Forum Archive Index - July 2001

["Peter" <pmaiden@xtra.co.nz>]

Gerry - interesting subject you have raised here.

 

Risk, return, volatility, diversification etc are all the basics of portfolio management.

 

The question of volatility, in particular, is intriguing, especially in the context of a diversified portfolio.

 

Wheras the mathematics of diversifiaction is such that the return on a diversified portfolio will equal the average of the returns of it's individual holdings, the volatility (as measured by the standard deviation of the returns) will be less than than the average volatility of the individual holdings.

 

One great example by way of demonstrating this is in Peter Bernstein's very readable book "Against the Gods". In that book there is a chart that plots the monthly returns and volatility of 13 emerging stock markets in the early 1990s. 

 

The monthly returns vary from barely nothing to 4% per month (Phillipines). The average volatility ranges from 5% to 20% (Turkey) per month.

 

However an equally weightd index had a return of nearly 2% per month but only a volatility of 4.7% per month. Therefore about two thirds of the monthly returns of the index fell between -3% and 7% - hardly a reflection of the volatility of the individual stockmarkets.

 

In the same period the S&P 500 returned 0.5% per month with a volatility of 2% - ie two thirds of the monthly returns were between -1.5% and 2.5%.

 

The point being that even though the emerging markets looked pretty risky (volatile) when consolidated they were really not all that volatile. Hence the power of diversification and the spreading of risk.

 

Cheers

 

Peter