Investors have to ensure their investments achieve their future needs. Irrespective of what the future financial goals are, a portfolio approach to investment decision making to create a diversified investment portfolio is important.
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.
Diversified portfolios have a lower portfolio risk or volatility (as measured by standard deviation) than any one 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.
Each individual security has a historic risk and return profile. By combining securities within a portfolio, we can produce a risk and return profile for the portfolio itself. Through an examination of different portfolios – allocating different percentages to the underlying securities – we can determine the portfolio composition that produces the best risk-return profile.
Portfolio diversification is not an absolute failsafe for investors. During times of market turmoil, a diversified portfolio may not protect an investor from losses. The reduction in risk as a result of portfolio diversification comes about due to the uncorrelated nature of the individual portfolio holdings. However, this correlation is not fixed and when markets are stressed, as was the case during the 2007-2008 financial crisis, previously uncorrelated assets can become correlated. This is known as contagion and in 2008, global assets experienced price declines simultaneously proving portfolio diversification not to be as effective as the mathematical models previously suggested.
The Modern Portfolio Theory
Although adopting a portfolio approach to investing seems intuitive, the theory behind this diversification concept follows the work of Harry Markowitz’s 1952 publication and is now known as Modern Portfolio Theory (MPT). The principle concept is that investors should not only hold portfolios but should also focus on the relationship between the individual securities within the portfolio. MPT has its limitation but continues to be a cornerstone for portfolio managers.
A portfolio approach to investing provides which of the following benefits?
A. The highest investment returns
B. Protection against investment losses
C. A reduction in risk during normal market conditions
The correct answer is C.
A diversified portfolio reduces risk without needing to compromise on investment returns but will not completely protect against investment losses during times of market turmoil.
Reading 38 LOS 38a:
Describe the portfolio approach to investing