Diversification and Modern Portfolio Theory

„Don’t place all your eggs in one basket; it might have a hole&ldquo, is a popular saying on the stock market. It advises investors not to invest all their capital in one area since they would risk losing their entire capital if a crisis came up. Instead, it suggests looking into a variety of capital investments that vary in terms of risk and return. This process of spreading risks and minimizing chances of a total loss is called diversification. Studies have shown that it can minimize portfolio risk by 25-30% (Bernstein, 2000). There are a variety of diversification tactics which investors can use to minimize risks.

Diversification and modern portfolio theory

Portfolio theory is a subcategory of the capital market theory that deals with the behavior of investors in capital markets. Large insurance, hedge funds, and asset managers base their investment decisions on modern portfolio theory. Its creator, Harry Max Markowitz (born 24 August 1927 in Chicago), was an American economist and Nobel laureate for economics.

In the 1950s, he provided empirical evidence that a diversified investment portfolio is superior to any individual investment in terms of its risk-return ratio, no matter how well the individual investment is selected. According to the stock market encyclopedia, a portfolio comprises all valuables that an investor owns. While this refers primarily to securities, it also includes real estate and property. Individual capital investments should never be examined separately, but rather be considered in relation to each other.

Every investment has consequences on the returns and risk of the entire portfolio. The first step is determining the expected value of the investment’s future returns. The second step is focusing on the yield’s range of fluctuation since investment developments can differ from expectations. Looking at the standard deviation of the expected yields helps determine outliers in both directions.

Lastly, one examines the correlation of the investments amongst each other. Correlation can have a value between -1 and 1. If an investment does not react to another’s fluctuation in value at all, they do not correlate and the correlation value is equal to 0. If an investment’s value fluctuation does not always lead to an equivalent fluctuation of another, the correlation value is weak. Investments can also have a negative correlation, in which case the increase in one’s value would result in a decrease of another’s value.

Diversification and correlating capital investments

According to the stock market encyclopedia, diversification is the spreading of risks across several unrelated risk bearers. Investors who want to diversify their portfolio should start by examining the correlation of their investments. After all, investments with different ranks have differing degrees of risk. The second step is checking how investments within the same category correlate. Portfolio asset classes describe investments with similar value drivers. One differentiates between traditional and alternative classes.

The traditional class includes: taxable securities (also known as bonds), stocks, cash, and real estate (with specified use to the investor). These categories can be subdivided by similarities, such as shares within one economic region (Europe vs. Asia). The alternative investment class comprises: resources (crude oil, natural gas, precious metals, industrial metals, and minerals), private equity (including venture capital), hedge funds, profit-oriented real estate investments (regardless of purpose, direct investment or real estate funds), derivatives (derived financial products like credit default insurance or warrants), art, wine, and vintage cars.

Alternative investments usually have above-average potential for risk and returns, and limited transparency and liquidity. Investors should practice diversification here, too. Risks are reduced when investments are not all made within the same category. It is also important to consider that correlation values are not always consistent and are subject to market fluctuation. In times of a global economic crisis, these values increase sharply – a result of psychological effects. Pessimism among investors can lead to panicked sales. Nevertheless, a portfolio based on diversification is more advantageous for investors than individual investments, both in times of rising markets and in times of crisis.

Examples for positive and negative correlation

One example of a positive correlation is the price for crude oil and the shares of oil companies. When the price of oil increases, so do the shares of the oil companies. When oil prices fall, so does the value of oil company shares, since their profits are lower. Another example is the price of gold and of silver. Both of these are alternative investment objects (precious metals). The price of silver increases when the price of gold increases, and the other way around.

An example of a negative correlation is the relationship between the German Stock Index (Deutscher Aktienindex, DAX) and the price of gold. When the DAX increases, the price of gold usually falls. Due to its characteristic as value storage, investors consider gold as a “safe harbor” during times of crisis. When the stock index falls, investors often turn toward gold. On the other hand, they sell their shares of gold when the stock market is booming in order to profit from the upturn.

What are the characteristics of an efficient portfolio?

An investment portfolio that only binds positively correlating investments ignores the basics of diversification and is not prepared to withstand crises. Since all investments correlate, they all fall simultaneously; none balances the loss of the others. Every investor thus faces the challenge of creating as much balance as possible in their portfolio. According to Markowitz, an efficient portfolio is a series of capital investments that achieve a maximum return at the lowest possible risk that the investor is willing to take. Efficient portfolios exist in every risk class. There is no standard definition of risk classes, and thus different financial service providers distinguish four, five, or six different risk classes. As a general rule, the risk classes differentiate between the investor’s risk tolerance and match suitable investment objects along these lines. A possible classification is as follows:

• Risk class 1: Security-oriented (fixed-term deposits, savings book, building society contract, mortgage bond, European money market funds, demand deposits, restricted cash)
• Risk class 2: Conservative (fixed-interest securities, bonds with a good credit rating, European pension funds, money market-related funds, risk-free government bonds, endowment policies)
• Risk class 3: Solid profit orientation (shares of established companies, equity funds with European standard values, international fixed-income, equity and mixed funds)
• Risk class 4: Speculative profit orientation (shares and equity funds with European and non-European standard values, certificates, medium-rated currency bonds, investment funds, foreign currency bonds)
• Risk class 5: High speculation (high speculative bonds, participation certificates, subordinated savings certificates and loans, warrants, futures, junk bonds, other government bonds)

According to modern portfolio theory, each risk class has its own respective efficient portfolio. These differ drastically in their make-up and are oriented along the investor’s risk tolerance. One end of the spectrum is the very speculative investment portfolio (100% stocks), at the other end the security-oriented one (100% bonds). In between, there are efficient portfolios with mixed investments, along which the so-called line of efficiency runs. The volume of all permissible portfolios is below the line of efficiency (see chart below).

Are diversification and portfolio theory still current?

In recent years, there has been a shift in risk from fixed-interest investments to more risky investment classes. In their effort to stabilize the world economy after the global financial crisis of 2008, central banks have continuously lowered key interest rates. The key interest rate in the Eurozone is currently at 0% and a reversal in the trend is nowhere in sight. This has far-reaching consequences for investors. Government bond yields have also fallen sharply. Investors have even had to accept negative returns on investments in German government bonds, i.e. they have to make additional payments if they want to lend money to the German state. As a result, what used to be a risk-free investment with low return has turned into a yield-free investment with low risk.

Insurance companies and banks also have problems generating returns in the low-interest rate environment, which means that they have difficulties keeping their promises for life insurance policies or building society savings contracts. They are increasingly forced to invest in high-risk investments such as corporate bonds and equities in order to achieve their return targets. As a result, the German share index (DAX) has more than doubled in eight years and the leading American Dow Jones index has also reached one all-time high after another.

Trotz dieser Risikoverschiebung hat die Portfoliotheorie mit ihren Diversifikationsstrategien für Anleger nicht an Bedeutung verloren, denn die Zukunft – und damit die Entwicklung ihrer Investitionen – bleibt ungewiss. Niemand kann sagen, wann die Leitzinsen wieder steigen und die Volatilität an den Aktienmarkt zurückkehrt. Die Vorteile der Diversifikation bestehen also weiterhin und Investoren sind gut beraten, ihr Depot auch in Zukunft zu diversifizieren.

Despite this shift in risk, portfolio theory and its diversification strategies have not lost importance for investors, because the future – and thus the development of their investments – remains uncertain. No one can say when key interest rates will rise again and volatility will return to the stock market. The advantages of diversification thus remain and investors are well advised to diversify their portfolio for the future.

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