Egg, basket and portfolio (I)-diversity

(This article only saves copies)

Author: Harry M Kat, Financial Times writer)

Http://www.ftchinese.com/ SC /story.jsp? Id = 001007832

Every day, we take many risks. We do everything possible to control risks by using a variety of risk management technologies, from carefully looking forward to buying fire insurance, all-encompassing. The wealth of investors changes with the rise and fall of global capital markets. Two risk management technologies are particularly popular among them. One is diversity, that is, "Do not put all the eggs in one basket"; the other is the use of derivative tools, that is, various financial contracts, the benefits of these contracts clearly depend on the performance of one or more indexes. These two technologies will be discussed in this article, but they are more specific, including their respective advantages and disadvantages.

Diversified

If an investor puts all his wealth into a stock, it will take a great deal of risk, because all her returns will depend on the performance of that stock. If the share price increases by 20 percentage points, she can earn 20 percentage points. If the share price drops by 20 percentage points, she will lose 20 percentage points. But if she invests in two different stocks, the situation will be different. In this case, winning and losing may offset each other to some extent, so the return of investors will fluctuate within a relatively small range. In other words, diversification will reduce the variability of return, or reduce the overall difference of possible results.

A basic element of successful diversified investment is that there is no strong correlation between different assets or asset classes in the portfolio. Investing in one oil company and one publisher will bring investors more diversity than buying shares from two oil companies. Because the oil companies and publishers have less in common than the two oil companies; correspondingly, the volatility of the previous combination is much greater than that of the latter one.

Risk Components

In terms of definition, the expected return rate of a portfolio is equal to the average value of the expected return rate of each asset in the portfolio. This means that, although diversified investment can reduce the overall variability of the ROI of the portfolio, it does not necessarily reduce the expected rate of return. As long as we combine assets with a close expected rate of return, the expected rate of return of the portfolio will not be affected by diversification. As a result, diversified investment is often considered free lunch. That is to say, by combining different assets or asset categories, the overall variability of portfolio return is reduced without generating any cost to offset the expected return.

However, the reference to free lunch ignores the important point, that is, the risk is not just about the overall difference of possible results. Two different combinations may have

The overall rate of return is variable to the same extent, but the performance in other aspects may be completely different. For example, a combination may produce unpleasant results with a higher probability, but if we only look at the overall variability, we will not notice this.

The risk is like a monster with several heads, but it cannot be completely described by one head. If we want to truly defeat this monster, we need to study it comprehensively. So what factors need to be considered? In addition to the overall difference of possible results (usually measured by the statistical standard deviation), we also need to examine the situation in extreme situations more closely, this can be achieved by calculating two less-known statistical values, skewness and kurtosis. Broadly speaking, the skewness measure the relative probability of a negative unexpected result (negative skewness) or unexpected surprise result (positive skewness, the kurtosis measures the probability of extreme results (positive or negative. Peaks can be understood as a measure of the gambling composition of an investment, because the higher the probability of extreme results, the more likely the investment is to be a pure gambling. Therefore, for long-term investors, the comprehensive results after the effects of various factors are extremely important and they will want to avoid medium-term major losses. Because of this, most investors hope that the skewness can be as high as possible, while the peaks can be as low as possible.

Therefore, the risk should include at least three different factors: standard deviation (the overall deviation of possible results) and skewness (the relative probability of positive or negative unexpected results) and kurtosis (probability of extreme results ). When we apply this extended concept of risk to global capital markets, we will find some very important phenomena. For example, sometimes when we buy hedge funds and private equity to diversify, diversification involves a balance between different risk factors. By purchasing new assets or asset classes to diversify investment, the ROI of the portfolio will be reduced by a standard deviation. However, it is very likely that the skewness of the portfolio will be reduced at the same time, and/or the peak will rise. In this case, a free lunch really does not exist, because investors buy assets with a low standard deviation at the cost of accepting unappealing skewness and/or kurtosis.

Use hedge funds to diversify

The current hedge fund fever shows how dangerous it is to ignore the skewness and peaks. Many investors and hedge funds are still operating under the traditional risk management framework, and the standard deviation is seen as the only criterion for measuring risks. Diversification is easy for them, that is, lowering the standard deviation while maintaining the expected rate of return. As long as they can, these investors will use as many hedge fund strategies as possible for investment, because in their view, the more assets not associated with the portfolio, the benefits of diversity increase. Unfortunately, once the skewness and peaks are taken into account, this is not the case. Multiple hedge fund strategies (such as fixed income arbitrage, merger arbitrage, and impairment securities) tend to bring bad skewness to the portfolio. Using these policies in a portfolio can indeed reduce the standard deviation, but also weaken the skewness, which increases the risk of negative unexpected results. Other hedge fund strategies (such as managed futures contracts) will bring a completely opposite feature to the portfolio: they will also reduce the standard deviation, but tend to increase the skewness, or an opportunity for positive unexpected results.

 

Some hedge fund strategies will certainly be more attractive than other strategies in their skewness and peak characteristics. Therefore, when we consider the skewness and peaks, using hedge funds to diversify is no longer as simple as using different strategies as possible, instead, it is a fund that searches for funds that are unrelated to traditional asset classes and will not bring any negative side effects of skewness and peaks when incorporated into the portfolio. Obviously, finding such a Fund requires us to have a thorough understanding of the hedge fund strategy. In addition, we also need to concentrate and invest a lot of work. Is it a free lunch? Obviously not.

(To be continued)

 

* How derivatives can help solve the pension fund crisis, by Van capelleveen, Kat, and kocken, alternative investment stment research centre Working Paper No. 17,200 4.

 

** Strategic interest rate hedges, or how derivatives can help solve the pension fund crisis Part II, by Engel, Kat and kocken, Alternative Investment Research centre Working Paper No. 24,200 5.

(Both papers can be downloaded from www. Cass. City. ac. uk/AIRC .)