Investment Education Series - 1/3: "Diversification - A Useful Tool, Until You Need It!"
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Investment Education Series - 1/3: "Diversification - A Useful Tool, Until You Need It!"I found a Series of Articles from Wealth Management Expert, Author, and Professor, Sharath Sury. There are three Ezinearticles written by Professor Sury, covering Diversification, ALM, and Risk Measurement. I felt Sharath Sury's articles are a must read for anyone wanting to sharpen their knowledge on important investing techniques. This entry includes Professor Sury's "Diversification - A Useful Tool, Until You Need It!" article. i will follow this article in a later post with "Risk Measurement - A Multi-Dimensional Concept!". ** If you find any of the articles in this series informative or useful, please leave a comment for author Sharath Sury on Blog.SuryOnline.net ! Diversification - A Useful Tool, Until You Need It!
 We have all been taught about themerits of diversification in investments. It is a variation of the oldadage, "Don't put all your eggs in one basket." Indeed, professional investment managers are trained to develop portfolios according to the tenets of Modern Portfolio Theory (MPT). MPT traces its roots to the work of Harry Markowitz and his seminal writings on "Portfolio Selection." In his pioneering research, Markowitz was able to demonstrate the mathematical basis for diversification.
Essentially, Markowitz showed that selecting assets that have a positive expected return but exhibit low or (preferably) negative correlation to one another produces a combined portfolio that retains the positive expected return properties, but with lowered risk (as defined by variance).
Theoretically, this result arises due to the presence of at least two major sources of risk: nonsystematic (or unique) risk and systematic (or market) risk. While it is very difficult to eliminate market risk, it is possible to reduce the risks associated with unique investment assets. By combining investment assets that are subject to certain specific, unique risks with other investment assets that are subject to other unique risks, it may be possible to reduce the overall risk of the combined portfolio.
For the past several decades, this has been the mantra to which all investment managers adhered. Unfortunately, recent experiences in the capital markets have led both academics and professional investment practitioners to rethink portfolio construction. With the increasing interconnectedness of global markets and investment pools, we have seen that correlation structures among various investment assets are not always stable.
As a result, investment managers need to be exceedingly careful in constructing portfolios that are able to withstand the dynamic nature of correlations, especially as the market experiences large disturbances. These "disturbances" are becoming much more commonplace: the Asian currency crisis of 1997, failure of the major hedge fund "Long Term Capital Management" in 1998, the burst of the "dot-com" bubble in 2000/2001, the terrorist attacks of 2001, the burst of the real estate bubble in 2007/2008, and the credit crisis of 2008/2009. In nearly every case, correlation structures among various assets increased at precisely the time when investors needed protection the most.
The best portfolio construction techniques have an appreciation for the fact that correlation structures may change during different "states of the world" or regimes. By incorporating these state-dependent correlation structures into portfolio design and optimization, investment managers can move to better protect portfolios during times of market distress.
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Professional Summary for Asset Allocation and Risk Management Expert, Sharath Sury:
Sharath M. Sury - Founder and Executive Director of the Sury Initiative for Financial Innovation & Risk Management (SIFIRM) at Santa Clara University, Sharath Sury devotes his time and energy to bringing together thought leaders who can address the development of real-world solutions to the current economic climate. Sharath Sury has worked with some of the brightest and most experienced experts in finance and risk management and aims to bring a greater sense of ethics and responsibility to his profession. Through his efforts, Professor Sury has established this invaluable forum for the research and discussion of new developments in the world of economics and finance and has attracted a renewed spirit of innovation to the industry. Sharath Sury also serves as an Adjunct Professor of Economics at the University of California and Adjunct Professor of Finance at DePaul University in Chicago. Sharath Sury's interest and experience in wealth management began as an Associate and later Vice President at Goldman, Sachs & Co. He later founded and worked at S4 Capital, where he earned numerous accolades for his work.
Article Source: Sury, Sharath "Diversification - A Useful Tool, Until You Need It!." Diversification - A Useful Tool, Until You Need It!. 9 Mar. 2010 EzineArticles.com. 31 Mar. 2010 <http://ezinearticles.com/?Diversification- - - A- Useful- Tool,- Until- You- Need- It!&id=3883169>.
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