Portfolio Diversification

  • 738 views
Uploaded on

 

  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Be the first to comment
    Be the first to like this
No Downloads

Views

Total Views
738
On Slideshare
0
From Embeds
0
Number of Embeds
0

Actions

Shares
Downloads
0
Comments
0
Likes
0

Embeds 0

No embeds

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
    No notes for slide
  • What is Asset Allocation? The asset-allocation decision is one of the most important factors in determining both the return and the risk of an investment portfolio. Asset allocation is the process of developing a diversified investment portfolio by combining different assets in varying proportions. An asset is anything that produces income or can be purchased and sold, such as stocks, bonds, or certificates of deposit (CDs). Asset classes are groupings of assets with similar characteristics and properties. Examples of asset classes are large-company stocks, long-term government bonds, and Treasury bills. Every asset class has distinct characteristics and may perform differently in response to market changes. Therefore, careful consideration must be given to determining which assets you should hold and the amount you should allocate to each asset. Factors that greatly influence the asset-allocation decision are your financial needs and goals, the length of your investment horizon, and your attitude toward risk.
  • Stock Diversification Diversification is a major benefit of investing in mutual funds. Company or individual security risk is the risk that a specific stock may fall in price due to non-market-related factors such as poor company management. It is the risk in excess of the overall stock market and is not always rewarded with higher returns. You assume greater company risk when you invest in a limited number of securities. Including more securities in a portfolio can reduce the level of company-specific risk you are exposed to. This is true for stocks as well as other types of asset classes. This image illustrates that an investor holding more than 100 stocks assumes very little company risk. Generally, it is impractical for most investors to buy hundreds of individual stocks. Mutual funds are able to reduce company risk because they have economies of scale. With millions of dollars in assets, mutual funds can afford to take positions in hundreds of stocks. Even mutual funds, however, cannot diversify away market risk. Market risk is the risk that the entire market will experience a decline in price. Even if you hold every stock in the market and have very little company-specific risk, you will still be exposed to market risk. Diversification does not eliminate the risk of experiencing investment losses. The portfolios used in this study are equally weighted. Returns and principal invested in stocks are not guaranteed. Mutual funds may have management fees and other additional costs. An investment cannot be made directly in an index. Source: Lawrence Fisher and James H. Lorie, “Some Studies of Variability of Returns on Investments in Common Stocks,” Journal of Business, April 1970; Edwin J. Elton and Martin J. Gruber, “Risk Reduction and Portfolio Size: An Analytical Solution,” Journal of Business, October 1977; and Meir Statman, “How Many Stocks Make a Diversified Portfolio?,” Journal of Financial and Quantitative Analysis, September 1987.
  • Potential to Reduce Risk or Increase Return 1970–2009 Historically, adding stocks to a portfolio of less volatile assets reduced risk without sacrificing return or increased return without assuming additional risk. This image illustrates the risk-and-return profiles of three hypothetical investment portfolios. The lower risk portfolio, which included stocks, had the same return as the portfolio comprised entirely of fixed-income investments, but assumed less risk. The higher return portfolio had the same risk level as the fixed income portfolio, but produced an increased return. Although it may appear counterintuitive, diversifying a portfolio of fixed-income investments to include stocks reduced the overall volatility of a portfolio during the period 1970–2009. Likewise, it is possible to increase your overall portfolio return without having to take on additional risk. Because stocks, bonds, and cash generally do not react identically to the same economic or market stimuli, combining these assets can often produce a more appealing risk-and-return tradeoff. Diversification does not eliminate the risk of experiencing investment losses. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. About the data Stocks in this example are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Long-term government bonds are represented by the 20-year U.S. government bond, intermediate-term government bonds by the five-year U.S. government bond, and cash by the 30-day U.S. Treasury bill. Bonds represent an equally weighted portfolio of long-term government bonds and intermediate-term government bonds. All portfolios are rebalanced annually. Risk is measured by standard deviation. Standard deviation measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
  • The Case for Diversifying Diversifying your portfolio makes you less dependent on the performance of any single asset class. Effective diversification requires combining assets that behave differently when held during changing economic or market conditions. Moreover, investing in assets that have dissimilar return behavior may insulate your portfolio from major downswings. This image illustrates the annual returns of three different portfolios over a 10-year time period. Stocks represent a 100% investment in large-company stocks. Bonds represent a 100% investment in long-term government bonds. When the stock and bond asset classes were combined into an equally-weighted portfolio, the portfolio experienced less volatility than stocks alone and still maintained an attractive return. Notice that stock returns were up at times when bond returns were down, and vice versa. These offsetting movements assisted in reducing portfolio volatility (risk). Diversification does not eliminate the risk of experiencing investment losses. Government bonds are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than bonds. About the data Stocks in this example are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general and bonds by the 20-year U.S. government bond. Annual rebalancing is assumed in the 50% stocks/50% bonds portfolio. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
  • Stocks and Bonds: Risk Versus Return 1970–2009 An efficient frontier represents every possible combination of assets that maximizes return at each level of portfolio risk and minimizes risk at each level of portfolio return. An efficient frontier is the line that connects all optimal portfolios across all levels of risk. An optimal portfolio is simply the mix of assets that maximizes portfolio return at a given risk level. This image illustrates an efficient frontier for all combinations of two asset classes: stocks and bonds. Although bonds are considered less risky than stocks, the minimum risk portfolio does not consist entirely of bonds. The reason is that stocks and bonds are not highly correlated; that is, they tend to move independently of each other. Sometimes stock returns may be up while bond returns are down, and vice versa. These offsetting movements help to reduce overall portfolio volatility (risk). As a result, adding just a small amount of stocks to an all-bond portfolio actually reduced the overall risk of the portfolio. However, including more stocks beyond this minimum point caused both the risk and return of the portfolio to increase. Diversification does not eliminate the risk of experiencing investment losses. Government bonds are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than bonds. About the data Stocks in this example are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general and bonds by the 20-year U.S. government bond. Risk and return are based on annual data over the period 1970–2009 and are measured by standard deviation and arithmetic mean, respectively. Standard deviation measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
  • More Funds Do Not Always Mean Greater Diversification Holdings-based style analysis can be used to determine security overlap. The image illustrates two different equity portfolios that individually comprise five mutual funds. Each oval within the style box represents an ownership zone of a mutual fund, which accounts for 75% of the fund’s holdings. The level of diversification provided by each portfolio is quite different. The funds in Portfolio A significantly overlap with one another, indicating that each fund may hold stocks sharing similar style characteristics. While some overlap is acceptable in a portfolio, too much of it defeats the purpose of using multiple funds to create a diversified portfolio. In contrast, Portfolio B contains funds that span across many different styles. While the holdings in Portfolio A are more concentrated in the giant and large-cap value and core segments, the holdings in Portfolio B are widely distributed among different investment styles. While not all investment styles are appropriate for all investors, it is important to be aware of the range of investment options and the possibility of security overlap when constructing a diversified portfolio. Source: Morningstar, Inc.
  • Asset-Class Winners and Losers It is impossible to predict which asset class will be the best or worst in any given year. The performance of any given asset class can have drastic periodic changes. This image illustrates the annual performance of various asset classes in relation to one another. In times when one asset class dominates all others, as was the case for large stocks in the late 1990s, it is easy to lose sight of the fact that historical data shows it is impossible to predict the winners for any given year. Investors betting on another stellar performance for large stocks in 1999 were certainly disappointed, as small stocks rose from the worst-performing asset class in 1998 to the best-performing one in 1999. Similarly, international stocks were the top performers from 2004 to 2007, disastrously sank to the bottom in 2008, and rebounded to the top position once again in 2009. These types of performance reversals are evident throughout this example. Although investing in a diversified portfolio may prevent an investor from capturing top-performer returns in any given year, this strategy can also protect an investor from experiencing extreme losses. For example, in 2009 a diversified portfolio would have returned 14.0%, which was approximately 18.5% lower than the top asset class that year—international stocks. However, the diversified portfolio would also have performed better than the worst-performing asset class—long-term government bonds—by about 28.9% this past year. A well-diversified portfolio allows investors to mitigate some of the risks associated with investing. By investing a portion of a portfolio in a number of different asset classes, portfolio volatility may be reduced. Diversification does not eliminate the risk of experiencing investment losses. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small stocks are more volatile than large stocks and are subject to significant price fluctuations, business risks, and are thinly traded. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards. About the data Small stocks are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general, government bonds by the 20-year U.S. government bond, Treasury bills by the 30-day U.S. Treasury bill, and international stocks by the Morgan Stanley Capital International Europe, Australasia, and Far East (EAFE ® ) Index. An investment cannot be made directly in an index. The data assumes reinvestment of all income and does not account for taxes or transaction costs. The diversified portfolio is equally weighted between small stocks, large stocks, long-term government bonds, Treasury bills, and international stocks.
  • Correlation Can Help Evaluate Potential Diversification Benefits A well-diversified portfolio should consist of individual investments that behave differently. It is possible to determine how closely two asset classes move together by evaluating their correlation. Correlation ranges from –1 to 1, with –1 indicating that the returns move perfectly opposite to one another, 0 indicating no relationship, and 1 indicating that the asset classes react exactly the same. For example, small stocks and large stocks have risen and fallen to the same market conditions. Their high correlation suggests combining them may do little to lower the risk of a portfolio. In contrast, the negative correlation of small stocks and intermediate-term government bonds illustrates the potential for better diversification. Investments still need to be evaluated for investor suitability, but understanding asset class behavior may help enhance the diversification benefits of investor portfolios. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than bonds. Furthermore, small stocks are more volatile than large stocks and are subject to significant price fluctuations, business risks, and are thinly traded. Diversification does not eliminate the risk of experiencing investment losses. About the data Small stocks are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Corporate bonds are represented by the Ibbotson Associates U.S. long-term high-grade corporate bond index, long-term government bonds by the 20-year U.S. government bond, intermediate-term government bonds by the five-year U.S. government bond, and Treasury bills by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index.
  • Diversification in Bull and Bear Markets Diversification is the strategy of combining distinct asset classes in a portfolio in order to reduce overall portfolio risk. The graph on the left illustrates the hypothetical growth of $1,000 in stocks, bonds, and a 50% stock/50% bond diversified portfolio from October 2002 to October 2007. Stocks provided increased growth in bull markets. It is important to understand, however, that this greater wealth was achieved with considerable volatility in stocks compared to the diversified portfolio. The significance of holding a diversified portfolio is most apparent when one or more asset classes are out of favor. The graph on the right illustrates the hypothetical growth of $1,000 in stocks, bonds, and a diversified portfolio between November 2007 and February 2009. Notice that by diversifying among the two asset classes, the diversified portfolio experienced less severe monthly fluctuations than stocks or bonds alone. While bond prices tend to fluctuate less than stock prices, they are still subject to price movement. By investing in a mix of asset classes such as stocks, bonds, and Treasury bills, you may insulate your portfolio from major downswings in a single asset class. One of the main advantages of diversification is that it makes you less dependent on the performance of any single asset class. Diversification does not eliminate the risk of experiencing investment losses. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than bonds. About the data Stocks in this example are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general, and bonds by the 20-year U.S. government bond. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for taxes or transaction costs. The bull market analyzed is defined by the time period October 2002—October 2007, and the bear market by the time period November 2007—February 2009.
  • Diversified Portfolios in Various Market Conditions Diversification can limit your losses during a severe market decline. The benefits of diversification are most evident during bear markets. This image illustrates the growth of stocks versus a diversified portfolio during two of the worst performance periods in recent history. The blue line illustrates the hypothetical growth of $1,000 invested in stocks during the mid-1970s recession and the 2007–2009 bear market. The gray line illustrates the hypothetical growth of $1,000 invested in a diversified portfolio of 35% stocks, 40% bonds, and 25% Treasury bills during these same two periods. Over the course of both time periods, the diversified portfolio lost less than the pure stock portfolio. Over longer periods of time, the more volatile single asset-class portfolio is likely to outperform the less volatile diversified portfolio. However, you should keep in mind that one of the main advantages of diversification is reducing risk, not necessarily increasing return, over the long run. Diversification does not eliminate the risk of experiencing investment losses. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. About the data Stocks in this example are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Bonds are represented by the 20-year U.S. government bond, and Treasury bills by the 30-day U.S. Treasury bill. The mid-1970s recession occurred from January 1973 through June 1976. The 2007–2009 bear market began in November 2007 and reached a trough in March 2009. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for taxes or transaction costs.

Transcript

  • 1. Portfolio Diversification
  • 2. What is Asset Allocation?
    • © 2010 Morningstar. All Rights Reserved. 3/1/2010
    Asset allocation is the process of combining asset classes such as stocks, bonds, and cash in a portfolio in order to meet your goals. Stocks Bonds Cash
  • 3. Stock Diversification
    • Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    1 2 4 6 8 16 30 50 100 1000 Risk • Company risk • Market risk Number of stocks in portfolio
  • 4. Potential to Reduce Risk or Increase Return 1970–2009
    • Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. They are based on annual data over the period 1970–2009. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    Lower risk portfolio Higher return portfolio Fixed income portfolio Return: 8.0% Risk: 5.8% Return: 8.9% Risk: 7.8% Return: 8.0% Risk: 7.8% • Stocks • Bonds • Cash 15% 85% 19% 27% 37% 12% 44% 61%
  • 5. The Case for Diversifying
    • Past performance is no guarantee of future results. Time period illustrated is from 2000–2009. This time period was chosen as a dramatic illustration of stock and bond return behavior and how their often opposite movements reduced portfolio volatility. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    30% Return 20 10 – 10 – 20 0 – 30 – 40 Year 1 2 3 4 5 6 7 8 9 10 Compound annual return – 0.9 • Bonds • 50/50 portfolio • Stocks 7.7% 4.6
  • 6. Stocks and Bonds: Risk Versus Return 1970–2009
    • Past performance is no guarantee of future results. Risk and return are measured by standard deviation and arithmetic mean, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    12% Return 11 10 9 Maximum risk portfolio: 100% Stocks 60% Stocks, 40% Bonds 50% Stocks, 50% Bonds 100% Bonds Minimum risk portfolio: 28% Stocks, 72% Bonds 80% Stocks, 20% Bonds 11 12 13 14 15 16 19 17 18 10% Risk
  • 7. More Funds Do Not Always Mean Greater Diversification Identifying potential security overlap
    • Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    Equity portfolio B Deep-value Core-value Core Core-growth High-growth Micro Small Mid Large Giant Equity portfolio A Deep-value Core-value Core Core-growth High-growth Micro Small Mid Large Giant
  • 8. Asset-Class Winners and Losers
    • Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    2007 11.6 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 37.6% 23.0 33.4 28.6 29.8 21.5 22.8 17.8 60.7 20.7 14.0 26.9 2008 25.9 9.9 34.5 17.6 22.8 20.3 27.3 5.9 3.8 1.6 39.2 18.4 7.8 16.2 1.6 5.5 31.7 10.3 15.9 13.1 21.0 0 .6 3.7 – 6.5 28.7 12.0 7.3 15.8 – 20.7 23.8 5.4 6.4 15.9 12.2 14.3 – 3.6 – 0.8 – 13.3 24.8 10.9 5.7 12.9 – 36.7 4.7 11.6 5.2 5.3 4.9 4.7 – 9.1 – 11.9 – 15.7 1.4 8.5 4.9 4.8 – 37.0 – 5.2 5.6 – 0.9 2.1 – 7.3 – 9.0 – 14.0 – 21.2 – 22.1 1.0 1.2 3.0 1.2 – 43.1 2009 32.5 28.1 26.5 14.0 0.1 – 14.9 Highest return Lowest return • Small stocks • Large stocks • International stocks • Long-term government bonds • Treasury bills • Diversified portfolio
  • 9. Correlation Can Help Evaluate Potential Diversification Benefits Asset-class correlation 1926–2009
    • Past performance is no guarantee of future results. Correlation ranges from –1 to 1, with –1 indicating that the returns move perfectly opposite to one another, 0 indicating no relationship, and 1 indicating that the asset classes react exactly the same. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    Small stocks Large stocks LT corporate bonds LT govt bonds IT govt bonds Treasury bills Small stocks Large stocks LT corporate bonds LT govt bonds IT govt bonds Treasury bills 1.00 0.79 0.07 – 0.07 – 0.10 – 0.09 1.00 0.17 0.03 – 0.01 – 0 .01 1.00 0.89 0.88 0.20 1.00 0.90 0.22 1.00 0.47 1.00
  • 10. Diversification in Bull and Bear Markets
    • Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    $2,500 Bull market 2,000 1,500 1,000 500 2002 2003 2004 2005 2007 2008 500 750 1,000 1,250 $1,500 Bear market $1,160 $767 $491 $1,274 • Stocks • 50/50 portfolio • Bonds 2006 2007 Oct Oct Oct Oct Oct Oct Nov Nov $2,084 $1,653
  • 11. Diversified Portfolios in Various Market Conditions Performance during and after select bear markets
    • Past performance is no guarantee of future results. Diversified portfolio: 35% stocks, 40% bonds, 25% Treasury bills. Hypothetical value of $1,000 invested at the beginning of January 1973 and Nov 2007, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    Mid-1970s recession (Jan 1973–Jun 1976) 2008 bear market (Nov 2007–Mar 2009) $1,150 $1,014 $844 $491 $1,250 1,000 750 250 Jan 1973 Jan 1974 Jan 1975 Jan 1976 Nov 2007 Mar 2008 Jul 2008 Nov 2008 • Stocks • Diversified portfolio 500 Mar 2009