Best Value For Your Money from RamaKrishnaVadlamudi: September 2013

Sunday 29 September 2013

Five Investment Gurus on Diversification

Guru Speak on Diversification

Here is what five investment gurus tell about portfolio diversification:

Benjamin Graham: He was considered the father of value investing. He said, “That there should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.”

Benjamin Graham further suggested that an individual investor should never have less than 25 per cent or more than 75 per cent of his funds in common stocks, with a consequent inverse range of between 75 per cent and 25 per cent in bonds. Graham suggested a 50-50 bond-stock allocation for many of the conservative investors even though this 50-50 mix looked like an oversimplified formula. Graham ignored other asset classes – gold, real estate, etc. – saying he did not have the required expertise in them.

Philip A Fisher: Philip Fisher was a legendary growth-stock investor. He was not a great believer in over-diversification. He stressed, “For individual investors, any holding of over twenty different stocks is a sign of financial incompetence. Ten or twelve is usually a better number. An investor should always realize that some mistakes are going to be made and that she should have sufficient diversification so that an occasional mistake will not prove crippling.” However, Fisher warned that one must be alert to the danger of investing in companies of a single industry.

John Templeton: Philanthropist-cum-fund manager John Templeton was renowned as one of the best investment managers in the 20^th century. He advocated diversification by company and by industry. He said, “There is safety in numbers in stocks and bonds. No matter how careful you are, you can neither predict nor control the future. So you must diversify.”

Warren Buffett: The Omaha, Nebraska-based legendary investor Warren Buffett does not believe in diversification. He says one should only invest a lot of money in a few quality companies. “Diversification serves as a protection against ignorance,” he avers. A major portion of his investments are in a few companies – like, Coca-Cola, Gillette, Wells Fargo and American Express.

David Dreman: He suggested holding of 20 or 30 stocks across 15 or more industries. He said that returns from individual issues will vary widely, so it is dangerous to rely on only a few companies or industries.

My Personal Opinion

In times of market crashes and crises, correlation among asset classes is especially high as was proved during the global financial crisis in 2008, when most of the major asset classes suffered heavy losses and asset allocation did not provide the benefit expected of it. This is a major limitation of asset allocation. During market meltdowns, it is extremely difficult to deflect the downside risks.

The asset allocation process is neither a silver bullet nor a magic wand. Even if you follow asset allocation process meticulously, there is no guarantee that you will be able to attain satisfactory results. Ultimately, asset allocation is vulnerable to market gyrations. If and when markets do well, our portfolio value also will outshine. If investor’s circumstances and market conditions change, asset allocation also should undergo a change. Asset allocation is a forward-looking process.

Diversification is a useful concept in finance. However, owning more than 15 to 25 stocks in an individual investor’s portfolio does not make sense. If one is extremely intelligent and knowledgeable about financial markets and has the required time and patience, one can hold a concentrated portfolio of 10 to 15 stocks as suggested by Philip Fisher.

Insurance companies have always thrived on the principle of diversification – they collect premiums from a large number of people and companies but pay only to a few. The total profits will exceed the total losses from insurance underwriting, which is a long gestation business.

Future is always almost uncertain. There is always a risk of losing our hard-earned money. As human beings, we have to make intelligent choices about our financial future. Being aware of the risks involved, we have to move forward with our decisions.

As our investment goals are varied, putting all our surplus money in a single asset class is risky. For conservative and common investors, the time-tested principles of asset allocation and diversification will, in all probability, provide an adequate safety net in the face of adversity.

Depending on your temperament, personal situation and available resources, you have to choose your asset mix properly and diversify your investments carefully – knowing fully well the limitations of asset allocation, your capacity and ability to understand and gain knowledge of markets. Finally, the most precious thing is to have a good night sleep!

Related: Understanding Asset Allocation 14Oct2012

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Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:

http://ramakrishnavadlamudi.blogspot.in/

http://www.scribd.com/vrk100

Connect with him on twitter @vrk100

Saturday 28 September 2013

Benefits of Portfolio Diversification

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Benefits of Portfolio Diversification

In many cases, it is beneficial for equity investors to diversify across companies and industries to mitigate risks. For most investors, diversification is the simplest and cheapest way to risk mitigation. Diversification is an established tenet for conservative investors and it is especially helpful when the returns of two or more investments are perfectly negatively correlated, resulting in substantial risk reduction. Negative correlation expresses the inverse relationship between the returns of two securities – which means their returns move in opposite direction.

On the contrary, in cases when returns of two investments are perfectly positively correlated, diversification will not provide risk reduction, only risk averaging. Positive correlation indicates that the returns of two securities move in the same direction – that is, they tend to go together. If the return of one security goes up, the return of the other security also tends to increase and vice versa.

Diversification can substantially reduce security-specific risk, but not market risk. That is why for a well-diversified portfolio, security-specific risk is practically insignificant.

Some sophisticated and institutional investors go for international diversification, investing in securities in different countries. Of course, they have to take care of political risk and currency risk involved in such international securities.

Institutional investors broadly consist of pension funds, sovereign wealth funds, endowments, insurance companies, banks and other financial institutions.

Over-diversification is detrimental to an investor’s wealth. So is under-diversification. Many investors hold 15 to 30 different mutual fund schemes. A mutual fund itself holds a number of securities. So it does not make any sense to hold more than three or four mutual fund schemes belong to a particular asset class. For example, it is better to stick to holding not more than three or four equity schemes under equity asset class.

Portfolio Rebalancing

Suppose an investor in 2012 has 40 per cent of his assets in equities, 20 per cent in bonds, 35 per cent in real estate and 5 per cent in gold. After one year assume that the investor’s asset mix changes as – equities 50% and bonds 10%; while real estate and gold remain the same proportionately. So in 2013, 10% of the wealth can be sold out of equities and the same can be ploughed back to bonds to restore the original balance in the total portfolio. This is called portfolio rebalancing.

Several mutual funds do this type of portfolio rebalancing through funds such as, balanced/hybrid funds, asset allocation funds and funds of funds. Some sophisticated and knowledgeable investors do portfolio rebalancing every year on their own.

Related: Understanding Asset Allocation 14Oct2012

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Importance of Asset Allocation with an Example

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Why is Asset Allocation so Important?

In 1952, Harry Markowitz floated an innovative theory, known as Modern Portfolio Theory (MPT) for which he received a Nobel Prize in Economics. MPT basically demonstrates why putting all your eggs in one basket is an unacceptable risky strategy and why investors get benefits from diversification. The theory has been used widely across the world for more than five decades but of late it has received wide criticism following the global financial crisis in 2008 when all asset classes heavily suffered the same fate of severe meltdown.

Many investors sold heavily during the market crash of 2008 – but they did not reinvest when the markets were extremely cheap in that period. After March 2009, the markets recovered spectacularly and many investors could not benefit from the large upswing in asset prices.

A few studies in the 1980s and 1990s have shown that asset allocation explained more than 90 per cent of the variation of returns over time for large pension funds. Another study done in 2000 found that about 40 per cent of the variation of returns across funds was explained by asset allocation policy and the remaining 60 per cent was explained by factors such as market timing, security selection, fees and investment style.

Whatever be the percentage, asset allocation still is very important for investors, who have to take into account their return objectives in line with their own risk appetite. It would be beneficial for long-term investors to invest across asset classes.

In my village where I was born, a typical middle class family was following a simple asset mix plan. In the1970s and 1980s, the family’s homemaker would buy gold ornaments and house furniture while the husband would invest in property or land – a simple asset mix without knowing it! Now that land and gold prices have soared, these middle class rural people proved to be much smarter than you and me!

Related: Understanding Asset Allocation 14Oct2012

What is the Suitable Asset Allocation?

Rakesh Jhunjhunwala is a well known equity investor from Mumbai, India. He has invested across a number of companies’ equity shares. He is said to be worth a few billion dollars, if not more. He claims that he has invested 100 per cent of his money in Indian stocks! He asserts that he does not like to invest in real estate nor in international equities.

Obviously, his allocation is not suitable for others. The allocation differs from person to person or institution to institution. No emotions should be involved while choosing asset mix. Let us take a hypothetical example.

Mike Gates from the US is a 35-year old senior executive in a well-established pharmaceutical company. He has received a windfall gain of $1,000,000 from stock options. His total surplus is $1,000,000 and he has to decide about the investments to be made out of this.

His risk tolerance is above average and expects to receive above average returns from the investment. He wants to retire by age 60 and would like to invest the surplus for his retirement needs. He requires a little liquidity for his lifestyle needs. It is assumed that he has no tax concerns. He has no other constraints, like supporting a family financially.

What kind of asset allocation would be suitable to Mike Gates? Mike is young and the potential to earn future income is very high. His risk tolerance and expected return are above average and as such he can put a higher share in equities, say 65 per cent of $1,000,000 surplus. The remaining can be put in bonds, real estate and commodities. Periodic interest from the bonds (fixed income) and salary income will take care of his liquidity needs. The following asset allocation is suggested for Mike:

Note: The above graph is only for illustrative purposes

Related: Understanding Asset Allocation 14Oct2012

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http://www.scribd.com/vrk100

Connect with him on twitter @vrk100

Speed Read: What is Asset Allocation?

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Speed Read: What is Asset Allocation?

Simply put, asset allocation is distribution of investible surplus money into various asset classes, such as equities, commodities, bonds, or real estate. The purpose of asset allocation is to achieve an investor’s objectives from investments and to moderate investment risks.

Let us assume an individual investor has $ 1,000,000 of available funds to invest in some asset classes. She has to make a decision regarding the asset mix – how much amount to put in equities, how much in bonds or commodities or how much in other asset classes. While deciding the asset mix, she needs to keep in mind her investment goals, her risk appetite, time period of investments, tax concerns and her personal situation.

Institutional investors also, more or less, follow a similar approach though institutional investors have larger resources, their investment universe is bigger, they have higher regulatory hurdles, and they have both assets and liabilities to take care of more seriously.

Asset allocation is not static, it is a dynamic process. It is an important part of an investor’s portfolio management process. Before deciding on the asset allocation, the following aspects need to be examined thoroughly:

1. Risk tolerance – the ability and willingness to take risk

2. Expected return – the expected return from the proposed investments

3. Liquidity needs – any requirement for cash in the near term

4. Tax concerns – tax concessions, if any or the investor’s tax bracket

5. Personal situation – e.g., an investor has no time or expertise

6. Time horizon – investment’s time period like, one year, 5 years or more

There are several types of asset allocation. Strategic asset allocation (SAA) involves specifying an investor’s long-term return objectives, depending on investor’s ability & willingness to take risk, market expectations and investment constraints.

Another major type of asset allocation is tactical asset allocation, which focuses on making short-term changes to weights of asset classes based on short-term view on market performance of selected asset classes.

Related: Understanding Asset Allocation 14Oct2012

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Connect with him on twitter @vrk100

Speed Read: What are Asset Classes?

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What are Asset Classes?

The broad asset classes are equities or shares, bonds or fixed income, cash & cash equivalents, real estate and alternative investments.

Cash equivalents are investments in liquid instruments, for example, US Treasury bills. Alternative investments can be further classified as commodities (like gold, silver, crude oil, copper, coffee, and soyabean), currencies, private equity and hedge funds’ derivative strategies.

Shares and bonds can be subdivided into assets in emerging markets, developed markets or frontier markets. In fact, one can subdivide these broad asset classes into several kinds of narrow asset classes – for example, large cap stocks, mid cap stocks, growth or value stocks, non-US bonds or treasury-inflation protection securities (TIPS).

What are the Features of Asset Classes?

Different asset classes have different features. Investment in real estate is highly illiquid in general; whereas investment in large-cap equity shares is highly liquid – in the sense that investments can be converted into cash easily and immediately.

This table gives a broad overview of liquidity, risk and return parameters of some asset classes:

Asset Class	Liquidity	Short-term return	Long-term return	Short-term risk	Long-term risk

Large cap equity shares	High	Uncertain	High	High	Low to Moderate
Mid cap equity shares	Moderate	Uncertain	High	Very High	Moderate to High
Real estate	Low	Uncertain	Moderate to High	Low to Moderate	Moderate to High
Commodities	High	Uncertain	Moderate to High	Moderate to High	Low to Moderate
Govt. Bonds (long term)	Low to Moderate	Low	Moderate	Low	Low to Moderate
Govt. Bonds (short term)	High	Low to Moderate	Low to Moderate	Low	Low
Cash	Very High	Low	Low	Low	Low

Note: The above table is only for illustrative purposes

1. Short-term returns on equities, real estate and commodities are uncertain – but the chances of getting attractive and superior returns from them in the long-term is high

2. From a risk point of view, the risk of losing one’s money in the short-term is higher in case of equities and commodities

3. Cash entails low risk and return, but offers higher liquidity

4. Government bonds bear no default risk, but have interest rate risk – the latter risk is higher for long-term bonds

5. As we have experienced in the past few years, even government/sovereign bonds may suffer huge risk – for example, as in Greece, Spain, and Portugal, following the ongoing euro crisis

Related: Understanding Asset Allocation 14Oct2012

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The following images (from old files) are included here after 06Oct2020 for reference purpose >

These images are sourced from various web sources >

These images are just for information purposes only, this is not investment advice. Readers should consult their own advisers for advice before making any investment decisions.

http://ramakrishnavadlamudi.blogspot.com

http://www.scribd.com/vrk100

Connect with him on twitter @vrk100