Diversification Mitigates Risk
Diversification—a concept as simple as not putting all your eggs in one basket—is an effective method of managing risk in your investment portfolio. Intuitively, it makes sense, and this easily understand concept is at the heart of a theory that guides investment management and dates back to the work of economist Harry Markowitz in the 1950s. Markowitz’s modern portfolio theory (MPT) assumes that investors are risk-averse—that they prefer less risk to more risk for the same level of return. The flip side is that investors will take on more risk, but only if they expect a higher return. Risk is an inherent part of return. MPT provides a mathematical framework for building investment portfolios to optimize or maximize return based on a given level of risk.
According to MPT, it is possible to construct an “efficient frontier”—basically, various portfolios that offer the maximum possible return for a given level of risk. One way to think of or measure risk is variance, or how variable the return is, relative to expectations. A major insight provided by MPT is that an investment’s risk and return characteristics should not be viewed alone, but should be evaluated by how an investment affects the total portfolio’s risk and return. An investor can reduce portfolio risk simply by holding combinations of securities or assets that are not perfectly positively correlated. In other words, investors can reduce their exposure to risk by holding a diversified portfolio (allocating between assets and/or diversifying among securities). Diversification allows for the same expected return with reduced risk.
Investors should consider the following:
- Ensure that the organization has sufficient liquidity to meet ongoing obligations by investing a portion of its portfolio in readily available funds (e.g., local government investment pools, money market funds, or other liquid funds).?Establish limits on positions with specific issuers, securities, sectors, or assets.
- Develop strategies and guidelines for investments in single classes of securities (e.g., commercial paper, bankers acceptances, or repurchase agreements).
- Limit investments in securities that have high credit and/or market risks (e.g., derivatives).?Limit particular structures (e.g., optionality, amortizing components, coupons, issue sizes).
- Define parameters for maturity/duration ranges.?Understand the organization’s risk tolerance and establish a target risk profile for the investment portfolio.
- Understand that even if an individual investment is diversified (e.g., a pool), the organization still needs to make sure its overall investment portfolio is diversified.
- Review the GFOA best practices on these topics.