Portfolio Management in turbulent times – Is diversification still possible?

Table of contents

List of Abbreviations

List of Figures

1 Introduction

2 Theoretical foundation
2.1 Portfolio Management / Correlation of Assets
2.2 Volatility and Risk
2.3 Diversification and Efficiency Curves

3 Practical analysis: Portfolio management in turbulent times
3.1 Sample portfolio in turbulent times
3.2 Is diversification still possible?

4 Opportunities to hedge in volatile times
4.1 Futures / Forwards / Swaps / Options
4.2 Further Hedging / Diversification

5 Conclusion

Appendix

Bibliography

Internet sources

List of Abbreviations

ETF Exchange Traded Funds

MPT Modern Portfolio Theory

UK United Kingdom

List of Figures

Figure 1: Efficient Frontier Line for a two-assets example

Figure 2: Correlation Region - Asset Classes / Return

Figure 3: Non-diversified Portfolio

Figure 4: Diversified Portfolio

Figure 5: Golar LNG - Energy stock

Figure 6: Types of Derivatives

Figure 7: Tesla Chart

Figure 8: Gold price fluctuations

Figure 9: Asset allocation in general

1 Introduction

“A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.” - Harry Markowitz (Markowitz, n.d.)

Looking at the newspaper and television reports on stock prices and their highs and lows in the various economic phases of recent years, it seems hardly surprising that an ambivalent impression of the events surrounding the stock market has taken root in the minds of a large part of the population. In accordance, newspapers and television repeatedly report on the one hand about miraculous increases in wealth caused by the strong and sometimes sudden rise of various stock prices. These reports force the question on one or the other, why one still works, since the earning of the large money at the stock exchange seems to be simple finally. On the other hand, the financial markets have been shaken again and again by crises, which have provided ample proof that it is not advisable to leave the earning of money to stocks alone.

Harry Markowitz, American economist and professor, is still one of the pioneers in the field of capital market theory with his modern portfolio theory (MPT). Every investor faces the hurdle of finding the most efficient portfolio. In this case, liquidity, risk and the expected return play the central triangle. Both the own risk awareness, which correlates with the return, and exogenous influences, such as in turbulent times, have an impact on the portfolio and its result. Markowitz and his MPT states that the reason for this is that the professional selection of securities in an investment portfolio within the framework of asset management reduces the risk of the portfolio in comparison to the risk of the individual securities. Accordingly, no one needs to fear the financial markets as long as he does not pay more attention to the individual securities than to the securities portfolio as a whole.

This paper provides an understanding of portfolio management, especially in turbulent times. The central question is whether diversification of the portfolio is still possible. What exactly diversification is and how to build an efficient portfolio with asset classes will be explained in the following chapters of this paper.

The reader should gain a solid understanding about portfolio management. For this purpose, some terminology will be explained in the theory part, which will then be applied in practice in the further course. Finally, possibilities are shown how to hedge one's portfolio in volatile times.

2 Theoretical foundation

2.1 Portfolio Management / Correlation of Assets

What is portfolio management and what exactly does Markowitz's Modern Portfolio Theory say?

Portfolio analysis has its fundamental origins in finance (Baum, Coenenberg, & Günther, 2013). As already mentioned at the beginning, Markowitz developed a model for the optimal composition of a securities portfolio in the 1950s. The core of this model is the evaluation of different financial assets with respect to the expected return as well as the risk of not achieving this return (Markowitz, Portfolio Selection, 1950).

Here, the risk of an individual financial investment is measured as the variance of the expected future return. Markowitz found that the average of the variances of individual security returns directed with the respective shares in the portfolio is larger than the variance of the returns of a mixed portfolio, which therefore fundamentally implied a higher risk.

In addition to expected return and risk, the correlation to other asset classes must also be forecast for each asset class. These forecasts, both the return forecasts and the correlation, are included in the calculation for an investment portfolio, whereby the maximum efficient frontier between risk and return is selected. This is referred to as the "efficient frontier line". The correlation between two asset classes is derived from the covariance, whereby:

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And therefore, the correlation coefficient is:

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This correlation coefficient ranges between -1 and +1, with a value of +1 indicating a completely positive dependency between the (here two) asset classes. A completely negative correlation of -1 between two asset classes means that they behave in the opposite way. For understanding: A correlation coefficient of 0 gives no correlation between the asset classes.

This means that in order to determine the correlation between individual asset classes, the variance, meaning the risk between the assets, must also be determined. This will be discussed explicitly in chapter 2.2.

2.2 Volatility and Risk

Basically, the risk components within the portfolio can be distinguished between systematic risk (market risk) and unsystematic risk (specific risk). Systematic risk refers to macroeconomic factors such as gross domestic product, the inflation rate or geopolitical factors (Bierman & Smitdt, 2003). Unsystematic risk takes into account factors such as the level of development or the quality of management. As a result, the risk assessment and thus the diversification of the portfolio is limited, since the market risk always remains an uncertainty factor (Bierman & Smitdt, 2003).

In order to determine the risk of an asset class, other factors must be taken into account. The risk is described as the variance of the asset class, which is calculated as follows:

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Thereby is:

- P(s): The probability of the Scenario s
- r(s): The rate of return of asset s
- E(r): The expected Return

In order to calculate the variance, meaning the risk, of a portfolio that contains two asset classes, for example, the following is calculated:

Abbildung in dieser Leseprobe nicht enthalten

whereby:

- w . = weighting of the individual asset

Additionally, when several asset classes are combined, this is referred to as portfolio risk (Markowitz, Portfolio selection, 2008) .

2.3 Diversification and Efficiency Curves

Diversification basically describes the distribution of the risks of an investment across several risk carriers (Lynch, 2017). This means that, on the one hand, several asset classes are selected within a portfolio and, on the other hand, these should have as low a correlation as possible (Financescout24, 2020). As already mentioned, the decisive factors for an investor are the expected return and the associated risk of the investment. According to MPT, investors are rational and risk-adverse, from which it can be concluded that a higher risk also results in a higher return. By including many individual assets in a portfolio and calculating the above factors, one obtains the already mentioned "efficient frontier line”. This reflects the relationship between risk and return of the underlying asset classes.

Figure 1: Efficient Frontier Line for a two-assets example E(r)

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Source: Cf. Kienzle, F., Andersson, G., 2008, p. 6

The figure above shows the Efficient Frontier Line of Asset A and Asset B. The X- axis shows the standard deviation (the root of the variance, which reflects the risk) and the Y-axis shows the expected return.

Thereby, the investor has to decide at which risk he wants to achieve the expected profit. Nevertheless, the MPT assumes efficient markets as a hypothesis, with investors being risk-adverse. Thus, in figure one, the investor would choose the minimum variance portfolio that yields the highest expected profit (Markowitz, Portfolio Selection, 1950).

3 Practical analysis: Portfolio management in turbulent times

3.1 Sample portfolio in turbulent times

Looking at the beginnings of 2020, it is clear that turbulent times within the financial market has been arising. These are exemplary caused by the trade war between the USA and China, the Brexit, the presidential election or the COVID-19 pandemic.

The COVID-19 pandemic, as a global health crisis, highlights that there is some contrast between different asset classes and different regions.

Figure 2: Correlation Region - Asset Classes / Return

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The above figure shows the returns of the individual indices of the different regions to the year-end 2020. The global returns of the indices vary between -18.76% of the region United Kingdom (UK) and +11.64% of Inflation-Linked Gilts, also the so-called Inflation Bonds.

Considering only the following four asset classes within an exemplary portfolio based on figure two (2020 year to date Return):

- 25%(weighting) - EURO STOXX 50 ETF
- 25% (weighting) - UK FTSE All- Share ETF
- 25% (weighting) - ASIA PACIFIC MSCI IMI ETF
- 25% (weighting) - US S&P 500 ETF

Figure 3: Non-diversified Portfolio

Investment Portfolio

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Source: own representation

With a respective weighting of 25% and a diversified portfolio of only four equity positions, the investor would suffer losses except for the S&P 500 position. Already at this point, it becomes apparent that an insufficiently diversified portfolio will have to accept large downturns.

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