Investors typically do not invest all their money in one asset class or one single security. The reasons for this will become obvious as we continue through this article. Asset allocation depends heavily on the individual needs of investors, their risk profiles and unique constraints. Young investors with a high disposable income tend to invest heavily in stocks while middle aged investors tend to invest in balanced portfolios consisting of both stocks and fixed income securities. Retirees tend to invest heavily in high grade debt securities (bonds etc).

As discussed in the previous article, tax structures influence asset allocation. Equities are preferred in countries with high tax rates as taxes typically apply only to dividend income and realized capital gains. The tax drag can be minimized by deferring the realization of capital gains. We will discuss different tax structures and tax drag in a separate article.

A study found that up to 90% of the return of portfolios can be explained simply by asset allocation (as opposed to market timing or other factors). Thus, in my opinion, asset allocation is the single most important part of portfolio management.

Diversification
Diversification is the process of reducing the overall risk of the portfolio by investing in several securities (typically across different asset classes) instead of investing in a single security.

Benefits of diversification
The main benefit over diversification is the reduction of risk (volatility of returns).As we discussed in the previous article; risk is the volatility of returns. Every fund manager would like to have the highest possible return with the lowest possible risk.

Example of the benefits of diversification
Suppose there exist two companies, IcecreamLand and BlanketWorld which manufacture and sell ice-creams and blankets respectively. On hot days, IcecreamLand has high sales and makes a profit of $1 per share while BlanketWorld has low sales and no profits. On cold days, BlanketWorld has high sales and makes a profit of $1 per share while IcecreamLand has very low sales and no profit.

An investor with $2000 to invest could choose to invest in IcecreamLand and/or BlanketWorld. Suppose Mark Alphonso invests $2000 and buys 2 shares of IcecreamLand, George Santino invests $2000 and buys 2 shares of BlanketWorld and Bill Yang too invests $2000 and buys 1 share of IcecreamLand and 1 share of BlanketWorld.

Their returns would be as follows:

Note that all three investors earn the same return i.e. $360 over the entire year, an impressive 18% p.a. However, the important point to note here is that the variance in the total income is different for different investors. Mark Alphonso and George Santino experience huge volatility in their incomes, a semi-annual standard deviation of $255 as opposed to Bill Yang whose semi-annual standard deviation is 0. All three investors got the same return (18%p.a) but Bill Yang’s portfolio was far less volatile and thus far less risky. Thus, Bill’s diversified portfolio outperformed the other two portfolios as it achieved the same return as the other two portfolios despite being much less risky.

The lesson to be taken away from here is that diversification reduces the overall risk of the portfolio. The larger the number of securities, the lower the variance and thus, the lower the risk of the portfolio (assuming a correlation of less than 1 between the stocks).

The importance of correlation
Correlation is a statistical measure that characterizes the linear relationship between two variables. The correlation coefficient measures the strength and nature of that relationship. From a qualitative perspective, the returns of two stocks are positively correlated if the return of one stock increases as the other increases; and are negatively correlated if one increases as the other decreases.

Illustration
Series A: 1, 3, 4,5,6,8

Series B: 3, 4, 6, 8, 6, 9

Series C: -5,-, 3, 1-, 7-, 12,-14

Series A and Series B are highly correlated (correlation coefficient of 0.9) while Series A and Series C are negatively correlated (correlation coefficient of -0.7).

We will cover the quantitative aspects of correlation in a different article. For now it will suffice to understand that the overall volatility (risk) of the portfolio decreases as the correlation between the different in the portfolio decreases.

Monitoring, Rebalancing and Optimization
It is essential for investors to monitor the performance of their portfolios over time and make adjustments as the need arises. Rebalancing is the process of restoring portfolio component weights to their target weights when they change significantly.

Example of rebalancing
Suppose Bob Enslow decides that his portfolio will comprise 60% of equities and 40% of commodities. In August 2008, he invests $6000 in a mutual fund tracking the Dow Jones Industrial Average and $4000 in a commodity mutual fund tracking the Rogers International Commodity Index. Suppose in August 2009, he finds that his equity mutual fund holdings are valued at $10000 and that his commodity mutual fund holdings are valued at $4500. His portfolio now consists of 69% equities and 31% commodities.

In order to restore his portfolio to its original asset weights, he would sell $1300 worth of his equity holdings and invest the returns in a commodity mutual fund. His new portfolio would consist of $8700 worth of equities and $5800 worth of commodities.

Portfolio Management Best Practices

• Come up with a written plan detailing you investment objectives and constraints.
• Diversify across asset classes.
• Diversify your portfolio across different securities within an asset class.
• Don’t trade too often as brokerage and transaction costs may dampen your return.
• Think long term.
• Understand business cycles and their impact on the economy.

The difference between investing and trading
Investors are people who buy assets (in this case, stocks) in anticipation of long term appreciation in their value. Traders are people who buy (or short sell) assets, expecting to profit from short term appreciation (or decline) in their value.

So can be observed, investing and trading are two totally different activities.

Long term and short term investing
Investors buy assets (in this case, stocks) for the long run, typically for periods in excess of 5 years. Medium term investors invest with time horizons of 1-3 years while short term investors invest with time horizons of les than 1 year. Traders and speculators hold positions for short periods lasting less than 1 year. Day traders hold positions for less than 1 day at a time.

Returns to be expected from investing
Before one starts investing/trading, it is important to have a rough idea of the kind of return to be expected. Returns from investing in broad-based developed market indices over long periods (30 years +) tend to be about 10-12 % p.a. Returns from emerging market indices tend to be higher than those from developed market indices. Investing in individual stocks is more risky than investing in diversified portfolios and often yields more than investing in broad based indices.

Returns to be expected from trading
Returns from trading stocks vary significantly and could theoretically range from negative infinity to positive infinity. Speculative investments in stocks have often yielded over 100% in a single day, just as they have also resulted in returns of minus 90% over a few hours. This kind of volatility is especially present in penny stocks and stocks of companies in emerging markets. Trading is risky business and therefore should be approached with caution by beginners.

Risk
Risk here, is defined as the volatility of returns. For the sake of quantification, risk is taken as the standard deviation of the returns earned from an investment.
Assume that Stock A’s monthly returns are 5%,-6%,10%,1%,-8% and that Stock B’s returns are 1%,0.2%,0%,-0.2%0.2% .Stock A is considered more risky than Stock B since its standard deviation of returns is 7.5% while that of Stock B is 0.45 %. That is despite the fact that Stock A has a higher average return than Stock B.

Risk and Reward
In the world of investing, the reward that an investor gets depends heavily on the risk that he/she is willing to take on. Government bonds are the least risky and could yield anywhere between 1% and 5% p.a. depending on the maturity of the bond, the issuing government, the currency of issue and the prevailing interest rates. Bonds of robust companies with fairly certain cashflows yield more than government bonds while bonds of companies with poor credit ratings yield even more. Stocks and real estate typically have the highest average return as well as the highest risk(volatility of returns) among all asset classes.

If one desires a high return, she must be willing to take on a higher amount of risk. It is improbable that one will consistently be able to find investments with low risk and high return.

Further Reading

I would recommend  the book,“A Random Walk Down Wall Street” to those interested in reading more about the basics of investing.

Bid-Ask Spread
Stock brokers charge clients a commission for executing their trades. They also earn money from the bid-ask spread. Example – If you ask a broker for a quote for 1 share of Citi and receive the following price: “3.10, 3.20”, it means that the broker is willing to buy(from you) 1 share of Citi for $3.10 and sell(to you) 1 share of Citi for $3.20.

Here, the bid price is $3.10 and the ask price is $3.20.Notice that if the broker buys 1 share at $ 3.10 and sells it at $3.20, she will make a profit of $0.10 . This difference in the ask price and the bid price is known as the bid-ask spread.

Brokers
Cost is a very important consideration in choosing a broker as commissions and spreads can add up to a substantial sum especially for active traders. Most brokers allow clients to place orders online or via telephone. Deep Discount brokers charge very low commissions and can provide reasonable execution. Most brokers also offer access to global markets. Therefore, it should be possible for a trader based in Singapore to buy stocks traded on the NYSE through his broker in Singapore.

Costs
Commissions typically amount to about 0.25% of the value of the trade. The catch here is that most brokerages charge a “minimum commission”. That would imply that the client could end up paying $20 as commission for buying a stock worth $1. Minimum commissions vary across countries. They typically stand at around US$10 in USA, SGD 25 in Singapore and INR 25-50 in India.* Some brokers offer very good “per-trade” rates subject to a minimum number of trades every month.

The broker not only executes trades on the client’s behalf but can also provide research reports that help clients make better trading decisions. Different levels of service are available for different fees. These usually pertain to trade execution and research reports. In my opinion, beginners need not lose sleep over these details.

Some Brokers
USA:  Charles Schwab, E-Trade
Singapore: Kim Eng Securities, CIMB
India: HDFC Securities, ICICI Securities

* Clients should contact their brokers for detailed information in this regard.