Portfolio Approach to Investing

Investors have to ensure their investments achieve their future needs. A portfolio approach to investment decision-making is important regardless of future financial goals. It enables an investor to create a diversified investment portfolio.

Portfolio Diversification

The benefits of a diversified portfolio are best summarized by the anecdotal wisdom of “don’t put all your eggs in one basket.” If a portfolio is too heavily allocated to one individual security, and that security fails for some reason, an investment portfolio can be reduced to zero. Diversification allows investors to spread some of the downside risk associated with any one investment position without necessarily decreasing the expected rate of return.

Reducing Risk

Diversified portfolios have a lower portfolio risk or volatility (as measured by standard deviation) than any individual position within the portfolio. Due to the statistical relationship or interactions between individual portfolio positions (correlation), the overall volatility is lowered by including multiple positions within a portfolio.

Composition Matters

Each security has a historical risk and return profile. By combining securities within a portfolio, we can produce a risk and return profile for the portfolio itself. Through examination of different portfolios – allocating different percentages to the underlying securities – we can determine the portfolio composition that produces the best risk-return profile.

Downside Protection

Portfolio diversification is not an absolute failsafe for investors. A diversified portfolio may not protect an investor from losses during market turmoil. The reduction in risk as a result of portfolio diversification comes about due to the uncorrelated nature of individual portfolio holdings. However, this correlation is not fixed. As was the case during the 2007-2008 financial crisis, previously uncorrelated assets can become correlated when markets are stressed.  This is known as contagion, and in 2008, global assets experienced price declines. This proved that portfolio diversification is not as effective as the mathematical models had previously suggested.

The Modern Portfolio Theory

Although adopting a portfolio approach to investing seems intuitive, there is a theory behind it. The diversification concept follows the work of Harry Markowitz’s 1952 publication and is known as Modern Portfolio Theory (MPT). The principle concept is that investors should not only hold portfolios but also focus on the relationship among the individual securities within the portfolio. MPT has its limitation but continues to be a cornerstone for portfolio managers.

Question

A portfolio approach to investing provides which of the following benefits?

1. The highest investment returns.
2. Protection against investment losses.
3. A reduction in risk during normal market conditions.

Solution

The correct answer is C.

A diversified portfolio reduces risk without compromising investment returns. However, it does not completely protect an investor against investment losses during times of market turmoil.