15.3.3 Combining Securities In Portfolio

Combining Securities In a Portfolio

This section integrates the concepts of risk and return within portfolio management, highlighting the selection of securities based on their collective contribution rather than individual merit. Effective portfolio management suggests that the interplay among securities can cumulatively achieve greater returns than individual investments.

Risk in Single Security Investments

Investors placing all their savings in a single security expose their entire portfolio to substantial risk. For instance:

• Equity Securities: Subject to business and market risks.
• Debt Securities: Exposed to default and interest rate risks.

Such concentrated investments carry inherent risks but can be mitigated through careful diversification. However, simply holding multiple similar-risk securities does not achieve optimum diversification.

Diversification Not A Panacea

Although diversification can significantly reduce risk, the benefit diminishes as more securities are added. Ultimately, a stage is reached where further diversification does not result in considerable risk reduction.

Correlation

Correlation is a statistical measure indicating how the returns of two securities move in relation to one another. It is crucial in portfolio management, particularly in assessing how securities combined within a portfolio influence its total risk and return.

• Perfect Positive Correlation (+1): If securities move in the same direction and proportion, they hold a perfect positive correlation, as denoted by +1.

An example cases:

1Your client has invested 100% in a gold mining stock. To diversify, she preferences another gold mining stock. However, due to perfect positive correlation tied to gold prices, diversification is inadequate.

• Perfect Negative Correlation (-1): Preferred for diversification, as securities move in opposite directions proportionally. Holdings with such correlations reduce total portfolio variability and risk.

Another situation scenarios:

1Your client balances a portfolio with airline and bus company stocks. In strong economies, airline stock value rises, while bus company stock decreases. In a downturn, the inverse occurs, balancing the portfolio significantly.

Systematic Risk in Diversified Portfolios

However, perfect negative correlation securities are rare, leaving portfolios subjected to systematic risk - the inevitable market-wide risk. The risk reduction main point detail can be by adding securities visualized using the following diagram:

    graph LR
	  A[Total Portfolio Risk] -->|Number of Securities added, diminishes risk| B(Systematic Risk)

Portfolio Beta

Discussing previously, beta measures an equity or its portfolio’s volatility relative to the market, indicating the extent of its return changes per market change.

• Beta of 1.0: Represents benchmark market volatility.
• Beta > 1.0: Indicates greater volatility than the market.
• Beta < 1.0: Indicates less volatility comparatively.

Illustrated beta application examples:

1- S&P/TSX rises by 10%, equity fund (beta 1.0) anticipates a 10% similar rise.
2- S&P/TSX falls by 5%, equity fund (beta 1.0) forecasts a 5% decline.
3- High beta economically cyclical industries versus low beta defensively on market conditions.

Portfolio Alpha

Portfolio Alpha represents excess return attributed to strategies and management skill beyond market-explainable (beta) movements.

Alpha denotes the superior performance, reflecting the advisor’s or manager’s security selection skill pro portraits net excess returns.

1Alpha = Actual Portfolio Return - (Expected Return on beta) 

Key Takeaways

• Effective portfolio diversification and careful correlation comprehension can reduce risk greatly and enhance returns efficiency.
• Portfolio strategies differ fundamentally by impact on overall performance depending market conditions.

Frequently Asked Questions (FAQs)

Q1: What is the importance of diversification in a portfolio?

Diversification decreases total portfolio risk by constructing securities unlikely to perform uniformly under identical conditions.

Q2: Why are perfect negative correlation and positive alpha ideal but rare in real-world portfolios?

Negative correlations perfectly offset each security’s risks - rarely match in practice. Alpha stems from over-performance but isn’t reliably predictable by every manager.

Q3: How does beta influence investment strategy in varying market conditions?

Higher beta favorably aligns in bull markets for enhanced return. In contrast, defensively low beta securities preservation during market downturns.

• Test your understanding attempting portfolio optimization challenges!