Safe Investment??

(A case study on Risk of Diversification)

Introduction: Equity shares are issued by limited liability companies as risk capital. Shareholders have voting rights and collectively, therefore, have control of the company. They have the right to share in any distribution of dividend, in proportion to their percentage shareholding, and they have the right to a proportion of any residual assets in the case of dissolution. A key characteristic of equities is that both future dividend income and future share values are at all times uncertain. It is for this reason that equity investors seek a higher expected return than that which is available on alternative risk-free investments. Investors accept that there is uncertainty, or risk, associated with equity investment returns. Consequently, equities are normally priced so that they provide a premium to the returns available on risk-free investments. Equity returns, however, are cyclical. There can be long periods when equity returns greatly exceed risk-free returns; there can also be long periods when the premium disappears altogether. Rational investors hold portfolio of securities rather than single investments to mitigate the risk. As the stock market benchmark, equity index is a collection of stocks that can be taken as a proxy portfolio for the overall economy. Summary Statistics for LSE and NYSE Equities

The above table drawn from Goetzmann and Ibbotson (2006), shows that the long-term, annual, geometric capital appreciation of London Stock Exchange (LSE) equities over the total period was 2.1%; the equivalent average for New York Stock Exchange (NYSE) equities was 3.9%. The annual standard deviations in annual performances were 15.7% and 18.4% respectively. It is particularly interesting to note that the appreciation rate in LSE equities was much lower than that of NYSE equities over the eighteenth and nineteenth centuries but more than matched the appreciation rate of NYSE equities over the twentieth century. The standard deviation in returns for both markets was higher during the twentieth century than during earlier periods (AB Fitzgerald, 2009). Investment in stocks can be risky. The return on investment (ROI) of stock can be hard to predict, as the price of stock is determined by the financial success of the company, the demand for that companys stock by investors, and the overall confidence investors have in the market at a given moment. Investment in the stock market depends as much upon factual, logical decisions as well as gut-feeling emotional ones. Because of its relative unpredictability and therefore inherent possibility for huge returns, the stock market is one of the most popular investment decisions among private investors. The stock markets constant fluctuation empowers investors with a multitude of opportunities for

substantial profits. This possibility of high returns and the unpredictability of the market are enticing to excitable investors, however with wise decision-making, the stock market can be a stable, long-term investment opportunity as well. For this reason, there are many stock market investment strategies that help investors make tough decisions. The stock market investment strategies are relevant to investors who are in it for the long haul. There are basically two strategies that an investor can apply; the first one being to "buy low and sell high" and the second one being to "buy high and sell higher". There are plenty of stock market investing strategies that can be extremely profitable, but it requires making decisions based on reason and not emotion. Smart investors diversify their asset holdings by owning a portfolio, which are a collection of financial assets consisting of stocks, bonds, gold, foreign exchange, asset-backed securities, real estate certificates and bank deposits.

Portfolio Diversification is the means by which investors minimize or eliminate their exposure to company-specific risk, minimize or reduce systematic risk and moderate the short-term effects of individual asset class performance on portfolio value. In a well-conceived portfolio, this can be accomplished at a minimal cost in terms of expected return. Such a portfolio would be considered to be a well-diversified. Although the concepts relevant to portfolio diversification are customarily explained with respect to the stock markets, the same underlying principals apply to all types of investments. For example, corporate bonds have specific risk that can be diversified away in the same manner as that of stocks.

Smart investors explore alternatives to beat the street. Broadly speaking, these alternatives include asset-classes or investment strategies that fall into at least one of the four categories: Real estate-related investments, which directly or indirectly participate in the income and/or capital appreciation potential of land and buildings.
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Commodities-related investments tied directly or indirectly to the performance of agro products, livestock, natural resources, metals and the companies that process these.

Nontraditional asset classes, or investments linked to stock and bond asset classes that are not as widely analyzed and utilized by the majority of investors and, generally speaking, typically are not included in asset allocation programs.

Nontraditional investment strategies. Unlike the three groups above, these are not assetclasses but a style of investment. They are investments that often invest in the traditional asset classes but manage their holdings with strategies not generally used by traditional portfolio managers (e.g., mutual fund managers).

Asset Class definition is dependent on the context in which the term is used, the investment strategy employed in the management of a portfolio, and to some extent, the person who is rendering the definition. Suffice it to say that asset classes are significantly different investments. Investors hold a variety of significantly different investments that are not highly correlated with each other and investment diversification within asset classes is to the degree at which specific risk has virtually been eliminated within each class. Assets that are not highly correlated are considered to be complementary, as they complement one another as constituents of a portfolio, forming a unit that dominates the individual assets on a risk-to-return basis.

In an effort to exploit market inefficiencies and trends or to reduce downside risk, these investments may use leverage (i.e., debt or borrowed money), derivatives, arbitrage, shortselling, intense concentration, tactical allocation or other approaches. They may also make direct investments in small, start-up businesses or use capital to purchase companies outright.

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays off when energy prices rise and another that pays off when energy prices fall. A portfolio that contains both assets will always pay off, regardless of whether energy prices rise or fall. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio. In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's nest egg. Modern portfolio theory states that the risk for individual stock returns has two components: Systematic (Non-diversifiable Risk) and Unsystematic (Diversifiable Risk). Systematic risk originates from macroeconomic variables such as interest rates, inflation rates and exchange rates while Unsystematic risk is companyspecific risk of the stock. It can be diversified away by adding more stocks in an equity portfolio. International diversification provides a good example of the effects of diversifying across asset classes. A portfolio invested 50% in domestic large-cap stocks and 50% in international largecap stocks would have approximately half the residual risk of a portfolio comprised solely of domestic large-cap stocks, assuming that the investments in each market were sufficiently diversified to eliminate specific risk. Some investors may choose to be exposed to specific risk

with the expectation of realizing higher returns. But this is contrary to financial theory and such investors are therefore deemed to be irrational. Deliberate exposure to specific risk is unnecessary and is essentially gambling. Thus, the residual risk of a portfolio should be equal to market risk, a.k.a. systematic risk, and systematic risk can be reduced by investing over a broader market, i.e., a larger universe.

Traditional asset pricing theories suggest that only non-diversifiable risk is priced. In solving for equilibrium where investors are able to diversify all risks except market risk, these models often rely on strong assumptions (e.g., homogenous beliefs, perfect markets). In the case of the capital asset pricing model (CAPM), such assumptions allow for a simple expression of expected returns as a function of a firms market risk. While these models have strong intuitive appeal, empirical work has struggled to support the notion that only risk related to a systematic market factor is priced. In addition, several empirically-motivated risk factors (e.g., size, book-to-market) have been proposed based on consistent evidence that they significantly explain expected returns (Fama and French, 2004).

One possible explanation for deviations from the CAPM is that investors are constrained in some way from holding diversified portfolios (e.g., Levy, 1978; Merton, 1987; Malkiel and Xu, 2006; Fama and French, 2007). For example, Fama and French (2007) conclude that distortions of expected returns away from the theoretical models can be large when investors with asset tastes account for substantial invested wealth and take positions much different from the market portfolio. If a firms investors are unable or unwilling to diversify away a particular type of risk, then the firms exposure to this risk should be related to its expected returns.

For a well-diversified portfolio, the risk - or average deviation from the mean - of each stock contributes little to portfolio risk. Instead, it is the difference - or covariance - between individual stock's levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks.

In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3290 securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n. Their results are summarized below. It can be seen that most of the gains from diversification come for n30.

Number of Stocks Average Standard Deviation of Ratio of Portfolio Standard Deviation to in Portfolio Annual Portfolio Returns Standard Deviation of a Single Stock 1 49.24% 1.00 2 37.36 0.76 4 29.69 0.60 6 26.64 0.54 8 24.98 0.51 10 23.93 0.49 20 21.68 0.44

30 40 50 400 500 1000

20.87 20.46 20.20 19.29 19.27 19.21

0.42 0.42 0.41 0.39 0.39 0.39

Moderate the Effects of Individual Asset Classes: Moderating the effect of individual asset class performance on portfolio value is another benefit of portfolio diversification. This is desirable because the lower the variance of our portfolio value, the greater the certainty of its value at any given time, which is extremely important if we have a need to liquidate all or part of our portfolio for some reason, not to mention the fact that lower variation will reduce stress and anxiety. If, for example, we blend five assets that are not highly correlated and all of those assets have expected returns of 12% and standard deviations of 10%, our expected return will be 12% but the standard deviation of our portfolio's returns will be significantly less than 10%. If the assets were only slightly correlated and/or negatively correlated, our portfolio standard deviation would be very significantly less than 10%. Individually, these assets are equivalent investments based on their risk and return, but together they form an investment that is superior to each of the individual assets, which can be attributed to the lack of perfect correlation between the assets. As we don't get to select our holding periods after the fact, it's desirable to insure ourselves against the probability of liquidating at a time when under-performance outweighs overperformance within our holding periods. This is where the correlation between asset classes really comes into play. Asset classes that are not highly correlated can be expected to under- and over-perform at different times. Thus, holding a variety of asset classes that are not highly

correlated is insurance against the probability of having a low terminal value when liquidation occurs during or shortly after a period of under-performance of a minority of the asset classes in a portfolio. In such cases, the other asset classes should moderate or fully offset the effects of the under-performing asset class or classes. Core Assets: When examining a complete portfolio it is imperative to consider fully the important factors that comprise core investable assets. Dr. David Swensen, the Nobel Price winner in economics, has identified three characteristics of core assets that should be part of our evaluation to help reduce systematic or market risk. Use assets to hedge the market risk of other assets. For example, real estate is a good hedge against the ravages of inflation, while bonds offer protection from a financial crisis. By recognizing these inherent characteristics of our core assets, we can hedge some of the market risk inherent in an investing portfolio. There should be fundamentally based market returns from the asset class. If we are depending only on active management of the asset class, we are increasing the risk of losses by not being investing in the market. Rely on liquid markets where there is a ready market to buy and sell our core asset. Assets that cannot be immediately priced and sold, are subject to sudden and deep losses. Liquid markets give us the opportunity to employ stop loss techniques should the market turn against us as in a recession.

How many asset classes are enough? : The number of asset classes required to achieve the desired level of portfolio diversification depends on the degree of correlation between the asset classes which comprise our investment universe. The lower the degree of correlation, the greater the potential for diversification and the fewer the number of asset classes required to achieve the desired level of diversification. And the broader our universe, the higher our expected rate of return for any given level of risk, although this does have some limitations. If our universe is very broad, it's quite likely that optimizing our asset allocation at a given level of risk will result in a zero allocation for one or more of the assets. In such cases, further diversification would lead to over-diversification. So it is indeed possible to have too much of a good thing. Over-diversification is addressed below. Our investment universe is the group of asset classes from which we select our investments. At this point it's important to realize that the correlations of individual assets may vary considerably from the correlations of their respective asset classes. So, although asset class correlations provide a good means of defining our universe, the final selection of assets must be based on the correlations of the individual assets. One thing to keep in mind about asset correlations is that they are by no means static. Correlations can and do change over time, and sometimes the magnitude of change can be relatively large. But even a relatively small change can have a significant impact on portfolio models. This is one case where using a long time series can work against us unless we adjust for any trends that may be present in asset correlations. Therefore, it's better to use correlations calculated from recent data and update regularly. Changing correlations will affect the dynamics

of our portfolio and need to be responded to by changing allocations and in some cases, replacing some of the assets in our portfolio. The desired level of portfolio diversification will be defined in part by our risk profile, i.e., our tolerance for risk. At the level of risk that is right for us, a properly blended portfolio of complementary assets will have a higher expected return than any individual assets with the same level of risk drawn from the same universe. Over-Diversification: Over-diversification can occur when two or more investments overlap. For example: If we hold an index fund that tracks the Wilshire 5000, investing in any other actively traded U.S. stocks will result in overlap and over-diversification. Owning a Wilshire 5000 index fund and a U.S. technology fund wouldn't necessarily double our investment in U.S. technology stocks, as the Wilshire 5000 is capitalization weighted and most non index funds are not, but we would have a significant overlap in the technology sector. This is more likely with mutual funds but it also can occur with the securities of large diversified corporations. A Well-Diversified Portfolio: A well diversified portfolio is dependent upon factors that are unique to each investor. Those factors include: risk tolerance, targeted terminal wealth, investment horizon (planned holding period) and the universe an individual is willing to accept as the pool from which they will select their assets. A well-diversified portfolio should be diversified within asset classes to the degree at which specific risk has virtually been eliminated, and diversification across asset classes should be such that the residual risk of the portfolio is consistent with the investors risk tolerance. The residual risk of a portfolio will diminish as asset classes are added to the investment universe, but there is a point of diminishing returns and there

are a finite number of asset classes, which implies that there is a point beyond which no further reduction of residual risk can be achieved. A portfolio would be fully diversified at this point. Diversification can lower the variance of a portfolio's return below what it would be if the entire portfolio were invested in the asset with the lowest variance of return, even if the assets' returns are uncorrelated. For example, let asset X have stochastic return x and asset Y have stochastic

return y, with respective return variances

and

. If the fraction q of a one-unit (e.g. one-

million-dollar) portfolio is placed in asset X and the fraction 1 q is placed in Y, the stochastic portfolio return is qx + (1 q)y. If x and y are uncorrelated, the variance of portfolio return is

The variance-minimizing value of q is

, which is strictly between 0 and 1.

Using this value of q in the expression for the variance of portfolio return gives the latter as

, which is less than what it would be at either of the undiversified values q = 1

and q = 0 (which respectively give portfolio return variance of

and

). Note that the

favorable effect of diversification on portfolio variance would be enhanced if x and y were negatively correlated but diminished (though not necessarily eliminated) if they were positively correlated. In general, the presence of more assets in a portfolio leads to greater diversification benefits, as can be seen by considering portfolio variance as a function of n, the number of assets. For example, if all assets' returns are mutually uncorrelated and have identical variances ,

portfolio variance is minimized by holding all assets in the equal proportions 1 / n. Then the portfolio return's variance equals var[(1 / n)x1 + (1 / n)x2 + ... + (1 / n)xn] = which is monotonically decreasing in n. The latter analysis can be adapted to show why adding uncorrelated risky assets to a portfolio, thereby increasing the portfolio's size, is not diversification, which involves subdividing the portfolio among many smaller investments. In the case of adding investments, the portfolio's return is the portfolio return instead of (1 / n)x1 + (1 / n)x2 + ... + (1 / n)xn, and the variance of if the assets are uncorrelated is = ,

which is increasing in n rather than decreasing. Thus, for example, when an insurance company adds more and more uncorrelated policies to its portfolio, this expansion does not itself represent diversification. Rational investors would like to drive down risks associated with a single investment by blending with other investments in the same category of assets to form portfolio of equities. Despite holding a portfolio of equity shares, there would still be variance of returns warranting addition of other class of assets to the portfolio. Equity investors add fixed income securities to their portfolio to reduce the volatility of returns. This diversification strategy of adding different class of assets to optimize the portfolio returns while mitigating risk is considered to be a safer bet as the overall returns get normalized. Institutional investors take this diversification further by including commodities in the portfolio as commodities are a good hedge against inflation. Diversification helps investors to take advantage of the 'ups' while moderating the 'downs'. Simply put, diversification is not putting all

your eggs in one basket. Or not putting all your money into just one type of investment. All investments are subject to some level of risk. Some are more risky than others. Different types of investments perform better under different market conditions. By investing in more than one type of investment you diversify, which can help reduce the risk for your overall investment portfolio. When constructing an investment portfolio around the traditional assets, risk can be removed by spreading allocations across a selection, or a complete range of alternatives, but two problems have hindered this strategy:

Correlation: Asset price correlations are not static, and can be very unpredictable. Liquidity: Asset classes such as Structured Products, Property, PE Funds, and Hedge Funds can be illiquid, particularly if their values are falling.

The rise of commodities as an asset class in portfolio investment has resulted in commodity prices becoming intimately linked to price behavior in equities and other financial markets (Gorton and Rouwenhorst 2004; Domanski and Heath 2007; Doyle, Hill et al. 2007). Commodities and equities are distinct asset classes, influenced by a similar set of factors, namely global GDP, but in different ways. Commodities tend to perform well in times of inflation, as increasing natural resource prices typically cause product prices to increase. Periods of inflation are generally accompanied by rising interest rates, which control the inflation that generally creates a challenging environment for equities. Conversely, periods of low interest rates and low inflation or deflation are normally bullish for equities and bearish for commodities. In times of extreme panic or market distress however, the correlation between stocks and commodities tends to increase as investors decide between risk-on or risk-of attitudes, as opposed to fundamentals.

Das and Uppal (2004) claim that jumps typically occur across markets at the same time having a large impact on correlations and covariances. As global market volatility continues, investors of diversified portfolios are continually looking for uncorrelated investments in an attempt to reduce unsystematic risk and improve the risk/return profile of the total portfolio. Many investors have looked to the alternative asset classes as a way to provide this sought-after diversification. Alternative investments such as private equity and real estate have been a key part of institutional portfolios for over 20 years, but there continues to be a search for newer opportunities in the Commodities space. According to Bloomberg, California Public Employees' Retirement System, a $240 billion pension fund, is planning to increase its Commodities investment to $7.2 billion (3% of its assets) through 2010.

Commodity investments, which fall under the real assets category of the alternative asset class, have many characteristics that make them attractive to institutional investors. Commodities are broken into several main categories such as energy, agriculture, livestock and metals. These groupings are comprised of numerous raw materials, including natural gas, crude oil, aluminum, copper and gold. Investment in this asset class is typically gained through the use of commodity futures. The Dow Jones AIG Commodity Index and the S&P GSCI Commodity Index, which are the global benchmark indices, show very low/negative correlation with several other asset classes that are typically part of a broadly diversified portfolio, including equity, fixed income and real estate. This characteristic, combined with consistently positive returns, will serve to lower the overall volatility and improve the risk-adjusted returns of a total plan portfolio.

The subprime crisis that originated in USA during 2007-08 had a huge impact on financial markets worldwide and the global economies. During the crisis, volatility of S&P 500 implied in option prices rose from the usual 15-30% range to 40-80%. It has been shown that large jumps exert huge influence on correlation dynamics and volatility forecasts (Eraker, Johannes and Polson, 2003, and Maheu and McCurdy, 2004). In the derivative markets, jump commands a huge premium especially in a market that has just experienced a jump (Todorov, 2009). Das and Uppal (2004) claim that jumps typically occur across markets at the same time having a large impact on correlations and covariances. Hence my research is most relevant as even the most diversified investment portfolios across geographical markets and asset-classes had made most institutional investors suffer huge losses. One probable explanation for this could be that the correlation coefficients in the aftermath of the economic crisis had been much higher than what was witnessed historically. Case against Diversification: Talk with any investment advisor, and what's the first piece of advice you will hear? Diversify your portfolio. The case for diversification is repeated so often that it's come to be thought of as an indisputable rule. Hardly anyone makes the case against diversifying your portfolio. It is repeated daily that global diversification is self evidently an intelligent approach to investing. In brief, goes the line, an investor should not restrict himself to domestic stocks and bonds but also buy stocks and bonds of as many other countries as possible to spread the risk and ensure safety. According to Bob Prechter, Diversification for its own sake means you dont know what youre doing. The proper approach is to take everything you can out of anticipated trends, using indicators that help you do that. Those times you make a mistake will be made up many times over by the successful investments you make.

Despite near-unanimous endorsement among mainstream advisors, the strategy of portfolio diversification has a huge, glaring flaw, viz., when large sums of liquidity begin to flow into global investment markets, formerly disparate trends become strongly correlated. And markets that go up together ultimately go down together; in turn, the value of diversified portfolios goes down with them. For years now, Wall Street has tap-danced around the liquidity risk. Here's how former Citigroup CEO Charles Prince described it in July 2007: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance." Three months later, Prince announced that Citigroup's quarterly earnings would be down 60%. Diversified investors around the world were feeling the liquidity crunch. But after many miserable months for stock and commodity investors, the markets rebounded together - almost in lock-step. Commodities lifted off in late 2008, and stocks followed in March 2009. Everything that declined together was going up together. "Liquidity with respect to stocks has become indiscriminate," reported a widely respected market technician. "When money's flowing in, they all go up. When money's flowing out, they all go down." Mainstream investors finally began to recognize the phenomenon Elliott Wave International's Robert Prechter warned about in his 2002 best-seller, Conquer the Crash. Turns out, now almost 10 years after Prechter coined the phenomenon "All The Same Markets," the correlation is still positive. Unfortunately for millions of diversified investors, the outlook is not According to a new report authored by Prechter and his EWI colleagues, the second round of liquidity crisis is fast approaching and perhaps has already begun.

The Elliott Wave Theorist's position has been that successful investing requires one thing: anticipating successful investments, which requires that one must have a method of choosing them. Sometimes that means holding many investments, sometimes few. Recommending diversification so that novices can reduce risk is like recommending that novice skydivers strap a pillow to their backsides to reduce risk. Wouldnt it be more helpful to advise them to avoid skydiving until they have learned all about it? Novices should not be investing; they should be saving, which means acting to protect their principal, not to generate a return when they dont know how. For the knowledgeable investor, diversification for its own sake merely reduces profits. Therefore, anyone championing investment diversification for the sake of safety and no other reason has no method for choosing investments, no method of forming a market opinion, and should not be in the money management business. Objectives: Commodities have historically provided an excellent diversification benefit when combined with the traditional asset classes. As institutional investors have discovered these phenomena, they have been constructing optimal portfolios with historical data to maximize returns and minimize risk. The proposed case study tries to determine: Whether equities and commodities (UK and USA) still move in the same direction? Whether equity markets across countries (UK and USA) move in the same direction?

Methodology: The proposed research to track the co-movement of equities and commodities across geographical markets has identified three variables to measure the benefits of a diversification strategy. These variables are popular indices like FTSE 100 and DJIA 30 (equity

market benchmarks for UK and USA) and the S&P GSCI Commodity Index (global commodity benchmarks). The period of study has been restricted to the calendar years 2005-2009 where monthly data has been sourced from www.bloomberg.com. When we diversify across asset classes that are not perfectly correlated (that is, have a correlation coefficient less than +1) the volatility of the portfolios returns will be less than the weighted sum of the volatilities of the individual asset classes. All other things being equal, the lower the correlation between the different asset classes the greater the diversification benefits will be. The theoretical benefits available when investing between two asset classes are shown in the diagram below for differing magnitudes of correlation coefficient.

As the level of correlation between asset classes A and B reduces, the diversification benefits increase and we are able to reduce the level of the portfolios volatility whilst still maintaining the same expected level of return. Domestic institutional investors in UK would diversify across equity markets to optimize their portfolios. Hence, correlation coefficient between FTSE and DJIA would enable us to know if such a diversification strategy pays-off in the long run.

Furthermore, they would also spread their investment bets across different class of assets primarily such as, equities and commodities. A study of multiple correlation coefficients between FTSE, DJIA, and S&P GSCI will give us the insight about optimal returns through diversification across two different asset-classes. If the correlation/multiple correlation is low or negative, it indicates that there are rich opportunities to explore through diversification of portfolios across geographical markets and different asset-classes.