Diversification generally means have a wide range, in portfolio terms having a wider range of stocks and shares. Wider range meaning having shares in different sectors as it is said that shares in the same sector trend similar, also having stock and shares which are not perfectly correlated this will stop all your shares acting similar to each other.
We need to diversification to reduce risk this is the fundamental thing here, one other way to diverse is to hold many shares, people will always ask how many share of different companies do I need to reduce risk and different text books will always give different answers some will say 10 others as much as 30 this manly gets systematic risk out the way. Reducing risk will always be in the mind of portfolio mangers and ever searching ways to reduce it and one way they found to reduce risk is known as international diversification, the benefits of using international diversification are numerous ways.
All stocks in Britain are constrained to have the same exposure to the UK country factor. It does not matter whether this company is a multinational or a company only operating within the borders. This is like diversifying industry sectors; when a portfolio manager will pick shares in different sectors thus will eliminate sector influences, meaning the portfolio will not follow a sector pattern. I. e. when it shares go down not all share will go down, this is using the same principal but on a wider scale.
In general diversification gives reduction in portfolio volatility and higher overall returns so theoretically international diversification will give even lower volatility because it has reduced country risk as all shares and stocks are not from the same country. Portfolio managers always look not only to reduce risk but also find the best returns, in the past non-UK equities has indicated and performed well providing better risk- adjusted returns than UK equities. The Concept of diversification can be explained a few ways; one way one will explain it is as follows, and here numerical examples are used to compliment the written Explanation.
CAPM is an economic model for valuing stock by relating risk and expected return. CAPM is one of the most used investment models to determine risk and return this model like other models can be criticized within portfolio management. The main criticisms are That the model makes some unrealistic assumptions, which are not true to all portfolios these cause problems. A normality of returns is a crucial assumption. It is also based on an idealistic investment environment where everything is perfect which we know is different from the real world it also
The model does not work well- If the model was correct we should see a linear relationship between betas and the returns which is not the case, instead we have a very weak relationship Variables may explain otherwise that cannot with this model such as firm size, price, book. The models constraints cannot be properly estimated where an error in any of the variables (the risk-free rate, the expected return of the market portfolio, and the beta of the asset) will lead to wrong information and a bad decision might be made.
There are many market returns available to choose from (FTSE, NYSE S&P 500). Beta is volatile to change in a particular company also estimates of beta changes among managers and agents a major criticism is that it only uses a single factor in determine the return of portfolio. Although they are many criticisms we have t understands it is one of the best models it has been in use for several decades and still going strong We have and a newer better one has yet to be developed so until then it will carry on being used.
“Most empirical evidence supports the view that abnormal equity returns cannot be generated systematically. ” The statement above will have a few academics split while thee are some that agree with the statement others don’t it is a highly controversial and often disputed. While some believe in an efficient market where at any point in time the actual price of equity will be an accurate or good estimate of the intrinsic value. They believe in the Efficient Market Hypothesis.
This assumes that all Investors, managers and interested parties have and perceive the information available in the same approach. It has the view that it is impossible to beat the market and that you cannot continually outperform the market by the information known, as it is know by everybody, but only beat it by luck and chance. There are three common forms where EMH is stated Weak form, semi-strong form and strong form all three state that no excess return can be earned.
Assumptions Believers point out that it is a waste of time to search for under or over valued stock and search for patterns in the market through technical. They believe not only stocks are efficient they are also random know as the ” the random walk”, showing there is no pattern but prices are random. Counter arguments have risen, investors will always look at the information differently and there fore act differently, so therefore they can reach a different value of the stock, and invest differently.
Also there are a range of investors, managers and funds but not all are making a profit if market is efficient than all should make a profit or all a loss but we know this is not the case. Analyst working trying to find trends are supposedly wasting there time as trends and patterns do not exist although there are many and working it as a career. It is noted that there are several trends have been found within the markets which show there is a pattern the January effect and the weekend effect are a couple, these would not exist if prices were random and patterns did not exist.
The most important counter argument maybe the fact that investors have out beaten the market consistently namely Warren Buffett focusing on undervalued stocks. Going back to the statement we can see that abnormal can be generated but weather systematically that is still questionable. The fact that not all can generate abnormal returns makes it a less systematic, but one comment that can be made is we know he market is not fully efficient or fully inefficient but somewhere in-between.