Safe Investment??

(A case study on Risk of Diversification)

``As more money has chased (...) risky assets, correlations have risen. By the same logic, at moments when investors become risk-averse and want to cut their positions, these asset classes tend to fall together. The effect can be particularly dramatic if the asset classes are small -- as in commodities. (...) This marching-in-step has been described (...) as a 'market of one'." The Economist, March 8th, 2007.

Introduction: Equity investors would like to multiply wealth by generating high returns. But whenever an investment decision is made, we are also exposed to the risk of principal amount (read: safety) and inability to sell off our investment without much loss of time and value (read: liquidity). Generally, returns are negatively related to safety and liquidity of the underlying instrument. If you had all your money in just one investment and that investment didn't perform you would make a loss. But, if you spread your money across different types of investments you may have a better chance of including some investments that will perform.

Traditional Asset classes can be summarized as: Equities, Fixed Income, and Cash. Alternative Asset Classes can be summarized as: Hedge Funds, Commodities, Property, Private Equity and Structured Products.

Alternatives can be used in different ways within a portfolio. Structured Return Products, for example, can produce excellent returns at low risk of capital, provided that the investor is happy to hold products till their maturity, should the need arise. Hedge Funds can be used to gain access to obscure asset-classes, for example, Distressed Debt. In terms of pure diversification of risk, however, Absolute Return strategy, particularly Global Multi-Asset, Absolute Return Strategy, can offer a more suitable method of diversifying risk. Commodities have historically provided an excellent diversification benefit when combined with the traditional asset classes.

Absolute Return Strategy can be employed to dampen the effect of asset price movements, and typically employs the following types of financial derivatives with the underlying assets originating from commodities, currencies, securities, indices, and events: Futures & Options Credit & Interest Rate Swaps (including Credit Default Swaps) Forward Rate Agreements Both, which are the global benchmark indices, show very low/negative correlation with several other asset classes that are typically part of a broadly diversified portfolio, including equity, fixed income and real estate. This characteristic, combined with consistently positive returns, will serve to lower the overall volatility and improve the risk-adjusted returns of a total plan portfolio.

The global financial crisis in 2008 caused investors to question what went wrong with many of their portfolios, which were believed to be diversified. Mean-Variance Optimization (MVO), 60/40, Modern Portfolio Theory (MPT) and others seem to have been put on trial by practitioners and critics alike for their apparent under-diversification and accused failure to provide risk control. A list of new paradigms or next generation solutions has been declared to displace MPT. A growing amount of literature on portfolio construction approaches focused on risks and

diversification rather than estimating expected returns, collectively called risk-based asset allocation in this study, has been documented.

The Concept of Equity Diversification In its most basic sense, diversifying or the process of diversification means to vary, to give variety, or to spread out. In an investment context we vary or spread out our investments by holding multiple securities, and the reason for doing so is to reduce risk. Introductory finance textbooks generally have a section on this topic, and they show how, within a market such as the Canadian equity market, adding securities reduces overall portfolio risk. This happens dramatically at first, as you add a second, a third, and a fourth security to your portfolio, but as you reach perhaps 20 securities, the marginal reduction in risk gets to be quite small. Of course the ultimately diversified portfolio within a market holds all the securities in the market. There are two related themes in this process of diversification. The first is the point that adding securities lowers risk due to the imperfect correlation(1) between individual stocks in a market. This is the risk reducing aspect of diversification. But the second point is that you cant diversify away the market itself by adding more and more diversifying holdings --- in fact the more holdings you add, the closer you get to the market. In the jargon of finance theory, we say that you can diversify away non-systematic or non-market risk, but you cannot diversify away systematic or market risk. So here is a good definition of diversification as found on the Bloomberg Financial Website in their Financial Glossary: Diversification: Dividing investment funds among a variety of securities with different risk, reward, and correlation statistics so as to minimize unsystematic risk.(2) Diversifying Equities Globally Now, when we take the step of diversifying our equity portfolios globally, the same process is in play. The risk we are able to reduce is the unsystematic risk relative to the global market. By adding global securities, or (in our case) S&P500 and EAFE ETFs, and perhaps Emerging Markets as well, we are hoping to lower portfolio risks by adding imperfectly correlated securities. Using the finance jargon, we are also lowering our non-systematic risk relative to the global equity market, and we are getting closer and closer to holding the global market itself --the systematic global equity risk that we cannot diversify away. When we lower our non-systematic risk, we are lowering the risk that our portfolio will behave very differently from the market itself. So when a globally diversified portfolio experiences a global selloff, such as the 2008 plummet generated by the real estate crash and broader financial system blow up, it just goes down! We had (and are still experiencing in March 2009) a global market phenomenon. Global equity diversification cannot protect an investor from a global market event --- by definition.

In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents.[1]. Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more completely than less risk-averse investors. Diversification is one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive. Hedging relies on negative correlation among assets, or shorting assets with positive correlation. It is important to remember that diversification only works because investment in each individual asset is reduced. If someone starts with $10,000 in one stock and then puts $10,000 in another stock, they would have more risk, not less. Diversification would require the sale of $5,000 of the first stock to be put into the second. There would then be less risk. Hedging, by contrast, reduces risk without selling any of the original position[2]. The risk reduction from diversification does not mean anyone else has to take more risk. If person A owns $10,000 of one stock and person B owns $10,000 of another, both A and B will reduce their risk if they exchange $5,000 of the two stocks, so each now has a more diversified portfolio[3]. The simplest example of diversification is provided by the proverb "don't put all your eggs in one basket". Dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified. There is more risk of losing one egg, but less risk of losing all of them. In finance, an example of an undiversified portfolio is to hold only one stock. This is risky; it is not unusual for a single stock to go down 50% in one year. It is much less common for a portfolio of 20 stocks to go down that much, even if they are selected at random. If the stocks are selected from a variety of industries, company sizes and types (such as some growth stocks and some value stocks) it is still less likely. Further diversification can be obtained by investing in stocks from different countries, and in different asset classes such as bonds, real estate, private equity, infrastructure and commodities such as heating oil or gold[4]. Since the mid-1970s, it has also been argued that geographic diversification would generate superior risk-adjusted returns for large institutional investors by reducing overall portfolio risk while capturing some of the higher rates of return offered by the emerging markets of Asia and Latin America.[5] [6]

[edit] Return expectations while diversifying

If the prior expectations of the returns on all assets in the portfolio are identical, the expected return on a diversified portfolio will be identical to that on an undiversified portfolio. Ex post, some assets will do better than others; but since one does not know in advance which assets will

perform better, this fact cannot be exploited in advance. The ex post return on a diversified portfolio can never exceed that of the top-performing investment, and indeed will always be lower than the highest return (unless all returns are ex post identical). Conversely, the diversified portfolio's return will always be higher than that of the worst-performing investment. So by diversifying, one loses the chance of having invested solely in the single asset that comes out best, but one also avoids having invested solely in the asset that comes out worst. That is the role of diversification: it narrows the range of possible outcomes. Diversification need not either help or hurt expected returns, unless the alternative non-diversified portfolio has a higher expected return.[7] But risk averse investors may find it beneficial to diversify into assets with lower expected returns, thereby lowering the expected return on the portfolio, when the risk-reduction benefit of doing so exceeds the cost in terms of diminished expected return.

[edit] Maximum diversification

Given the advantages of diversification, many experts recommend maximum diversification, also known as buying the market portfolio. Unfortunately, identifying that portfolio is not straightforward. The earliest definition comes from the capital asset pricing model which argues the maximum diversification comes from buying a pro rata share of all available assets. This is the idea underlying index funds. One objection to that is it means avoiding investments like futures that exist in zero net supply. Another is that the portfolio is determined by what securities come to market, rather than underlying economic value. Finally, buying pro rata shares means that the portfolio overweights any assets that are overvalued, and underweights any assets that are undervalued. This line of argument leads to portfolios that are weighted according to some definition of economic footprint, such as total underlying assets or annual cash flow.[8] Risk parity is an alternative idea. This weights assets in inverse proportion to risk, so the portfolio has equal risk in all asset classes. This is justified both on theoretical grounds, and with the pragmatic argument that future risk is much easier to forecast than either future market value or future economic footprint.[9]

[edit] Effect of diversification on variance

One simple measure of financial risk is variance.

[edit] Diversifiable and non-diversifiable risk

The Capital Asset Pricing Model introduced the concepts of diversifiable and non-diversifiable risk. Synonyms for diversifiable risk are idiosyncratic risk and security-specific risk. Synonyms for non-diversifiable risk are systematic risk, beta risk and market risk. If one buys all the stocks in the S&P 500 one is obviously exposed only to movements in that index. If one buys a single stock in the S&P 500, one is exposed both to index movements and movements in the stock relative to the index. The first risk is called non-diversifiable, because

it exists however many S&P 500 stocks are bought. The second risk is called diversifiable, because it can be reduced it by diversifying among stocks, and it can be eliminated completely by buying all the stocks in the index. Of course, there's nothing special about the S&P 500; the same argument can apply to any index, up to and including the market portfolio of all assets. The Capital Asset Pricing Model argues that investors should only be compensated for nondiversifiable risk. Other financial models allow for multiple sources of non-diversifiable risk, but also insist that diversifiable risk should not carry any extra expected return. Still other models do not accept this contention[13]

[edit] Corporate diversification strategies

In corporate portfolio models, diversification is thought of as being vertical or horizontal. Horizontal diversification is thought of as expanding a product line or acquiring related companies. Vertical diversification is synonymous with integrating the supply chain or amalgamating distributions channels. Non-incremental diversification is a strategy followed by conglomerates, where the individual business lines have little to do with one another, yet the company is attaining diversification from exogenous risk factors to stabilize and provide opportunity for active management of diverse resources.

History [edit] Diversification with an equally-weighted portfolio

The expected return on a portfolio is a weighted average of the expected returns on each individual asset:

where xi is the proportion of the investor's total invested wealth in asset i. The variance of the portfolio return is given by:

Inserting in the expression for

Rearranging:

where

is the variance on asset i and ij is the covariance between assets i and j. In an equally.

weighted portfolio, The portfolio variance then becomes:

And simplifying:

Now, taking the number of assets, n, to the limit gives:

Thus, in an equally-weighted portfolio, the portfolio variance tends to the average of covariances between securities as the number of securities becomes arbitrarily large.

[edit] See also

Asset Allocation on Wikibook

Modern portfolio theory Central limit theorem Dollar cost averaging Systematic risk List of finance topics

[edit] References
^ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 273. ISBN 0-13063085-3. 2. ^ Fama, Eugene F.; Merton H. Miller (June 1972). The Theory of Finance. Holt Rinehart & Winston. ISBN 978-0155042667. 3. ^ Sharpe, William; Gordon J. Alexander, Jeffrey W. Bailey (October 30, 1998). Investments. Prentice Hall. ISBN 978-0130101303. 4. ^ Campbell, John Y. Campbell; Andrew W. Lo, A. Craig MacKinlay (December 9, 1996). The Econometrics of Financial Markets. Princeton University Press. ISBN 9780691043012. 5. ^ (French) see M. Nicolas J. Firzli, Asia-Pacific Funds as Diversification Tools for Institutional Investors, Revue Analyse Financire/The French Society of Financial Analysts (SFAF), retrieved 2009-04-2 6. ^ (English) see Michael Prahl, Asian Private Equity Will it Deliver on its Promise?, INSEAD Global Private Equity Initiative (GPEI), retrieved 2011-06-15 7. ^ Goetzmann, William N. An Introduction to Investment Theory. II. Portfolios of Assets. Retrieved on November 20, 2008. 8. ^ Wagner, Hans Fundamentally Weighted Index Investing. Retrieved on June 20, 2010. 9. ^ Asness, Cliff; David Kabiller and Michael Mendelson Using Derivatives and Leverage To Improve Portfolio Performance, Institutional Investor, May 13, 2010. Retrieved on June 21, 2010. 10. ^ Samuelson, Paul, "General Proof that Diversification Pays,"Journal of Financial and Quantitative Analysis 2, March 1967, 1-13. 11. ^ Samuelson, Paul, "Risk and uncertainty: A fallacy of large numbers," Scientia 98, 1963, 108-113. 12. ^ Ross, Stephen, "Adding risks: Samuelson's fallacy of large numbers revisited," Journal of Financial and Quantitative Analysis 34, September 1999, 323-339.
1.

^ .Fama, Eugene F.; Merton H. Miller (June 1972). The Theory of Finance. Holt Rinehart & Winston. ISBN 978-0155042667. 14. ^ E. J. Elton and M. J. Gruber, "Risk Reduction and Portfolio Size: An Analytic Solution," Journal of Business 50 (October 1977), pp. 415-37 15. ^ Life Application Study Bible: New Living Translation. Wheaton, Illinois: Tyndale House Publishers, Inc.. 1996. p. 1024. ISBN 0-8423-3267-7. 16. ^ Ecclesiastes 11:2 NLT 17. ^ The Only Guide to a Winning Investment Strategy You'll Ever Need 18. ^ Markowitz, Harry M. (1952). "Portfolio Selection". Journal of Finance 7 (1): 7791. doi:10.2307/2975974.
13.

[edit] External links

Macro-Investment Analysis, Prof. William F. Sharpe, Stanford University Portfolio Diversifier, Dynamically-generated diversified portfolios Asset Correlations, Dynamically-generated correlation matrices for the major asset classes An Introduction to Investment Theory, Prof. William N. Goetzmann, Yale School of Management Overview of Managed Futures

Safe Investment??
(A case study on Risk of Diversification)
Introduction: Equity shares are issued by limited liability companies as risk capital. Shareholders have voting rights and collectively, therefore, have control of the company. They have the right to share in any distribution of dividend, in proportion to their percentage shareholding, and they have the right to a proportion of any residual assets in the case of dissolution. A key characteristic of equities is that both future dividend income and future share values are at all times uncertain. It is for this reason that equity investors seek a higher expected return than that which is available on alternative risk-free investments. Investors accept that there is uncertainty, or risk, associated with equity investment returns. Consequently, equities are normally priced so that they provide a premium to the returns available on risk-free investments. Equity returns, however, are cyclical. There can be long periods when equity returns greatly exceed risk-free returns; there can be long periods when the premium disappears altogether. Rational investors hold portfolio of securities rather than single investments to mitigate the risk. As the stock market benchmark, equity index is a collection of stocks that can be taken as a proxy portfolio for the overall economy. Summary Statistics for LSE and NYSE Equities

The above table drawn from Goetzmann and Ibbotson (2006), shows that the long-term, annual, geometric capital appreciation of London Stock Exchange (LSE) equities over the total period was 2.1; the equivalent average for New York Stock Exchange (NYSE) equities was 3.9%. The annual standard deviations in annual performances were 15.7% and 18.4% respectively. It is particularly interesting to note that the appreciation rate in LSE equities was much lower than that of NYSE equities over the eighteenth and nineteenth centuries but more than matched the appreciation rate of NYSE equities over the twentieth century. The standard deviation in returns for both markets was higher during the twentieth century than during earlier periods (AB Fitzgerald, 2009). Investment in stocks can be risky. The return on investment (ROI) of stock can be hard to predict, as the price of stock is determined by the financial success of the company, the demand for that companys stock by investors, and the overall confidence investors have in the market at a given moment. Investment in the stock market depends as much upon factual, logical decisions as well as gut-feeling emotional ones. Because of its relative unpredictability and therefore inherent possibility for huge returns, the stock market is one of the most popular investment decisions among private investors. The stock markets constant fluctuation empowers investors with a multitude of opportunities for

substantial profits. This possibility of high returns and the unpredictability of the market are enticing to excitable investors, however with wise decision-making, the stock market can be a stable, long-term investment opportunity as well. For this reason, there are many stock market investment strategies that help investors make tough decisions. The stock market investment strategies are relevant to investors who are in it for the long haul. There are basically two strategies that an investor can apply; the first one being to "buy low and sell high" and the second one being to "buy high and sell higher". There are plenty of Stock market investing strategies that can be extremely profitable, but it requires making decisions based on reason and not emotion. Smart investors diversify their asset holdings by owning a portfolio, which are a collection of financial assets consisting of stocks, bonds, gold, foreign exchange, asset-backed securities, real estate certificates and bank deposits. They explore alternatives to beat the street. Broadly speaking, these alternatives include asset classes or investment strategies that fall into at least one of four categories: - Real estate-related investments, which directly or indirectly participate in the income and/or capital appreciation potential of land and buildings. - Commodities-related investments tied directly or indirectly to the performance of agricultural products, livestock, natural resources, metals and the companies that process these. - Nontraditional asset classes, or investments linked to stock and bond asset classes that are not as widely analyzed and utilized by the majority of investors and, generally speaking, typically are not included in asset allocation programs.

- Nontraditional investment strategies. Unlike the three groups above, these are not asset classes. They are investments that often invest in the traditional asset classes but manage their holdings with strategies not generally used by traditional portfolio managers (e.g., mutual fund managers). In an effort to exploit market inefficiencies and trends or to reduce downside risk, these investments may use leverage (i.e., debt or borrowed money), derivatives, arbitrage, shortselling, intense concentration, tactical allocation or other approaches. They may also make direct investments in small, start-up businesses or use capital to purchase companies outright. The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays off when energy prices rise and another that pays off when energy prices fall. A portfolio that contains both assets will always pay off, regardless of whether energy prices rise or fall. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio. In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's nest egg. Modern portfolio theory states that the risk for individual stock returns has two components: Systematic (Non-diversifiable Risk) and Unsystematic (Diversifiable Risk). Systematic risk originates from macroeconomic variables such as interest rates, inflation rates and exchange rates while Unsystematic risk is companyspecific risk of the stock. It can be diversified away by adding more stocks in an equity portfolio.

For a well-diversified portfolio, the risk - or average deviation from the mean - of each stock contributes little to portfolio risk. Instead, it is the difference - or covariance - between individual

stock's levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks.

In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3290 securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n. Their results are summarized below. It can be seen that most of the gains from diversification come for n30.

Number of Stocks Average Standard Deviation of Ratio of Portfolio Standard Deviation to in Portfolio Annual Portfolio Returns Standard Deviation of a Single Stock 1 49.24% 1.00 2 37.36 0.76 4 29.69 0.60 6 26.64 0.54 8 24.98 0.51 10 23.93 0.49 20 21.68 0.44 30 20.87 0.42 40 20.46 0.42 50 20.20 0.41 400 19.29 0.39 500 19.27 0.39

1000

19.21

0.39

Diversification can lower the variance of a portfolio's return below what it would be if the entire portfolio were invested in the asset with the lowest variance of return, even if the assets' returns are uncorrelated. For example, let asset X have stochastic return x and asset Y have stochastic

return y, with respective return variances

and

. If the fraction q of a one-unit (e.g. one-

million-dollar) portfolio is placed in asset X and the fraction 1 q is placed in Y, the stochastic portfolio return is qx + (1 q)y. If x and y are uncorrelated, the variance of portfolio return is

. The variance-minimizing value of q is

, which is strictly between 0 and 1. Using this value of q in the expression

for the variance of portfolio return gives the latter as

, which is less than what

it would be at either of the undiversified values q = 1 and q = 0 (which respectively give

portfolio return variance of

and

). Note that the favorable effect of diversification on

portfolio variance would be enhanced if x and y were negatively correlated but diminished (though not necessarily eliminated) if they were positively correlated. In general, the presence of more assets in a portfolio leads to greater diversification benefits, as can be seen by considering portfolio variance as a function of n, the number of assets. For example, if all assets' returns are mutually uncorrelated and have identical variances ,

portfolio variance is minimized by holding all assets in the equal proportions 1 / n. Then the

portfolio return's variance equals var[(1 / n)x1 + (1 / n)x2 + ... + (1 / n)xn] = which is monotonically decreasing in n.

The latter analysis can be adapted to show why adding uncorrelated risky assets to a portfolio, thereby increasing the portfolio's size, is not diversification, which involves subdividing the portfolio among many smaller investments. In the case of adding investments, the portfolio's return is the portfolio return instead of (1 / n)x1 + (1 / n)x2 + ... + (1 / n)xn, and the variance of if the assets are uncorrelated is

which is increasing in n rather than decreasing. Thus, for example, when an insurance company adds more and more uncorrelated policies to its portfolio, this expansion does not itself represent diversification. Investors would like to drive down risks associated with a single investment by blending with other investments in the same category of assets to form portfolio of equities. Despite holding a portfolio of equity shares, there would still be variance of returns warranting addition of other class of assets to the portfolio. Equity investors add fixed income securities to their portfolio to reduce the volatility of returns. This diversification strategy of adding different class of assets to optimize the portfolio returns while mitigating risk is considered to be a safer bet. Institutional investors take this diversification further by including commodities in the portfolio as commodities are a good hedge against inflation. Diversification helps investors to take advantage of the 'ups' while moderating the 'downs'. Simply put, diversification is not putting all your eggs in one basket. Or not putting all your money into just one type of investment. All investments are subject to some level of risk. Some are more risky than others. Different types of

investments perform better under different market conditions. By investing in more than one type of investment you diversify, which can help reduce the risk for your overall investment portfolio. The more ways you diversify the more likely you are to reduce your risk. For example, across

Different asset classes (cash, fixed interest, property, shares) More than one investment in each asset class (e.g., several different industries and companies when investing in shares)

More than one type of fund and investment manager when investing in managed funds.

When constructing an investment portfolio around the traditional assets, risk can be removed by spreading allocations across a selection, or a complete range of alternatives, but two problems have hindered this strategy:

Correlation: Asset price correlations are not static, and can be very unpredictable. Liquidity: Asset classes such as Structured Products, Property, PE Funds, and Hedge Funds can be illiquid, particularly if their values are falling.

The rise of commodities as an asset class in portfolio investment has resulted in commodity prices becoming intimately linked to price behavior in equities and other financial markets (Gorton and Rouwenhorst 2004; Domanski and Heath 2007; Doyle, Hill et al. 2007). Commodities and equities are distinct asset classes, influenced by a similar set of factors, namely global GDP, but in different ways. Commodities tend to perform well in times of inflation, as increasing natural resource prices typically cause product prices to increase. Periods of inflation are generally accompanied by rising interest rates, which control the inflation that generally creates a challenging environment for equities. Conversely, periods of low interest rates and low

inflation or deflation are normally bullish for equities and bearish for commodities. In times of extreme panic or market distress however, the correlation between stocks and commodities tends to increase as investors decide between risk-on or risk-of attitudes, as opposed to fundamentals.

As global market volatility continues, investors of diversified portfolios are continually looking for uncorrelated investments in an attempt to reduce unsystematic risk and improve the risk/return profile of the total portfolio. Many investors have looked to the alternative asset classes as a way to provide this sought-after diversification. Alternative investments such as private equity and real estate have been a key part of institutional portfolios for over 20 years, but there continues to be a search for newer opportunities in the Commodities space. According to Bloomberg, California Public Employees' Retirement System, a $240 billion pension fund, is planning to increase its Commodities investment to $7.2 billion (3% of its assets) through 2010. Commodity investments, which fall under the real assets category of the alternative asset class, have many characteristics that make them attractive to institutional investors. Commodities are broken into several main categories such as energy, agriculture, livestock and metals. These groupings are comprised of numerous raw materials, including natural gas, crude oil, aluminum, copper and gold. Investment in this asset class is typically gained through the use of commodity futures. The Dow Jones AIG Commodity Index and the S&P GSCI Commodity Index, which are the global benchmark indices, show very low/negative correlation with several other asset classes that are typically part of a broadly diversified portfolio, including equity, fixed income and real estate. This characteristic, combined with consistently positive returns, will serve to lower the overall volatility and improve the risk-adjusted returns of a total plan portfolio.

The subprime crisis that originated in USA during 2007-08 had a huge impact on financial markets worldwide and the global economies. During the crisis, volatility of S&P 500 implied in option prices rose from the usual 15-30% range to 40-80%. It has been shown that large jumps exert huge influence on correlation dynamics and volatility forecasts (Eraker, Johannes and Polson, 2003, and Maheu and McCurdy, 2004). In the derivative markets, jump commands a huge premium especially in a market that has just experienced a jump (Todorov, 2009). Das and Uppal (2004) claim that jumps typically occur across markets at the same time having a large impact on correlations and covariances. Hence my research is most relevant as even the most diversified investment portfolios across geographical markets and asset-classes had made most institutional investors suffer huge losses. One probable explanation for this could be that the correlation coefficients in the aftermath of the economic crisis had been much higher than what was witnessed historically. Objectives: Commodities have historically provided an excellent diversification benefit when combined with the traditional asset classes. As institutional investors have discovered these phenomena, they have been constructing optimal portfolios with historical data to maximize returns and minimize risk. The proposed case study tries to determine: Whether equities and commodities (UK and USA) still move in the same direction? Whether equity markets across countries (UK and USA) move in the same direction?

Methodology: The proposed research to track the co-movement of equities and commodities across geographical markets has identified three variables to measure the benefits of a diversification strategy. These variables are popular indices like FTSE 100 and DJIA 30 (equity market benchmarks for UK and USA) and the S&P GSCI Commodity Index (global commodity benchmarks). The period of study has been restricted to the calendar years 2005-2009 where

monthly data has been sourced from www.bloomberg.com. When we diversify across asset classes that are not perfectly correlated (that is, have a correlation coefficient less than +1) the volatility of the portfolios returns will be less than the weighted sum of the volatilities of the individual asset classes. All other things being equal, the lower the correlation between the different asset classes the greater the diversification benefits will be. The theoretical benefits available when investing between two asset classes are shown in the diagram below for differing magnitudes of correlation coefficient.

As the level of correlation between asset classes A and B reduces, the diversification benefits increase and we are able to reduce the level of the portfolios volatility whilst still maintaining the same expected level of return. Domestic institutional investors in UK would diversify across equity markets to optimize their portfolios. Hence, correlation coefficient between FTSE and DJIA would enable us to know if such a diversification strategy pays-off in the long run. Furthermore, they would also spread their investment bets across different class of assets primarily such as, equities and commodities. A study of multiple correlation coefficients between FTSE, DJIA, and S&P GSCI will give us the insight about optimal returns through diversification across two different asset-classes. If the correlation/multiple correlation is low or negative, it indicates that there are rich opportunities to explore through diversification of portfolios across geographical markets and different asset-classes.

Literature Review: Diversification is first mentioned in the Bible, in the book of Ecclesiastes, which was written in approximately 935 B.C.: But divide your investments among many places, for you do not know what risks might lie ahead. Shakespeare in Merchant of Venice talks about diversification: My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate Upon the fortune of this present year: Therefore, my merchandise makes me not sad.

The modern understanding of diversification dates back to the Modern Portfolio Theory (MPT) which was developed by Harry Markowitz and published as "Portfolio Selection" in the 1952 Journal of Finance. MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification - chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket. For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls "risk".

Although a portfolio consists of certain assets, it is a specific entity with measurable qualities as there is a relationship between the assets in question. Therefore, a portfolio is not simply a sum of the assets it includes (Ceylan, Korkmaz, 1998). The basic motive behind portfolio

construction is risk dispersion. Since the returns on the assets constituting a portfolio do not move in the same direction, the risk of the portfolio will be lower than that of a single asset. From this principle it follows that the traditional portfolio management approach is based on the rule of increasing the number of assets in a portfolio. This approach could be described as not to put all the eggs in the same basket (Fisher, Jordan, 1991).

The traditional portfolio approach is treated as an art with its own specific rules and principles in portfolio management. The ability to use these rules and principles as well as other theoretical tools depends on the accumulated information and experiences that change from person to person (Christy, Clendedin, 1974). Considered as the father of the modern portfolio approach, Henry M. Markowitz demonstrated that risk could be reduced without giving up the expected returns by taking into account the relationship between the financial asset returns and combining in the same portfolio the assets that are not in a completely positive relationship (Markowitz, 1959). Markowitzs modern portfolio theory has made a new paradigm of portfolio selecting for investors in order to form a portfolio with the highest expected return at a given level of risk tolerance (Markowitz, 1952; Oh, Kim, Min, Lee, 2006).

Though there were references to the concept of risk in portfolio management up until the 1950s, there were no specific tools to measure the concept in question. Markowitz was the first to suggest that changes in the actual returns on a portfolio and the standard deviation or the variance of the new portfolio could be used to measure the risk of the portfolio (Markowitz, 1959). In the Markowitz approach, selecting the most appropriate portfolio requires calculating the correlation between all assets and all possible combinations of assets, along with the

expected returns and risk of each asset included in the portfolio (Karain, 1986). In a case with N number of stocks, the number of the covariance and correlation coefficients to be known is N*N1/2. To put it another way, one needs to know the covariance or correlation between any two stocks that could be included in the portfolio (Sang, Lerro, 1973).

Consequently, in order to construct an efficient portfolio in the Markowitz model could be summarized as follows, one needs to (Fabozzi, 1999):

Calculate the expected return rates for each stock to be included in the portfolio, Calculate the variance or standard deviation (risk) for each stock to be included in the portfolio, Calculate the covariance or correlation coefficients for all stocks, treating them as pairs. Later studies by Sharpe (1964), Lintner (1965) and Mossin (1966) on portfolio construction further investigated the trend of prices in case all savers invest in financial assets and particularly in share certificates in accordance with the modern portfolio theory (Zorlu, 2003).

On the topic of strategic asset allocation, we have been seeing more writings on the various versions of risk-based asset allocation approaches applied to a global universe of assets, especially in cases of pension and endowment management. See Allen (2010) and Foresti and Rush (2010), for examples. A common finding among these studies is the superior risk-adjusted return of a portfolio that is constructed in such a way that assets are expected to contribute equal risk to the whole portfolio an approach commonly labeled as Risk Parity. In a Risk Parity approach, only risk forecasts are used as inputs and no forecasts of returns of any assets are required.

In a study covering the period between August 1999-September 2003, Ulucan (2002) applied the Markowitz Quadratic Programming model on the 50-month returns of the companies enrolled in ISE-30 index. This two-step study first constructed portfolios yielding the same risk-returns as the index, and then continued in the second step with constructing portfolios with the same returns as but with lower risks than the index. Drawing upon the fortnightly, monthly, and trimonthly return values of the companies enrolled in the ISE-100 index as recorded between January 2003-July 2004, the study by Yaln, Ataner, Boztosun (2005) applied the Markowitz Quadratic Programming model to calculate the portfolio weights with return levels equal to the index but with lower risks and those with risk levels equal to the index but with higher returns.

If we simply choose a period of history, and calculate optimal portfolios with the benefit of perfect hindsight, we can find some combination of investments which have generated high returns with low risk. This is the problem with portfolio optimization on historical data: you end up estimating optimal portfolio returns that are not achievable in real life. Forward-looking models compensate for these effects by generating statistical outlooks for portfolio performance that account for the uncertainties in the future. However, in recent times, there has been greater convergence in the price movement of varied asset classes eroding the benefits of diversification. From January 1970 to February 2008, when both the U.S. and World ex-U.S. stock marketsas represented by monthly returns for the Russell 3000 and MSCIWorld Ex-U.S. indices, respectivelywere up more than one standard deviation above their respective full-sample

mean, the correlation between them was 17%. In contrast, when both markets were down more than one standard deviation, the correlation between them was +76% (Kritzman and Li [2010]).