Portfolio Approach to Investing | CFA Level I Portfolio Management

In this lesson, we shall learn the portfolio approach to investing. Please treat this as an introductory lesson. Some new concepts are only described briefly and will be revisited in detail later, so don’t worry if there are things you can’t grasp yet.

Understanding the Portfolio Approach

You’ve probably heard of this saying: “Don’t put all your eggs in one basket.” That is essentially the gist of portfolio management. An investor who places all his bets in a single stock is not taking the portfolio approach. He risks heavy losses if the basket breaks. When an investor takes a portfolio approach or perspective, he does not only hold a diversified portfolio of investments, but he also evaluates individual investments by their contribution to the risk and return of his entire portfolio.

Why Portfolio Approach is Important

So why is this important? The obvious reason is that diversification helps investors avoid disastrous investment outcomes. There is no shortage of examples, but this is more commonly observed in business owners or lifetime employees of a company. Such individuals tend to hold too much of their company’s shares, such that if the company goes bankrupt, they lose not just their jobs, but also a large portion of their investment portfolio. Investors can avoid such situations by taking a diversified portfolio approach, which is able to reduce the overall risk associated with their wealth, without necessarily decreasing their expected rate of return.

Diversification in Action

So how is this possible? Consider a portfolio of 3 different assets. If we calculate each of their mean annual returns and standard deviations for the period, we get the following figures. The average of the 3 assets will be as such. So guess what is the risk and return for a portfolio of these 3 assets in equal proportion? The portfolio return is, as expected, the average return of the 3 assets of 15%, but the standard deviation is actually lower than the average of the 3 standard deviations. This is an illustration of how risk is reduced, but not the expected rate of return when we diversify across assets. Studies of past returns on major markets conclusively support this.

Diversification Ratio

One measure of the benefits of diversification is the diversification ratio. It is calculated as the ratio of the standard deviation of the equally weighted portfolio to the standard deviation of the randomly selected security, which can be replaced by the average standard deviation of all the securities in the portfolio.

Diversification Ratio = Std dev of equal weighted portfolio / Std dev of randomly selected security

So for our example above, the diversification ratio is 18%/24%, which is 0.75. This means that the portfolio’s standard deviation is 75% of that of a security selected at random. Obviously, the lower the ratio, the higher the diversification benefit.

Global Minimum Variance Portfolio

One important thing to note is that an equal-weighted portfolio is not necessarily the portfolio that has the lowest possible standard deviation for this set of assets. There lies a set of weights that produces the minimum portfolio standard deviation for this group of assets, and computer optimisation techniques can be used to calculate them. This is known as the global minimum variance portfolio, which we will learn later in this course.

Correlation and Diversification

Besides the weightage, another major factor that influences the effectiveness of diversification is the correlation of returns between the various securities. When the returns between assets are highly correlated, the benefits of diversification diminish. Conversely, when the return between assets have little correlation, the benefits of diversification increase.

However, even if a portfolio is made up of assets that have little correlation with each other, correlations tend to increase during periods of market turmoil. In the 2008 global financial crisis, almost all risky assets fell in value as investors panic and rush for the exits. So as you can see, downside protection is limited, even for a well-diversified portfolio.

Modern Portfolio Theory (MPT)

And that brings us to the modern portfolio theory. One of the principles of MPT is that some of the risk in assets is non-diversifiable, known as systematic risk. The asset-specific risk is diversifiable as we increase the number of securities in the portfolio. The main conclusion of MPT is that investors should focus on how individual securities in the portfolios are related to one another in order to achieve maximum benefit of diversification, which is to reduce the asset-specific risk of the portfolio.

And that’s our introduction to portfolio management. We shall go deeper into some of these concepts in the rest of the course.