DWM Report: Portfolio Diversification and Risk Management in Stock Investing Part 1 of 2
DynamicWManagement - Stock market investors seek diversification for a multitude of reasons. Stock specific risk can be diversified by increasing the number of holdings in order to mitigate the effects of a blow up in any particular stock. However, the greater challenge lies with eradicating systematic or market risk.
Market risk can never be totally eliminated within a stock portfolio however it is possible to decrease the level of correlation within a portfolio. For example, investors could favour small caps over large caps. This is feasible because it is possible to find stocks whose earnings are less exposed to the economy at large. Indeed, it is easy to find counter-cyclical stocks within the small cap universe.
Dynamic Wealth Management Report-Portfolio Diversification and Risk Management in Stock Investing: Another option is to reduce the number of holdings and have a few ‘focused' positions. However, this approach will increase stock specific risk, so it is hard to argue that it is reducing risk.
DynamicWManagement - Non-Correlated Portfolio. Absolute Returns. Equity market risk can be reduced via hedging or other alternative strategies. Indeed, the single most important issue facing investors today may well be how to produce non-directional returns in a world that is becoming increasingly correlated.
DynamicWManagement - Stock Beta. Capital Asset Pricing Model CAPM enthusiasts such as Harry Markowitz would tend to argue that all the profit and price drivers will be captured in the beta of the stock. However, beta-by definition-is always a historical measure and will tell not necessarily predict the future. Markets change and there is an art to identifying and diversifying the profit drivers within a portfolio. Whilst beta will capture some elements, the factors of error in this approach may preclude its usefulness.
DynamicWManagement - Diversifying Investment. The essence of diversifying a portfolio is to diversify the profit drivers within it. Naturally, this approach relies on the corollary that earnings drive prices. The difficult part lies in identifying the profit drivers. The following method is a process based on that taken by the founder of Sony, Akio Morita in Made in Japan: Akio Morita and Sony. The investor discovers the individual profit drivers, he can then seek to diversify them within a portfolio.
Dynamic Wealth Management is an independent investment advisory firm which focuses on global equities and options markets. Our analytical tools, screening techniques, rigorous research methods and committed staff provide solid information to help our clients make the best possible investment decisions. All views, comments, statements and opinions are of the authors. For more information go to www.dynamicwmanagement.com
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