing in the stock market (Witt & Dobbins, 1979).  By accepting the market risk investors should in turn be rewarded with their returns.  Investors can choose their level of risk by the number of portfolio securities they hold, this has been illustrated in figure 1 below.

 A graph showing the risk versus the number of portfolio securities.

 

 Figure 1 (Ox Venture, 2012).

This graph shows the level of risk depending on the number of portfolio securities held.  It is believed that after a certain number of securities unsystematic risk cannot be reduced any further, it is thought to be around 30, as highlighted on the above graph.

Markowitz’s Efficient Frontier explains how to obtain an optimal portfolio, see figure 2.

 

Figure 2 (Edupristine, 2014).

Investors can construct their portfolios based on a combination of risks they are willing to take.  Investors must look at the idea of having a risk free rate and compare to the risk using the Capital Allocation Line based on the level of returns. Not as simple as it originally sounded?  So there is no wonder really that companies like KPMG are expanding into investment banking.  Many people wanting to create these complex investments need the guidance of a financial expert. KPMG are not the only company to be expanding into investment banking, Ernst and Young and PWC are also following in these footsteps (Financial Times, 2014).  As a portfolio owner myself, I certainly would not have had the knowledge to create one without financial expertise.

This then raises the question of whether it is possible to over-diversify?  A portfolio with a large number of securities is harder to manage and keep track of.  An increased number of securities will reduce the amount of time an investor can spend on it.  As mentioned above it is unnecessary for a portfolio to have more than 30 securities as this will not reduce the risk any further yet just creates a more complex portfolio.  It may be necessary to tweak the portfolios in order to increase the portfolios value for the shareholders.  I will go into more detail about shareholder value in my next blog. 

Looking at the theory as a whole, it seems like a positive concept, to hold an increased number of securities to produce more stable returns and reduce the amount of risk being taken. Yet leading academics and even Markowitz himself does not follow the theory. But why? There are many issues that arise when putting this theory into practice, only of the main problems is the assumptions that the theory is based on.  Firstly, Markowitz’s theory assumes that investors can borrow or lend at the risk free rate, showed in figure 2, however, in practice this is highly unlikely. Many borrowers are not risk free therefore, will be charged a premium.  Another major assumption, which is fundamentally wrong, that we live in a world with no tax or transaction costs. Each time a security is purchased or sold this incurs a charge, therefore diluting the returns received.  By ignoring these major factors, does this reduce the credibility of Markowitz’s theory? Yes, i think so. Especially as Markowitz himself does not follow the theory.

In conclusion, there are many other aspects about the portfolio theory that I have not touched upon however; from what I have written about it is clear to see that Markowitz’s theory has its complications.  Without going into too much complex detail this does show risk can be reduced by diversification, yet not how to do it.  Therefore, I definitely believe there is room for the accountancy companies, such as KPMG, to expand into investment banking.  Many people will always want investment advice, especially with current interest rates at the banks being so low and people being more careful with their money.  As this can be adjusted to suit the risk takers it could work for a wide variety of investors.

References

Arnold, G. (2013). Essentials of Corporate Financial Management. (2nd ed.). Essex: Pearson Education Limited

Baker, H. K., & Filbeck, G. (2013). Portfolio theory and management. Oxford: Oxford University Press. doi:10.1093/acprof:oso/9780199829699.001.0001

Edupristine (2014). Understanding Portfolio Management. Retrieved from http://www.edupristine.com/blog/understanding-portfolio-management

Financial Times (2014). Veteran Deutsche Banker to Join KPMG. Retrieved from http://www.ft.com/cms/s/0/c6f1fa4e-5441-11e4-b2ea-00144feab7de.html#axzz3UBqiVcS7

Ox Venture (2012). Understanding the risk of your investment portfolio. Retrieved from http://www.oxventure.com/newsletter/2012/02/26/understanding-the-risk-of-your-investment-portfolio-i/

Witt, S. F., & Dobbins, R. (1979). The Markowitz Contribution to Portfolio Theory. Managerial Finance, 5(1), 3-17. doi:10.1108/eb013433