Discussion: Pick a stock, any stock and the risk of the portfolio should be lowered

By | April 18, 2014

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(1) Comment on David Winner’s advice to, “Pick a stock, any stock and the risk of the portfolio should be lowered.”

 

David Winner’s advise to pick a random stock to reduce the overall portfolio risk is partially supported by the traditional portfolio theory. The portfolio theory is developed based on the Capital Asset Pricing Model (CAPM) which holds that: (a) Investors are risk averse, the reward is calculated by the mean returns when risk is measured by the standard deviation of returns; (b) Investors expect identical mean variance returns and hold the same risk market portfolio with different weights based on their risk profiles and they are rewarded by the market risk alone; (c) no transaction cost or other constrains (Lee, C. F. & Lee, A. C. 2010). The most basic portfolio model was developed by Harry Markowitz who derived the expected rate of return for a portfolio of assets and an expected risk measure (Markowitz 1952).

 

One simple conclusion that the portfolio theory makes is that it is not enough to evaluate the expected risk and return of a particular stock and by having more than one stock investors can reap the benefits of diversification with a reduction in the overall risk level of the portfolio. In a classic piece in Journal of Finance in 1968, Evans and Archer found that portfolios with as few as 10 securities had risk, measured as standard deviation, virtually identical to that of the market (Krantz 2008). This is also known as putting eggs in different baskets. Shown below in the figure is the graph drawn according to the data collected by Mr. Malkiel rom a paper by Bruno Solnik, the graph demonstrates that decreasing trend of risk of both US and world portfolios with the increase of the number of stocks.

 

Figure 1.0 The benefits of diversification

Source: Efficientfrontier.com 2000

 

Based on the rational investors and efficient market assumptions, the portfolio theory aims at reduce the total variance of the portfolio return by bundle a number of different assets which are not perfect positively correlated. And diversifying the portfolio by randomly picking up any stock will help to avoid having a bundle of stocks that are positively correlated, and it is also one of the disadvantages of Ester Tong’s investment as her investment portfolio are made up by technology stocks that worth RM 25,000. So in this point, David Winner’s advice to pick a stock, any stock to lower the risk of the portfolio is reasonable.

 

Despite the benefits of diversification among the portfolio, there are three major defects by randomly picking up any stocks. First of all, according to Markowitz’s model, the diversification of the portfolio request a lot of data inputs such as the expected rate of return of assets, and obviously David Winner’s advise does not include such data collection and analysis; secondly, in a actual scenario, there are transaction cost and other constrains by diversifying the investment portfolio. For example, the adjustment of the portfolio could incur unnecessary cost and other impacts so that the right decision could be to maintain the original portfolio rather than diversifying it. Thirdly, with the increase of the number of stocks in the portfolio, the management cost of the portfolio will increase and also the effect of reduction of the risk will become less obvious with the increase of the number of stocks.

 

What is more, it is not that simple to translate the theory into actual investment practice. And there are more factors and information to be taken into account in order for an ideal investing strategy to be formed which will be elaborated in the next part.