- April 15, 2014
- Posted by: essay
- Category: Term paper writing
The process of portfolio management aims at preserving the basic investment qualities of the portfolio and the features meeting the interests of its holder. Forming an investment portfolio, managers should first determine in what proportions the assets of different categories are to be included. In this perspective, the instrument of diversification is designed to reduce investment risks while maximizing profitability, being based on differences in income fluctuations and market value of securities.
Above all, it should be kept in mind that poorly diversified portfolio (e.g., when Nike Inc. shares make 100%) is characterized by both market and non-market risks. Non-market (systematic) risk is associated with factors influencing all the investment assets (e.g., economic cycle dynamics, unstable political situation in a country, war, etc.). Thus, an investor can minimize one’s risk to the level of market risk only and avoid serious losses by means of forming a widely diversified portfolio. In its turn, a widely diversified portfolio corresponds to mainly market (specific) risk, i.e. risk associated with individual characteristics of a particular security, but not the state of the market as a whole (e.g., risks of loss due to the deterioration of the financial situation of a particular company, incompetence of company’s leadership, conflicts among the shareholders, etc.).
Therefore, diversification helps minimize risks by compensating for relatively low income on one group of securities by relatively high income on others. Managing portfolio risks is taking place through including the securities of several branches and/or issuers which do not correlate with each other (e.g., both Nike Inc. and Tiffany & Company shares). The portfolio should also include a variety of securities: ordinary and/or preference shares, corporate and/or public (state entities, municipal) bonds, short-term and/or long-term, derivatives, futures, and others. At the same time, one should be aware that excessive adherence to this approach could lead to the conclusion that the best method of diversification is the investment in the largest possible number of securities of different companies. However, the practice has proved that the maximum reduction of risk could be achieved only in case the portfolio includes 10-15 different securities. Further increase in portfolio composition is unfeasible as this may generate an effect of excessive diversification, leading to such negative outcomes as: a) impossibility of qualitative portfolio management, b) buying insufficient number of reliable, profitable and liquid securities; c) increase in expenditures linked to the selection of the securities (additional costs of pre-analysis, consulting, etc.); d) high costs of buying small quantities of securities, etc.
Thus, while the insufficient number of portfolio securities leads to the increased risk due to the increased probability of simultaneous deviation of securities’ investment quality towards decline, the excessive diversification effect is characterized by the excess growth rate of costs over the portfolio yield growth rates. The major goal of balanced diversification is to achieve an optimal combination of risk and return within the portfolio assets. For instance, the active portfolio may include 60% of shares, 30% of corporate bonds, and 10% of state and municipal short-term securities. In passive management strategy, this could be 15-20% of shares, 60-80% of state and municipal short-term liabilities, and up to 10% of currency futures. However, since there are constant fluctuations in the value of a particular type of securities, the portfolio should also be periodically reviewed in order to preserve the original ratio of financial instruments.
In this way, diversification simultaneously helps investors to minimize the risk levels and maximize the expected return not of each single security, but of the whole portfolio. The application of the diversified portfolio approach to the investment management allows reducing the probability of the loss of revenue significantly. However, the risk may not be eliminated completely: the latter remains in the form of the non-diversified risk coming out of the general state of the economy. Therefore, other investment management instruments and prognostic methods should also be applied to keep the portfolio yield at the expected level.