Business Investing case study
Business Investing case study
Title: Business Investing
Release Date: 2010-8-26 15:10:37
Paper Language: English
Countries: Australia
Areas of expertise: Financial investment
Paper use: MA dissertation
Deadline for submissions:5 May 2007
words required: 1,607 words
School Background: sydney university
Refer to the essay below::
LP Diversifying allows investors to tuck into tasty returns while reducing the risk of reflux - if it's done properly. Simon Hoyle reports.
WHEN it comes to investing, the closest thing you'll ever get to a free lunch is the reward you get from diversifying your investment portfolio smartly. Correct diversification can help reduce the overall risk of your investments without affecting their returns.
TD But recent analysis by the financial planning group ipac Securities suggests that investors could need to rethink how they diversify their portfolios, or lunch could suddenly become a lot more expensive.
Diversification works most effectively when the performance of the various asset classes within the portfolio don't all perform well (or poorly) at the same time.
The statistical measurement of how two or more asset classes' movements are related is called "correlation". The correlations are measured on a scale ranging from +1 to -1. Assets with a correlation of +1 have perfect positive correlation, and move in the same direction at the same time. Assets with a correlation of -1 have perfect negative correlation, which means they move in opposite directions at the same time.
Assets with a correlation of zero have no correlation, and any movements in the same direction and at the same time are purely coincidental.
Diversification helps you to reduce risk (here, we define risk as the volatility of a portfolio's overall returns) when you spread your money among asset classes that do not all move up and down at the same time.
The effect of good diversification is to "smooth" the overall portfolio return, while still enjoying the performance of the underlying asset classes.
Ipac's analysis suggests the correlations between some traditional asset classes are increasing. That is to say, asset classes have tended recently to move up and down more in sync with each other than they've done in the past.
For example, the correlation between the Australian sharemarket and global sharemarkets has trended towards. And that means a portfolio that was adequately diversified, say, five years ago might no longer be as effective a risk-management tool as it was. #p#分頁標題#e#
Jeff Rogers, ipac's chief investment officer, says that if asset classes become more correlated, it becomes more difficult to diversify effectively.
It can be even more difficult if a portfolio contains only the well-established and traditional asset classes of Australian shares and fixed interest, Australian property (mainly listed property trusts) and cash.
It could require investors to consider some exposure to other, slightly more exotic or less traditional asset classes. But Rogers stresses it does not require a radical rethink, and will generally involve moving only a small proportion of your portfolio's total assets into new areas. "The way we try to think about it is that there are three categories of assets that people can invest in today," Rogers says.
"The first category is those that are widely available in public markets, that if you want to you can index, and which are easy to get. In some senses, a lot of people have built their investment portfolios off the back of those.
"Then there's this group of markets that are partially segmented. There, problems come from being completely different to 'normal' markets."
Rogers says the second group of markets includes global property, emerging equity markets and global small-capitalisation equity markets.
A decade ago - or perhaps not even that long ago, in some cases - it was very difficult for the average investor to access these markets.
But today they're moving towards being more like the first category of "normal" markets. Although they're not quite there yet, they're starting to provide investors with good liquidity (which means, among other things, that you can move into and out of a market without having an undue effect on asset prices as you do so), and a growing range of choices as to how to invest in them.
The third category includes markets that are still quite difficult for retail investors to gain effective access to, and include infrastructure, commodities, structured debt, private equity and a range of different hedge fund strategies.
It's possible to invest in these, but they're not as well-developed for retail investors as other markets and asset classes.
Nevertheless, if diversification is becoming more difficult to achieve in traditional markets, investors might have to consider their options.
"The only free lunch in capital markets is diversification," Rogers says. "People have been able to diversify in the first tier of liquid markets. But we're noticing an uptick in correlation. A reason could be globalisation - linkages between global markets, global interest rates and global capital flows. #p#分頁標題#e#
"We want to be diversified. But we're noticing we're a little less diversified at the moment." Ron Bewley, head of quantitative research at CommSec, says detecting and measuring changes in asset class correlations can be difficult.
It's not like measuring volatility of returns, which is relatively straightforward.
The conclusions you draw about asset class correlations can depend greatly on how often you measure it, and over what period.
Even so, "you need to get your correlations right to do proper diversification", Bewley says, and you need to be careful how you measure them. "In a world where they are changing often, you're using data that you see daily or weekly to get a handle on them," he says. "You often have these big shocks [movements in prices] coming though, and if you have, say, two asset classes, if one of them has a big 'outlier' [in price data] and the other one doesn't, then that makes it look like there's no correlation.
"If they happen to both have big outliers then they can look massively correlated. It's important, when we do our equity work, that we allow for all those sorts of things." Choosing how often you measure asset classes against each other is vital. If the timing gap is too big, and "correlations are evolving, then you're not going to be up with the changes as quickly as you'd like", Bewley says.
"It takes some time for the signals to be recognised. If you try to make the analysis too sensitive ... it overreacts to every little shock."
But if you can accurately measure correlations, and how correlations are changing, you can set your asset allocation more appropriately, Bewley says.
"The weights you use - your asset allocation - change, depending on the correlations," he says. Macquarie Bank and research group Investment Trends have found that a desire to achieve better diversification is, indeed, encouraging investors to think about "alternative" assets as part of a diversified portfolio.
A survey released last week noted "retail investors are increasingly venturing from the traditional mix of shares, property, bonds and cash to put in place multi-asset strategies that protect against market volatility".
It said the four most popular alternative investments among people who have received personal investment advice were:
* Listed investment companies,
* Capital guaranteed products,
* Infrastructure funds, and
* Private equity funds.
Ipac's Rogers says that when you're thinking about adding an asset to a portfolio, you have to think about two things. The first is the stand-alone risk of the asset in question. That is, if you invested in that asset only, what would the risks be? #p#分頁標題#e#
But the second thing is the correlation between that asset class and what you've already invested in, and the overall benefit to the risk/return profile of your portfolio from adding the new asset to the mix.
An asset that has high "stand-alone" risk might in fact be a risk reducer when you add it to an existing portfolio.
Rogers says that direct property might be a good illustration, as investors with diversification in mind are offered an increasing number of opportunities to add property to the mix. "People who just invest in property don't have a diversified, balanced fund," Rogers says. "They're seeking a return that compensates them for the risk of property.
"Now it's becoming more integrated, property doesn't have to offer as a high a return. It's got different characteristics, it's got real cash-flow characteristics that differ from those of equities and bonds, so it does not have to offer as a high a return as it previously did to make sense [in a portfolio]." Rogers says people who want to add property to a portfolio of diversified assets can afford to pay more for the asset than someone who invested only in property, because the diversified investor gets the additional benefit of property's low correlation with the other asset classes they hold. Of course, the key message from an analysis that says asset class correlations are changing is that investors need to revisit their portfolios' asset allocations.
Asset allocation isn't a set-and-forget deal; as correlations change, so does the ideal mix of assets needed to match a given risk and return profile.
In addition, recent runs in some asset classes - particularly Australian shares - mean that many investors' allocations could now be well out of whack.
This fact alone might be a strong enough reason to get in touch with a financial planner, revisit asset allocation and rebalance a portfolio back to its ideal long-term mix.
Rebalancing imposes a sound discipline on investors: it involves taking profits from assets that have already performed strongly, and reallocating the proceeds to those asset classes that may have lagged recently.