Naive Diversification Flashcards
Who developed mean variance portfolio analysis?
Harry Markowitz(1952)
According to Rubenstein (2002) what did the development of mean variance analysis mean?
Markowitz’s(1952) work was the birth of modern finance.
Single period model
Investment decisions are made for one time period.
Investors Aim?
To maximize expected return for a given level of risk (measured by variance)
In the mean-variance framework, how is risk measured?
Risk is measured by variance or standard deviation of returns.
Efficient frontier
This is where the optimal portfolio lies and no other portfolio offers a higher return for the same risk.
How to determine the best combination of assets
Relies heavily on matrix calculations to determine best combination
Expected return of the portfolio
The weighted average of the expected returns of the two assets. See ipad for equation
Portfolio variance (risk)
Measures how volatile or risky the portfolio is. See ipad for equation.
Portfolio standard deviation
This gives the risk in the same units as returns. Making it easier to interpret.
What is covariance?
A statistical measure of how two variables are related to one another.
If positive covariance?
Means assets rise/fall together
If negative Covariance?
One rises, the other falls
How to measure covariance?
A standardized measure of covariance is the correlation.
Correlation (corr)
Is a standardized version of covariance (unit free so easier to interpret)
Where does correlation lie?
Between -1 and 1
-1 correlation
Means perfect negative correlation (great for diversification, maximum risk reduction)
+1 correlation
Means perfect positive correlation (no diversification so no risk reduction)
Zero correlation
no statistically significant linear relationship between two variables
What does low correlation mean?
The lower the correlation the larger the risk reduction benefits.
For N risky assets
When there are N assets you generalize the two-asset model. Now each asset has its own weight and expected return. See ipad.
What does the covariance matrix V contain?
Diagonal: variances of each asset
Off-diagonal: covariances between asset pairs
What is a naive diversification strategy?
Investing equally in all assets.
A naïve diversification strategy is when an investor does not use an optimal investment theory to build a portfolio.
Why is the 1/N strategy notable?
DeMiguel, Garlpappi, and Uppal (2009) argue its hard to outperform.
For the more N the risk of the portfolio declines
What are the components of total risk?
Total risk = systematic risk + unique risk
How many stocks are enough for effective naive diversification?
Textbooks: 20 stocks
Campbell et al (2001): 50 stocks
Why diversify internationally?
Lower correlations between domestic and foreign markets so portfolio risk can be reduced (Solnik, 1974)
What happens to correlations during financial crisis?
The increase (Longin and Solnik(1995))
What is a major factor in international investing?
The role of currency
What are two key factors affecting foreign asset performance?
- Foreign market performance
2.Currency exchange performance
Notable currency regimes in the 20th century?
Gold standard
Bretton Woods (fixed exchange rate)
Floating exchange rates (post-1970s)
What does Modern Monetary Theory (MMT) argue?
Sovereign currencies with floating exchange rates allow greater fiscal flexibility
Can currency risk be hedged by investors?
Yes
Equity investors: Little benefit
Bond investors: Great benefit
Who benefits from currency hedging?
According to DMS(2012) there is little benefit for global equity investors but greater benefit for bond investors
Why trade currencies?
Markets are huge and liquid and returns can be driven by central bank policies, economic fundamentals, and macro trends.
What are three popular currency trading strategies (DMS, 2012)?
1.Value
2.Momentum
3.Carry Trade
Value currency strategy
Buy undervalued currencies and sell overvalued ones
Momentum currency strategy
Buy currencies that have recently appreciated, sell hose that have depreciated.
Assume the trend continues in the short run.
Carry trade strategy
Borrow in currency with low interest rate and invest in one with high interest rate.
Why are emerging international markets attractive?
Investing increases the risk reduction benefits
Lower correlations with developed markets.
Offer high average returns but also high volatility
How are countries classified into emerging vs developed markets?
By index providers (MSCI, FTSE) or GDP
What classifies an emerging market?
GDP per capita of less than $25,000
Benefits of investing in an emerging market when you are invested in developed markets?
Diversification
What are the risks of international investing?
Political
Regulatory
Operational
Higher costs
Currency risks
What is the investment horizon?
The length of time an investor expects to hold an investment
What role does investment horizon play?
It affects means, variances, correlations, and higher moments like skewness and kurtosis
