Diversification And Risk Reduction

RISK AND VARIABILITY
Funds would be augmented by industry investments typically seeking purchase prices lower than average multiples with a focus on selected industries. The group may have 10 or more focus industries such as telecommunications, transportation, health care, consumer, energy, financial service, and so forth. There would also likely be investments in Asia, Europe, and North America, with offices across six continents all pursuing investment opportunities.

In spite of the extensive diversification and drive to create value for investors, however, investment or asset management houses may in fact lose money, and results may not measure up to expected returns. You should have a picture of assets under management by segment, equity invested by industry, and by geography. Let's clarify:

Segment: 20% real assets, 40% corporate private equity, 20% global market strategies, funds 20%

Corporate private equity invested by industry: 12% telecom, 10% transportation, 15% energy, and so on

Geography: Asia 15%, Americas 70%, and Europe 15%

The major reason for the existence of this degree of diversity is to minimize risk and maximize return while attempting to compensate for unsystematic risk. Unsystematic risk (that is, variability) unique to a specific firm may be diversified away. However, over the past 10 years, this has become more difficult due to factors such as corruption, self-serving investments, mismanagement of funds, and other human, environmental, or governmental factors. Examples are plentiful: Enron, the repeal of the Glass-Steagall Act, private equity firms such as Blackstone Group and KKR & Co., Solyndra, and MF Global, among many others (see sidebar, "Risk-Related Terms").

Ten years ago, it was possible to incorporate such variability in a polynomial equation and obtain a series of ogive curves, which are utilized to ascertain degrees of uncertainty. An ogive is a graph of the frequency distribution of a given data set. For our purposes here, it is a series of curves representing the cumulative frequency distribution or cumulative frequency curves. Ogive is a term commonly used to describe curves or curved shapes. As of five years ago, the ability to incorporate such variability had become more difficult, according to institutional investment advisor Cambridge Associates.

FIGURE 1: MANUFACTURING INDUSTRIES GROWTH PERFORMANCE 2011. Here you see the macroeconomic data on expansion and contraction of manufacturing industries for 2011 and gives you an example of inherent investment risk.

FIGURE 2: DOW JONES GLOBAL INDEXES BY INDUSTRY GROUPS. Here's the percent performance change for industry groups and provides another view of risk. It is apparent why diversification is important and why an investor needs to utilize tools to assist in evaluating returns.

RISK AS VARIABILITY IN RETURN
The rate of return (R_r) that an investor receives from holding a stock for a given period of time is equal to the dividends (D) received plus the capital appreciation in the holding period divided by the initial market value of the security:

where
P_e = The selling price
P_b = The purchase price

You buy Pfizer at $16.63 and over a year you sell at $21.60. You also receive $0.67 in dividends in the year.

= 4% dividend yield + 29.9% appreciation = 33.9%

However, if the ending price is less than the purchase price, your return could be in the negative. The return on any security is the cash the investor receives, divided by the initial investment. If you invest in a savings account or CD that offers a 3% annual interest rate, you have no appreciation, so that:

You know before you commit your funds in the savings account, you will earn a return of 3%. The return on the savings account is certain, since the return will not differ from the expected return of 3%. This is called a riskless security.

Although you may expect close to a 34% return on Pfizer, you may or may not receive it. The return may be greater or less than 34%, depending on Pfizer's dividend payout, and the market price might differ from the price you anticipated to sell the stock.

As noted earlier, actual returns on common stock can vary over time. An investor committing funds at any period cannot be confident of receiving an expected return. An investment with actual returns that do not depart from the expected return is considered to be a low-risk investment. An investment with a volatile return is classified as risky. Accordingly, risk can be viewed as variability in return.

REDUCING RISK BY DIVERSIFYING
Risky stocks are combined in a way that a portfolio of securities is less risky that any of the component individual stocks. Note in Figure 2 that portfolios can be constructed from individual stocks in any of the industry groups and within the respective category. Your portfolio might include consumer goods as the industry group and soft drinks as the category. Soft drinks grew 5.4% from 2010, but not all soft drinks grew 5.4%, as that percentage represents the combined companies that make up the group included under the soft drinks category. Since an individual investor has limited funds, it is imperative that the right industry group and category and the individual company within the category is carefully selected.

Company Y is an alternative fuel stock and deals in ethanol. The stock depends upon regulations, subsidies, and agriculture. Returns for company Y stock depend on government support, regulations requiring the use of ethanol in gasoline, and good yields in crops and production. In pursing either stock, an investor is subject to variability in return.

Reducing risk through diversification

If you invest in company X, your returns will vary from -11% to 48%, depending on the oil available for transport by pipeline. Instead of buying only one security, you decide to put half of your funds in each stock. The possible returns on this portfolio consist of the amount invested in stocks X and Y:

R_portfolio = 0.50 invested (R_x) + 0.50 invested (R_y)

Portfolio containing X and Y:

The possible returns on this portfolio indicate a return of 18.5%. Accordingly, the return on this portfolio is 18.5% regardless of oil availability. Combining these risky investments yields a portfolio with a certain return. Since you are confident that you will earn 18.5%, it is a low-risk investment compared to a riskless investment in a CD or savings account. This demonstrates risk reduction through diversification. By diversifying your investment over the firms, you create a portfolio that is less risky than the component stocks from which your R_portfolio was created.

There will, however, always be some lack of parallelism in the returns of securities. Diversification will always reduce risk. Investment in your portfolio composed of several securities in various industry groups is less risky than investing in a few specific stocks.

It is important to consider systematic and unsystematic risk along with risk, return, and market equilibrium, and in that context we will employ the capital asset pricing model (CAPM) for evaluation and introduce β (beta), which is the level of systematic risk associated with a firm's stock.

This will be the subject of a continuing article on this subject. The purpose of this article is to build the foundation to understanding the CAPM.

SIDEBAR: RISK-RELATED TERMS

Glass-Steagall Act: The Banking Act of 1933 was a law that established the Federal Deposit Insurance Corporation (FDIC) in the United States and introduced banking reforms, some of which were designed to control speculation. It was introduced to prevent another crisis like the 1929 crash. It is most commonly known as the Glass-Steagall Act after its legislative sponsors, Sen. Carter Glass (D-VA) and Rep. Henry B. Steagall (D-AL).

Some provisions of the act, such as Regulation Q, which allowed the Federal Reserve to regulate interest rates in savings accounts, were repealed by the Depository Institutions Deregulation and Monetary Control Act of 1980. Provisions that prohibit a bank holding company from owning other financial companies were repealed on November 12, 1999, by the Gramm-Leach-Bliley Act, named after its cosponsors, Sen. Phil Gramm (R-TX), Rep. Jim Leach (R-IA), and Rep. Thomas J. Bliley Jr. (R-VA).

The repeal of the provisions allowed banks to speculate. Banks lobbied long and hard for the repeal using the profit motive of investment to justify repeal. Gramm played a significant role in pushing for the repeal of the Banking Act Provisions. The banking industry had been seeking the repeal of Glass-Steagall since at least the 1980s.

The repeal of provisions of Glass-Steagall by the Gramm-Leach-Bliley Act in 1999 effectively removed the separation that previously existed between investment banking, which issued securities and commercial banks that accepted deposits. The deregulation also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks. The Glass-Steagall Act was officially repealed by President Bill Clinton.

The repeal enabled commercial lenders such as Citigroup, which was in 1999 the largest US bank by assets, to underwrite and trade instruments such as mortgage-backed securities and collateralized debt obligations and establish structured investment vehicles (SIVs) that bought those securities. The repeal of this act contributed to the global financial crisis of 2008-09 that continues today.

The year before the repeal, subprime loans were just 5% of all mortgage lending. By the time the credit crisis peaked in 2008, they were approaching 30%. This correlation is indicative of causation, since repeal of the provisions allowed several events to occur that were needed to support the repeal. These include the adoption of mark-to-market accounting, implementation of the Basel Accords, and the rise of adjustable-rate mortgages.

In the 10 years since, Glass-Stegall's repeal is condemned for reestablishing conflict of interest within the financial industry and fostering giant institutions that led to the housing market collapse and its associated financial crisis.

Since the banks are continuing with the same practice, and legislation is too weak to provide adequate oversight, investments in this area will have a high probability of unsystematic risk on investment.

Private equity firms: Private equity firms buy business through the use of debt and resell them at a steep profit. The purchase of RJR Nabisco in 1988 by Kohlberg Kravis Roberts is a prime example. Today, the buyout business has become mundane and less lucrative, due to difficulty in selling companies; fewer buying deals; less available debt; higher prices for acquisition; and fewer investments. Unsystematic risk must be carefully considered.

Solyndra: California-based Solyndra was a manufacturer of cylindrical panels of thin-film solar cells. The company was once touted for its unusual technology, but plummeting silicon prices and nonperforming technology that was too expensive and cumbersome to build panel products led to the company being unable to compete with more conventional solar panels. In 2011, the company filed for bankruptcy and laid off all its employees. The government loan guarantee for this risky investment will lose more than $600 million.

MF Global: On Sunday, October 30, 2011, a unit of the New York-based brokerage reported to the Chicago Mercantile Exchange (CME) and the Commodity Futures Trading Commission (CFTC) a "material shortfall" of hundreds of millions of dollars in segregated customer funds.

Customer accounts with $5.45 billion were frozen that day and the parent company, MF Global Inc., filed the eighth-largest US bankruptcy. MF Global reported the shortfall in customer accounts at $891,465,650 as of close of business Friday, October 28, 2011. According to the trustee overseeing liquidation, the shortfall may be as large as $1.2 billion, or 22% of relevant funds. MF Global mixed customer funds and used them for its own account for several days before the bankruptcy and transferred funds outside the country.

MF Global was managed by Jon Corzine, the former governor of New Jersey. MF Global, formerly known as Man Financial, was a major global financial derivatives broker. MF Global provided exchange-traded derivatives, such as futures and options as well as over-the-counter products such as contracts for difference, foreign exchange, and spread betting. MF Global was also a primary dealer in US Treasury securities.