Modern Portfolio Theory and Diversification
Essay Preview: Modern Portfolio Theory and Diversification
Report this essay
DiversificationThe concept of diversification was defined by noble laureate Harry Markowitz in 1952 (Pfaff, 2012). According to the MPT (Modern Portfolio Theory) by Markowitz, there exists an optimal portfolio of securities, known as the efficient frontier. A portfolio on the efficient frontier provides an investor with the maximum level of return, given a particular level of risk. The efficient frontier can be drawn by having return on the y-axis and risk on the x-axis. The concept of diversification states that by adding more and more securities that have zero covariance amongst themselves can lead to a reduction in the risk of a portfolio (Richter et al, 2017). “Risk” is the measure of how widely distributed the returns of a security are about the average return. Risk can be measured either through variance, standard deviation or “beta”. Beta is also a measure of variance, but it is compared to the price movement of the overall stock market. The beta for the market is 1.0, and if a stock has a beta of 1.5, then it is 50% more volatile than the stock market (Black, 1993). There are two types of risk defined in the Modern Portfolio Theory, systematic and unsystematic risk. Systematic risk is also called non-diversifiable risk, and unsystematic risk is also referred to as diversifiable or specific risk. Unsystematic risk is the kind of vulnerability that accompanies the organization or industry you invest into. Unsystematic risk can be decreased through diversification. For instance, news that is particular to few stocks, for example, a sudden strike by the workers of an organization you have shares in, is thought to be unsystematic risk (Fischer & Jordan, 1975). Systematic risk is the vulnerability that is inherent to the whole market or at least a particular sector. Additionally alluded to as volatility, systematic risk comprises of the everyday variances in a stocks price. Volatility is a measure of risk since it alludes to the behavior of your investment instead of the purpose that causes the fluctuation. Since individuals can profit from stocks based on market movement, volatility is essential for returns, and the more unsteady the investment the more chance there is that it will see a price movement in either direction (Fischer & Jordan, 1975).The MPT essentially states that after a certain number of stocks in a portfolio, further reduction in risk becomes impossible, as systematic risk cannot be diversified away. The graph for diversification can be seen in the figure given below. [pic 1][pic 2][pic 3]Table 1: Summary Statistics of BLD and S&P/ASX200 from 6/2012-6/2017 S&P/ASX200BLDAverage weekly return0.1383%0.4668%Standard deviation of weekly returns1.7589%3.3905%Maximum week return4.5071%11.9467%Minimum week return-5.7611%-11.0247%Risk-to-reward ratio12.71917.2625
Stock AnalysisThe average weekly returns indicate higher returns investing purely in BLD stocks between 2012 and 2017 compared to investing in a diversified portfolio of stocks. Even though there are major fluctuations in Boral’s weekly returns between the given time period, the amount of losses are relatively small compared to larger gains earned as indicated in Diagram 2, However, as seen from the summary statistics table, the larger gains earned from investing in Boral stocks comes from a significantly higher risk (3.39%) compared to the relatively less volatile overall stock market (1.76%). Using the risk to reward measure, it is clear that the risk to earn each unit of reward in Boral stocks is much lesser compared to investing in a diversified portfolio. For every unit of reward, a risk of 7.26 units is undertaken while investing in Boral only; whereas a risk of 12.72 units would be undertaken to earn every unit of reward when investing in various socks. Therefore, investing in Boral stocks would be better holistically however, the high returns will be gained at a significantly higher risk as well as overall uncertainty in the market. Company DevelopmentsBoral Limited is a multinational corporation founded in Australia. The firm deals in construction and building materials. Boral has over $5 billion worth of annual sales, and employs more than 12,000 workers across 600 sites. Initially, Boral started as an oil and bitumen refining organization under the name of Bitumen and Oil Refineries Australia Limited. It later changed its name to Boral Limited utilizing the acronym of the name (Boral Annual Report, 2016). Boral has changed its core business since its initiation, and now has a different territory of operations within the construction industry, including asphalt, quarry, transport, bricks and roof tiles. Today Boral has transformed itself into a multinational organization, with operations in Australia, Asia and the United States, with its base camp situated in Sydney, Australia, it also has an office in NSW, Australia (Boral Annual Report, 2016). General and Specific RisksRecently, Boral has increased profit in year 2016 by 16 per cent to $296.9 million, assisted by higher construction activity in Australia and increased earnings from its US operations. Excluding significant items, profit for the year to June 30 grew by 27.9 per cent to $343 million, while sales were up 1.8 per cent per cent to $4.4 billion. The company also finalized acquisition of Utah based Headwaters inc, a deal that was worth $1.86 billion. This move was prompted by Donald Trump’s announcement to increase infrastructure spending, which is a signal for construction companies to increase investment. Although was an example of specific risk, the share price did not fluctuate by much during this time period. Another event that may be considered unsystematic risk is the gradual increase in housing activity in the USA. Since the recession, the housing markets have been stagnant. However, in recent years, construction companies are beginning to see increased sales, as homeowners are recovering from the effects of the 2007 crash. This bodes well for Boral, as it has now significant presence in the USA and will benefit much from the increased consumer spending. This is considered to be unsystematic risk since it affects only the housing industry, and not the overall market.