| Home | My photos | Forex | My trading | Contacts |
|
|
You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
|
As an investor, you could invest your entire portfolio in one assetWhy Diversification reduces or eliminates Firm-specific Risk: An Intuitive Explanation As an investor, you could invest your entire portfolio in one asset, say Boeing. If you do so, you are exposed to both firm-specific and market risk. If, however, you expand your portfolio to include other assets or stocks, you are diversifying, and by doing so, you can reduce your exposure to firm-specific risk. There are two reasons why diversification reduces or, at the limit, eliminates firm specific risk. The first is that each investment in a diversified portfolio is a much smaller percentage of that portfolio than would be the case if you were not diversified. Thus, any action that increases or decreases the value of only that investment or a small group of investments will have only a small impact on your overall portfolio, whereas undiversified investors are much more exposed to changes in the values of the investments in their portfolios. The second reason is that the effects of firm-specific actions on the prices of individual assets in a portfolio can be either positive or negative for each asset for any period. Thus, in very large portfolios, this risk will average out to zero and will not affect the overall value of the portfolio. In contrast, the effects of market-wide movements are likely to be in the same direction for most or all investments in a portfolio, though some assets may be affected more than others. For instance, other things being equal, an increase in interest rates will lower the values of most assets in a portfolio. Being more diversified does not eliminate this risk. A Statistical Analysis Of Diversification Reducing Risk We can illustrate the effects of diversification on risk fairly dramatically by examining the effects of increasing the number of assets in a portfolio on portfolio variance. The variance in a portfolio is partially determined by the variances of the individual assets in the portfolio and partially by how they move together; the latter is measured statistically with a correlation coefficient or the covariance across investments in the portfolio. It is the covariance term that provides an insight into why and by how much diversification will reduce risk. Consider a portfolio of two assets. Asset A has an expected return of A and a variance in returns of A , while asset B has an expected return of B and a variance in The savings that accrue from diversification are a function of the correlation coefficient. Other things remaining equal, the higher the correlation in returns between the two assets, the smaller are the potential benefits from diversification. Why is the marginal investor assumed to be diversified? The argument that diversification reduces an investors exposure to risk is clear both intuitively and statistically, but risk and return models in finance go further. The models look at risk through the eyes of the investor most likely to be trading on the investment at any point in time, i.e. the marginal investor. They argue that this investor, who sets prices for investments, is well diversified; thus, the only risk that he or she cares about is the risk added on to a diversified portfolio or market risk. This argument can be justified simply. The risk in an investment will always be perceived to be higher for an undiversified investor than for a diversified one, since the latter does not shoulder any firm-specific risk and the former does. If both investors have the same expectations about future earnings and cash flows on an asset, the diversified investor will be willing to pay a higher price for that asset because of his or her perception of lower risk. Consequently, the asset, over time, will end up being held by diversified investors. This argument is powerful, especially in markets where assets can be traded easily and at low cost. Thus, it works well for a stock traded in the United States, since investors can become diversified at fairly low cost. In addition, a significant proportion of the trading in US stocks is done by institutional investors, who tend to be well diversified. It becomes a more difficult argument to sustain when assets cannot be easily traded, or the costs of trading are high. In these markets, the marginal investor may well be undiversified and firm-specific risk may therefore continue to matter when looking at individual investments. For instance, real estate in most countries is still held by investors who are undiversified and have the bulk of their wealth tied up in these investments. III. Models Measuring Market Risk While most risk and return models in use in corporate finance agree on the first two steps of the risk analysis process, i.e., that risk comes from the distribution of actual returns around the expected return and that risk should be measured from the perspective of a marginal investor who is well diversified, they part ways when it comes to measuring non-diversifiable or market risk. In this section, we will discuss the different models that exist in finance for measuring market risk and why they differ. We will begin with what still is the standard model for measuring market risk in finance - the capital asset pricing model (CAPM) - and then discuss the alternatives to this model that have developed over the last two decades. While we will emphasize the differences, we will also look at what they have in common. A. The Capital Asset Pricing Model (CAPM) The risk and return model that has been in use the longest and is still the standard in most real world analyses is the capital asset pricing model (CAPM). In this section, we will examine the assumptions made by the model and the measures of market risk that emerge from these assumptions. Assumptions While diversification reduces the exposure of investors to firm specific risk, most investors limit their diversification to holding only a few assets. Even large mutual funds rarely hold more than a few hundred stocks and many of them hold as few as ten to twenty. There are two reasons why investors stop diversifying. One is that an investor or mutual fund manager can obtain most of the benefits of diversification from a relatively small portfolio, because the marginal benefits of diversification become smaller as the portfolio gets more diversified. Consequently, these benefits may not cover the marginal costs of diversification, which include transactions and monitoring costs. Another reason for limiting diversification is that many investors (and funds) believe they can find under valued assets and thus choose not to hold those assets that they believe to be fairly or over valued. The capital asset pricing model assumes that there are no transactions costs, all assets are traded and investments are infinitely divisible (i.e., you can buy any fraction of a unit of the asset). It also assumes that everyone has access to the same information and that investors therefore cannot find under or over valued assets in the market place. Making these assumptions allows investors to keep diversifying without additional cost. At the limit, their portfolios will not only include every traded asset in the market but will have identical weights on risky assets The fact that this diversified portfolio includes all traded assets in the market is the reason it is called the market portfolio, which should not be a surprising result, given the benefits of diversification and the absence of transactions costs in the capital asset pricing model. If diversification reduces exposure to firm-specific risk and there are no costs associated with adding more assets to the portfolio, the logical limit to diversification is to hold a small proportion of every traded asset in the market. If this seems abstract, consider the market portfolio to be an extremely well diversified mutual fund that holds stocks and real assets, and treasury bills as the riskless asset. In the CAPM, all investors will hold combinations of treasury bills and the same mutual fund3. Investor Portfolios in the CAPM If every investor in the market holds the identical market portfolio, how exactly do investors reflect their risk aversion in their investments? In the capital asset pricing model, investors adjust for their risk preferences in their allocation decision, where they decide how much to invest in a riskless asset and how much in the market portfolio. Investors who are risk averse might choose to put much or even all of their wealth in the riskless asset. Investors who want to take more risk will invest the bulk or even all of their wealth in the market portfolio. Investors, who invest all their wealth in the market portfolio and are still desirous of taking on more risk, would do so by borrowing at the riskless rate and investing more in the same market portfolio as everyone else. These results are predicated on two additional assumptions. First, there exists a riskless asset, where the expected returns are known with certainty. Second, investors can lend and borrow at the same riskless rate to arrive at their optimal allocations. While lending at the riskless rate can be accomplished fairly simply by buying treasury bills or bonds, borrowing at the riskless rate might be more difficult to do for individuals. There are variations of the CAPM that allow these assumptions to be relaxed and still arrive at the conclusions that are consistent with the model. Measuring the Market Risk of an Individual Asset The risk of any asset to an investor is the risk added by that asset to the investors overall portfolio. In the CAPM world, where all investors hold the market portfolio, the risk to an investor of an individual asset will be the risk that this asset adds on to the market portfolio. Intuitively, if an asset moves independently of the market portfolio, it will not add much risk to the market portfolio. In other words, most of the risk in this asset is firm-specific and can be diversified away. In contrast, if an asset tends to move up when the market portfolio moves up and down when it moves down, it will add risk to the market portfolio. This asset has more market risk and less firm-specific risk. Statistically, this added risk is measured by the covariance of the asset with the market portfolio. |
|
|||||||||||||||
Previous Issues
|
| ©2007 Olesia | Home • My photos • Forex • News • My trading • Contacts |