Sunday, March 9, 2008

Diversification Doesn't Lower Risk

“You want to reduce your portfolio risk. Diversify, diversify, diversify…” I remember hearing some stock broker ranting on TV a decade ago, as the bear market hit US in 98 along with the collapse of Long Term Capital Investments. The audience at the studio watched her intently, the pain of recent losses still apparent on their faces. They all wanted desperately a way out of the hole, and turned to this supposedly professional for advice. She kept going with the metaphors of eggs and baskets, how risk is bad... Just exactly how and why, she did not bother mentioning.

Hedging Via Diversification Limits Returns

The concept never made sense to me even before any exposure to the financial markets. You buy a stock, then you buy some more because you hope they will move against each other, does that not simply lead to low potential returns, if any, and high commission costs?

ETF’s and Hedge Funds Increase Correlations

With the advent of Exchange Traded Funds and the explosion of hedge funds throughout the world, correlations between stocks, bonds and commodities have become much higher than the days of Markowitz (founder of modern portfolio theory). Most of the cause points to speed of information between newly developed funds making similar price impacting transactions concurrently. The markets have changed.

While the investment fund industry grows, fund managers of similar sentiment tend to take action concurrently. This leads to unprecedented high levels of correlation between individual stocks, hence resulting in more volatile markets. In present industry conditions, and evident from recent turmoil, the volatility added risk has become effective regardless of diversification.

ING as an Example

ING, a fund management business based in Australia, likes their investment advisors boast “safety” of their holdings due to diversification. Look up ING fund unit prices, every single one has declined since the sell off of last July; some have taken draw downs up to 70%. So much for the magic of “diversification” huh?

Last Words

Does it even matter why or how this phenomenon has occurred? It simply happens, and knowing it alone could help you become a more informed investor or trader. The world changes, so does industries, and it takes work to adapt and stay profitable.

The market exists for the purpose of asset accumulation or reduction. With every transaction you make, the goal should remain to enlarge account size; anything else serves no purpose but noise. Read a few books and learn what risk management actually entails; it will make everything easier.

2 Reflections:

daniel said...

Modern Portfolio Theory is a pretty broad topic but if you're talking about Efficient Market Hypothesis and the Capital Asset Pricing Model -- how come you haven't mentioned Fama and French's work in the early 90's on the dimensions of stock market returns? That was a pretty important paper, dude! Do you have any thoughts on that?

Rocko Chen said...

Thank you for taking time to provide feedback, Daniel. Currently I do more research in the area of game theory and have not studied CAPM deeply.

The above article results more from personal experience trading the stock markets than academic.

If you could point to some specific inferences Eugene Fama has made, it'd be much appreciated.