Harry Markowitz revolutionalised the world of investment professionals in 1952 with his ‘Portfolio Selection’ paper. Simply put, the study revealed that investors need to bear in mind not just the market returns but also the market risk before making investing decisions!
If we could predict the markets, all our money would be in the stock most likely to deliver highest returns in near future. But the point is, do we know which investment will fetch us the moolah? Can we really time the market?
As investors, we choose to invest our hard-earned money in a security that can generate decent income over a desired period of time. However, the return generated from the security may be conditional to market movements, i.e., the returns may be volatile. The price of the security may vary due to supply-demand equation, economic factors and future growth potential of the business.
For example, suppose you purchased a stock at a price of Rs. 30. During a bull run, that stock may trade at Rs.100, maximising your gains. Subsequently, due to various reasons like recession or poor management, the stock price may fall to Rs. 20, wiping out your entire profits. However, owing to the intrinsic value, the stock price may stabilise around Rs. 40-60. Hence, the expected return from your investment may be exposed to any of the illustrated scenarios. Over time, we invest in multiple securities and thus, an investment portfolio is formed. The expected return from the total portfolio is the weighted average of returns from each security.
Let us begin with the first step of portfolio selection.
Step 1: Identify a security with maximum expected return at the least possible volatility
The Modern Portfolio Theory states that investors should devise portfolios based on their individual risk-taking capabilities and return preferences, instead of picking up stocks at random. The volatility from each security will push up or pull down the performance of your portfolio. The impact of volatility will depend upon the percentage share in the entire portfolio.
When the performance of one security can be linked with another security, the two securities are said to be correlated. The fluctuation in returns from each security and the correlation between the constituent securities of the portfolio will ultimately impact the overall profits of the portfolio.
For example, stocks of export-oriented companies suffer when the rupee depreciates as the value of the earnings gets reduced. A portfolio comprised of stocks having similar dependency for profit-generation is called a “highly correlated portfolio” – such a portfolio will see most of its securities going down when the rupee depreciates. The portfolio dependency can be addressed by including stocks or assets that do not depend on currency movements or benefit from falling rupee.
Hence, MPT states that the risk of the overall portfolio can be hedged by a combination of securities having contrary or independent price movements to each other. The best mix of assets or securities is the basis of an optimal portfolio. This led to the formulation of ‘efficient frontier’ in portfolio theory. The objective is to maximise expected return keeping variability at constant level or to minimise variance in the performance by maintaining expected return at constant level.
‘Efficient frontier’ is the representation of all the portfolios which can give highest returns at the least amount of risk taken by the investor.
The efficient frontier curve guides us to choose an optimal portfolio. We plot the graph of the potential portfolios. Portfolios A, B and C lie on the efficient frontier as represented in graph 1. The inclination towards risk differs for every individual. For a low-risk, low-return strategy, “A” offers the maximum returns at a certain level of risk preference. Investors with a preference towards high-risk, high-return investments, portfolio “C” gives maximum returns. Hence, we reject all the portfolios which lie ahead of C.
We arrive at the next step for portfolio selection.
Step 2: Diversify by sectors or asset class having independent, cyclical or inverse movement in prices
The recent rally in the stock markets saw a majority of the mutual fund schemes and stocks outperforming the indices, irrespective of the sector or group. But then the question arises, can the performance of individual securities be unrelated to each other?
The point is that in a bull-run everything seems rosy. Any upward movement in a portfolio of shares and equity funds will give whopping returns. Though, the same may apply in the case of downward movements wherein your entire portfolio may turn red. So, how do you address the risk of your entire portfolio going down at a go?
According to MPT, the two types of risks that need to be mitigated are systematic and non-systematic. Systematic or Non-diversifiable risks cannot be eliminated by diversification like terrorism but the risks that can be alleviated by having wide-ranging securities in the portfolio are known as unsystematic or non-systematic risks.A portfolio is said to be efficient when all the diversifiable risk within the portfolio is eliminated.
Graph 2: BSE Indices Closing Data
Graph 2 shows how the various sectors have fluctuated or remained flattish during the period January 2007 to June 2009 (source: BSE). The Fast Moving Consumer Goods (FMCG) sector performed flatly whereas Metals reached the peak levels, almost similar to the 30 stock BSE Sensitive Index (SENSEX), but fell more sharply compared to its peer sectoral indices.
Diversification can occur in terms of stock selection across different sectors or different mutual fund types as well as through asset class selection. Selecting a mix of asset classes as well as sectors whose performance is inversely related to each other will protect the downside and improve returns generated regardless of market cycles.Within the time frame of August 2008 to May 2009, we have seen the major indices plunging and recovering with flamboyance. Although markets have hit a rock bottom in 2008, debt market funds and gold delivered superior returns (source: AMFI, NSE Government Securities Index, iFAST Compilations).
Spreading your portfolio across different types of products brings us to the next step of the portfolio building exercise.
Step 3: Evaluate impact of adding a new security to the portfolio
The careful identification of assets within a portfolio is important if you want to manage the volatility within each asset class. It can be challenging to evaluate the riskiness of instruments. Generally, cash assets and fixed income instruments are considered to have lesser exposure to market movement than equities. But if your investment horizon is just three months, then a short-term bond fund can be a highly risky investment. The uncertainty in the interest rates and small fluctuations in fixed income markets can be damaging to your portfolio. For this reason, it is also essential to consider the horizon over which the returns are anticipated.
Cash funds can provide immediate liquidity in a contingency situation. Equities will continue to outperform other asset classes over long-term. This takes us back to the initial point: select securities so that you minimise variance and hold expected return constant. Take a note of how much exposure do you already have to a particular stock or a sector. Monitor the exposure of your portfolio at regular intervals so that your portfolio concentration does not become skewed. As you construct the portfolio, ensure that any addition to the portfolio matches your risk profile and investment horizon.
Step 4: Examine the performance of the portfolio
Understanding the portfolio theory is one thing but to implement it, is a difficult task. It can be quite complex to identify securities, manage volatility and get higher returns than, say, the SENSEX. As investors, we need to focus on how the portfolio is performing by being active managers of our own money and becoming aware investors in the market place. Select a portfolio after careful thought on the valuations, business trends and with a long-term horizon. Assess the transaction costs involved in maintaining the portfolio. Evaluate product features in terms of upfront charges as well as annual expenses. Determination of portfolio performance can be done with respect to movement in prices, risk reward trade-offs for various securities and benchmark performance.
Many a time, investor behaviour depends on market sentiments and following a herd mentality. In early 2000, even though the valuations of most of the IT companies were at all-time high, investors continued to hold on or buy stocks within the IT sector. Similarly, last year at the peak 20,000 levels, the euphoria over the Indian stock market propelled investors to buy rather than book profits. Not many believed that the markets could tank more than 50% in the following six months.
History has shown time and again that we need to consider risk and expected return before investing. Buy at the right price and hold the investment for right time should be your mantra. The purpose of the article was to help you understand the importance of diversifying and considering each security from the standpoint of your overall portfolio.
As we conclude the discussion on portfolio theory, you may wonder how much should we diversify?
With the Markowitz theory, we can clearly establish that a portfolio of diversified, uncorrelated assets can provide sustainable returns with reduced volatility. There is no rule to define adequate diversification. You can alternate investments between stocks, mutual funds, exchange traded funds (ETFs) and different asset classes like gold and real estate, by booking profits at consistent intervals and rebalancing your portfolio. Mutual funds are professionally managed and an inexpensive way to start planning your investments. Beginners can also take advantage of diversification offered by mutual funds.
Go give a head start to your investment strategy now!