A Central Theme In Asset Protection Concerns How We Can Limit Downside Risk.

By James F. Horrell, Ph.D - Email Editor

Date : July 04, 2006

Today's focus we will discuss the primary strategy for limiting investment risk. I have been reading Trustmakers' newsletters for some time, and I can say without question, that the topics covered are important refinements on the central theme discussed today. I am very pleased to come on board as a contributing writer and team-member. My name is James F. Horrell; I am a recently retired professor of the Price College of Business at the University of Oklahoma. I have a Ph.D. in Statistics, and during the past thirty-four years of teaching, I have focused on the application of mathematics and statistics to business settings, and in particular, to Investments and Portfolio Management. For my part with Trustmakers, I will discuss several topics that I have been teaching to students and writing about for several years. These topics employ mathematical skills and investment concepts that reduce unnecessary risk, and consequently, reduce your portfolio's risk exposure. While the concepts are based on what might be considered heavy mathematical derivations, the articles will emphasize an intuitive conceptualization of the concepts. The first article of a series tackles diversification at the core.

Intuitively, we all know that diversification is important for managing investment risk. But how does diversification work, and how can we be sure we have an efficiently diversified portfolio? Before getting into the answer to this question, let's define some terms and make sure we are all on the same page. "Portfolio" here refers to a group of assets held by an investor, and "diversification" refers to the number and variety of assets in the portfolio. A single asset portfolio is said to be highly concentrated. As we add assets, depending on the relationship of the new assets and the existing assets, we potentially begin to diversify the portfolio. Additional assets that have returns that are highly positively correlated (a portfolio of stocks that are from the same group i.e. Exxon, Mobile, Chevron, British Petroleum) with existing assets will contribute very little to the diversification of the portfolio. Assets that have low positive correlation with existing assets will add diversification (a portfolio of stocks that are not from the same group i.e. H & R Block, Carnival Cruise Line, Home Depot, Fifth Third Bank).

Academic research shows that "on average" portfolios holding a single domestic stock have a standard deviation of annual returns of approximately 49%, whereas diversified stock portfolios with 20-30 stocks will have a reduction in the standard deviation of portfolio returns to about 20%. (A less technical translation is a reduction in risk of 2.5 times). This reduction in the variability in annual returns is achieved without an accompanying loss in the average annual return of the portfolio. In short, a significant reduction in the risk of returns is achieved (without a loss in the expected return) by diversifying the portfolio. Diversified portfolios with more than 30 domestic stocks do not achieve significantly lower risk, and the risk that remains is referred to as the "stock market risk." Further significant reductions in risk are only achieved by enlarging the pool of assets used in the portfolio. Instead of a pool of stocks, the asset pool should be enlarged to include bonds, real estate, precious metals, etc. Additional risk reduction can also be achieved by enlarging the economic sphere of the asset pool. Specifically, a global asset pool will have a smaller market risk than any domestic asset pool.

Three important questions arise concerning the selection of an efficient diversified portfolio. First, how do we select an appropriate set of global assets so that we have a diversified portfolio? Second, what percentages of the total value of the portfolio should be allocated to the various subclasses of assets included in the portfolio? Third, what specific assets (i.e., stocks, bonds, real estate, etc.) should be selected to be part of the total investment portfolio? Prior to the development of investment portfolio theory by Markowitz, investors did not have the analytic tools by which to answer these questions. Markowitz's theoretical developments have taught us that our focus in the asset pool should be on the covariance structure of the assets selected for the portfolio. The intuitive translation of these theoretical developments is that we must be concerned with the correlations of the returns of the component assets.

At this point you might be saying, “Whoa, there are too many details here that need to be attended to for the non-specialist investor.” Of course, we don't try to practice medicine when we have medical needs, and we don't try to practice law when we have legal issues. However, that doesn't mean that we can't intuitively appreciate medical and legal explanation when given by doctors and attorneys. Ultimately, after intuitively grasping the principles espoused in such situations we may avail ourselves of the use of such advice.

There are, of course, other tools that can be brought to bear on the issue of portfolio selection and the efficient maintenance and modification. In principle, highly trained financial professionals devoting 100% of their time should have experiences and developed techniques that could benefit the general investor. Strategies such as those involving options and hedging come to mind. However, discussing such strategies will have to be subjects of later discussions.

James F. Horrell, Ph.D.