Investment strategy - Portfolio theory and diversification

The portfolio theory describes a strategy that enables you to consciously put together a diversified selection of stocks, so the overall risk in the portfolio is minimized, while potential returns are maximized

The concept of diversification allows you to remove specific types of risk from the portfolio and as you will learn the diversification effects occur with a surprisingly small number of stocks

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Portfolio Theory - Minimize risk and maximize return through diversification

Market risk

Upturn after the crisis

Historical bubbles

Relation between return and risk

Some buy shares in expectation of high returns, for example in terms of rising stock prices in connection with the introduction of new products, implementation of a new aggressive business plan, or perhaps the company had already in the past year, strong growth and you expect that this continues. You are obviously aware that if the assumptions fail, then the expected rise in value will not be realized and perhaps the disappointed investors will react by selling out and prices fall. You suffer the loss. Thus the expectation of the high yield was closely associated with a correspondingly high risk.

Conversely, an investment in a company with longstanding stable, but lower profits will be associated with a lower expected return but also a lower risk.

So there is a clear correlation between return and risk. A high expected return will typically be associated with a correspondingly high risk. And accordingly, on an efficient market there is no chance of acquiring a stock with low risk without also having to reduce the expectations of returns

Market risk vs. company specific risk

It's important to understand that the risk in proportion to the returns you expect, consists of a market risk and a company specific risk. There will be a risk that the market is changing, which will have an effect on your return and there will be a risk that the company does not perform as expected.

Furthermore, there is typically that context that high yield shares are more sensitive to market risk than the more stable low yield shares.

The significance of this are set out below

The portfolio diversification effect

Let us first have a look at the company specific risk.

If your expectations of return on a particular stock investment is realistic, there will be two possible deviations to the expected. Very simple, either the company performs better or it performs worse. If you have invested in two different companies, you will find that they perform randomly either in the same or in different directions. Which means that fluctuations in relation to the expected to some extent will net each other out. This case is what we want to achieve by pooling shares in a portfolio. This is called diversification.

With only two shares in the portfolio there will still be a significant risk that they both perform badly. The more shares we add to the portfolio, the less likely it will be that all independent of each other is doing a bad result and likewise the chance increases that the fluctuations cancel each other. The question is only how many shares we need to achieve the optimal result

The optimal number of stocks in the portfolio

There have been numerous studies on how stocks in a portfolio diversify the risk. The conclusion is that at just 10 shares in a portfolio a significant diversification is achieved. We will here typically achieve a reduction of approximately 80% of the company risk.

If we increase the number of shares in the portfolio to 15-20, studies show that we achieve an almost 100% reduction of corporate risk.

The conclusion is therefore that we already with a holding of a maximum of 20 shares almost completely have removed the corporate risk and that we can not reduce the risk further by adding additional shares to the portfolio.

Reducing market risk

As we have now removed the company specific risk, the question is now whether we can also eliminate the market risk. The answer is that we can not in real world completely and not even closely eliminate the market risk, but we can reduce overall portfolio risk if we take into account how the shares we select reacts differently to market risk.