“Diversification eliminates unique risk. But there is some risk that diversification cannot eliminate”
Diversification of portfolios is one of the effective ways to minimize the risks and increase the returns. However, it is acclaimed that there are certain risks that cannot be eliminated. These risks are called market risks that cannot be overcome through diversification of the portfolio. There are several theories that stress that the diversification of portfolios should be used to bring stability in its returns and lessen the risks. Systematic risks or market risk emerged because of the changes in the economic cycles of the market that are influenced by various factors and activities taken place in the economy (Petty et al., 2015).
Financial experts are constantly engaged to find different ways to calculate portfolio risk to make their investment safe and reduce risk. The main objective of the organizations is to estimate the variations taking place in the returns of the portfolios. Petty et al. (2015) highlighted “diversification could lead to potential risk reduction, but it shows that there is a limit to the risk reduction effects of diversification as there is some risk that cannot be removed” (Petty et al., 2015). Also, he mentioned that the variation in the returns couldn’t be estimated through diversification. It is because that the level of risk involved for portfolio evolves because of the common market.
There are numerous of macro factors that cannot be eliminated by the financials such as the state of the economy and the interest rates that lead to systematic risks to occur. These two are the main factors that cast a greater impact on the consumer discretions and incomes. Hence, the risks related to each portfolio vary according to the market (Brealey, 2007). There are certain risks that can be reduced through diversification. Diwas (2015) claims that diversification of portfolios is a strategic intervention that can be used as tools to eliminate unsystematic risks, i.e. firm-specific risks (Diswas, 2015).
Sarez (2013) argues that diversification is although an efficient way to optimize returns and reduce the risk. In the lights of CAPM model and the modern portfolio theory is claimed that if the selection of the portfolios is made on the basis of expected returns with the simultaneous minimization of associated risk of investment. Diversification would eliminate the risks assess the mean variance of the returns and the variances that are the determinant of indicated risks (Suarez, 2013).
Parra et al. (2016) illustrate that the control and risk are beyond the scope of the organization each decision involves failures and critical success factors that involved complex results (Parra et al., 2016). Besides of the efficient forecasting capacity, there are likely potential risks that the enterprises have to encounter in a different situation that is not able to predict through diversification. There is the probability that the risks can be diversified through applying particular equation. There are ways to make sensible diversification of the investment and reduce the potential risks.
Besides some of the financial model and theories such as CAPM accepting that the market risk/systematic risk are associated with the market condition perceive that the unsystematic risks have the ability to project returns of the portfolios. According to Capital Asset Pricing Model (CAPM), it is stated that the risk and returns have a positive relation. It means that if there are greater risks, then there is the possibility of earning greater returns. It is based on the assumption that all assets have a discounted rate that is the predictor of future cash flow. It depicts that the systematic risk is measurable through the sensitivity of the expected returns with the market return but cannot be mitigated (Parra et al., 2016). However, it is proclaimed that the diversification would enable the enterprise to determine expected returns of the organization. But there is variance in the strategies that the business can adopt to bring change in the market that may change with the circumstances that are estimated assessing conditions and trends.
Hou & Hung (2014) states that the diversification can improve the investment opportunities that are estimated on the basis of mathematical formula based on the diversification concept. In other words, it is explained that the diversification optimizes returns through lowering risk and withholding investment in one portfolio (Hou & Hung, 2014). Based on the mathematical calculations using theories and models financer assess the standard or norm behavior that helps the investor to make the decisions to develop its portfolio. For an instant, CAPM model also helps in estimating investment risk that determines the relationship between risk and investment. It also shows that the diversification can enable the investors to make the decision regarding portfolios.
Braeley et al. (2012) explain through a different dimension explaining that portfolio theoretical model improves portfolios management that is determined by determining the covariance relationship and volatility in the market to make the decisions regarding portfolio. Through this, the investors are able to develop a combination of the portfolio that offsets the risks (Braeley et al., 2012). Diversification provides an opportunity for the investors to combine their financial assets that improve the stability that eventually increases the returns and reduces the risks.
Megginson et al. (2008) claim that the investment in the portfolios can only be optimized if they are critically done on the two main dimensions. 1) risk or the variance of the portfolios 2) expected returns of the portfolios. These assumptions can be attained through financial theories (Megginson et al., 2008). However, in each of the case, the systematic risk still cannot be eliminated. However, in the stock markets the beta values can be used to assess the violated in the market. The value of beta is an estimate which is prone to change with a greater extends with the slightest change in the economy.
Marshall (2015) claims that the diversification of portfolios enables investors to trace unique risk through assessing different rates of returns and gains, standard deviation, and covariance values along with the beta value can be used to assess the risks that may emerge investing in the portfolio. He also claims that besides the factors that the unsystematic risks cannot be eliminated but the well-diversified portfolio can reduce the risk through looking into the present value, capital budgeting, and other values to determine the uncertainty in the industry (Marshall, 2015). Thereby, the use of the diversification can lead to a reduction in the unique risk/firm level risk that can be eliminated through the calculations of value additively to measure the risk of stocks (Huy, 2016; Petty et al., 2015; Megginson et al., 2008).
There are two basic assumptions on which the modern financial theories are based. First is that securities and money markets are highly competitive and efficient. The assumption is based on the hypothesis that the both the buyers and sellers in the market are well informed and are in large numbers. The second assumption is that the investors in these efficient markets are risk averse and seek to maximize return and minimize risk on return from investments. The assumption shows that investors do not take the high risk unless they are compensated by the premium for taking the higher risk (Duarte & Rosa, 2015).
These two assumptions are part of almost every modern financial theory. However, Capital asset pricing model includes other assumptions as well such as frictionless market and absence of transaction costs (Arnold, 2013).
The capital asset pricing model deals with the precise description of risk and returns on financial securities (Siddaiah, 2010). It can be said that if investors buy a common stock and hold it for a certain period, he receives a rate of return that is equivalent to the capital gain and the cash dividend received during the holding period, divided by the purchase price of common stock.
Although investors develop an expectation for a particular rate of return on the common stock, it may differ from their expectation due to the fluctuation in stock prices. Therefore, common stocks are regarded as risky securities. On the other hand, securities such as treasury bills provide the consistent returns and do not deviate from expected returns due to which they are regarded as riskless securities. An underlying assumption of capital asset pricing model is that combination of the risky securities could be made so that it would be less risky as compared to any of its individual components. However, it is important to evaluate the manner in which the risk is reduced through diversification.
Let’s assume that there are two companies working in a country. One company manufactures and sells coffee while the other company produces cold beverages. The company that produces coffee earns well in cold seasons while face loss in the summer season. On the other hand, the company that produces cold beverages earn high profits in summer season while performing poorly in cold weather. It is assumed that both the company earns 10% of the average return.
If an investor purchases stocks in either of the company, it faces a high risk due to the fluctuations in the stock prices as a result of the changes in weather conditions. However, if the investor invests in both the companies equally, he will earn the return of 10% regardless of the changes in weather condition. Thus the example shows that portfolio diversification converts two risky stocks into the comparatively less risky portfolio, with the high certainty of earning 10% expected return.
However, in the real world, the perfectly negatively correlated relationship depicted between the above two securities is impossible. Since the securities in the market move together to some extent, it is nearly impossible to eliminate the risk completely through portfolio diversification. Still, due to lack of parallel relation between securities, diversification reduces risk to the greater extent (Research, 2008).
Moreover, the risk assumed by the investors, to some extent, is irregular for certain individual stocks. For example, earnings of the company may decline as a result of the wildcat strike. However, since earnings and stock prices move together to some extent, even the highly diversified portfolio is exposed to the risk that is inherent in the overall performance of the security market (Omisore et al., 2012). Given this notion, the total risk related to the securities can be divided into two risks discussed above.one is a unsystematic risk, which can be reduced through diversification, and the systematic risk, that cannot be diversified and is related to the fluctuations in the stock market (Estrada, 2002).
The graph below illustrates how the risk is reduced as more and more securities are added to the portfolio. Researches and empirical studies conducted in the recent past have indicated that unsystematic risk can be highly reduced if there are 30-40 randomly selected securities in the portfolio.
It is important to note that investor can only eliminate company specific risks through diversification, and they are not compensated for the unsystematic risk. Since the highly diversified portfolio is only exposed to systematic risk, the risk with CAPM is only limited to the systematic risk instead of the total risk. It can thus be concluded that investors are rewarded with the higher returns only for bearing the market risk and not the total risk (Lynch, 2004).
Beta can be regarded as the standard measure of systematic risk. It measures the propensity of the return on security to move along with the stock market return. Thus, a stock with the beta of 1 can be regarded as having an average level of systematic risk that increase or decrease with the same percentage as that of the stock market (Genc et al., 2005). This follows that only the systematic risk, which is measured by beta, is important to consider. According to CAPM, price of the security is determined as:
Rs = Rf + risk premium
Where,
Rs = expected return on stock
Rf = risk-free rate
Risk Premium = the difference between the market rate and the expected rate, multiplied by beta. The relationship depicted by the above formula is known as “security market line” (Lee et al., 2009). An important thing to note in this formula is the risk premium of the security that is directly related to the beta. In risk premium, there is no measure of unsystematic risk since it I totally eliminated by the portfolio diversification (Ross et al., 2008).
One counter argument of CAPM could be a stock that exhibits a high total risk but very small systematic risk. In such a case, the investor would regard the security as being very less risky. The stock’s beta would be low and in security market line, it would lead to the low-risk premium. Hence, even though the stock exhibits a high level of risk, the market price would indicate the low expected return. However, examples of such companies in the real world are rare, and most businesses that have high total risk also exhibits high beta. The risk calculated by beta usually coincides with the judgment of investors in determining the risk of the particular stock. However, it can be concluded from the above discussion that total risk can never be equivalent to the security market line, in the market where investors are allowed to diversify their portfolio freely.
List of References
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