The first step is diversification. It has been demonstrated that diversification reduces individual event risk. This concept is so important that the author of the statistical framework received a Nobel Prize in Economics .

Diversification starts as soon as you have two assets. Quantitative analysts have determined that weighted random portfolios of 10 or more securities approximate an underlying rate of return for that class of asset.

Portfolios of 30 or more securities tend to approximate a market rate of return. These portfolios have statistical properties which are amenable to large sample testing. This testing depends on the familiar bell-shaped normal curve. This simple parameterization leads to linear analysis and standard Value at Risk (VAR) practices.

Depending on selection techniques, portfolios of 100 or more securities can represent the broader market in terms of capitalization or a focused segment such as small or midcap corporate issues.

More information about the differences between large and small sample statistics and the implications for VAR programs is presented in the Members Only Section

Portfolio and Risk Management: Complementary Differences

Portfolio management focuses on the selection of assets to generate gains or income. Risk management focuses on the exposure profiles of those positions. One way to view this is to consider portfolio management as a bottom-up process versus top-down for risk management. Another view is that portfolio management is a What do we buy? process versus risk management’s What do we sell?

Portfolio management deals with aggregates, whereas risk management deals with aggregate limits, net positions and exposures. Also, portfolio management tends to deal with long positions in actual securities such as equities, corporate bonds, and CMOs. Risk management tends to place offsetting positions in derivatives. One reason for this is the difficulty of short selling many actual securities. For example, you could be holding most or all of a CMO tranche. From whom could you borrow it in order to sell it short?

Buying and selling actual securities tends to be more expensive transactionally than placing derivative positions. Also, actual equity positions have the ballot or the vote: Derivatives do not. Therefore, an actual security may enjoy a variable option value predicated on the marginal value of the associated voting right. When push comes to shove, synthetic positions do not have that capacity

A portfolio can be actively or passively managed. Passive management can be as simple as sticking with an inherited position or buy-and-hold indexed mutual funds. Active management can include sector rotation, momentum investing, day trading, or market making.

Risk management can be either passive or active as well. In its passive state, it may be the strict reliance on diversification to reduce nonsystematic risk. In its proactive version, it dynamically adjusts exposures on a recurring basis.

Diversification and Hedging: Complementary Differences

Diversification reduces nonsystematic risk in a portfolio. Nonsystematic refers to a specific individual corporate or country financial risk event. Therefore, as the number of securities increase in a portfolio, the portfolio’s nonsystematic risk decreases. The remaining risk is called systematic or market risk.

Systematic risk cannot be diversified out of a portfolio: However, systematic risk can be hedged.

Consider a portfolio consisting of an indexation of the S&P 500. By holding positions in these 500 companies, a portfolio has reduced the nonsystematic risk. Now the dependence and exposure on the fortune or failure of each company is an approximation of a 1 in 500 chance. The portfolio’s remaining risk is viewed as systematic or market. This means that the portfolio value will swing with the benchmark market. A manager can treat this systematic risk by hedging.

To offset the systematic risk, a financial manager would establish a hedge. This hedge would offset the dollar changes in the underlying portfolio position. Typically, this offset is accomplished with the futures, options or other derivative markets.

If the actual portfolio had a market value of $1 million, and the S&P 500 was trading at 1,000.00, then four futures would be sold to effectively offset the market risk. This is so because each futures contract represents the index level times a multiplier of $250 per index point or $250,000 per contract. It can be readily seen that partial hedges are possible and sometimes advisable.

More advanced index, trading and hedging programs can be designed. For more information, contact us.