Diversification of Portfolios
Abstract
Diversification generally means the reduction of non-systematic risks by spreading out the
risks when investing by diversified range in stock portfolios. For example, investing in large cap
stocks as well as small cap stocks, real estate bonds and also having some cash in the bank.
(Markowitz, 1959)
Enron Corporation was an American multinational company that had its headquarters in
Houston, Texas. It had revenues over $111 billion in early 2000 before its bankruptcy in
December 2 the year 2001. Over 20,000 employees were rendered jobless besides most all their
investments in the company were also wiped out.
It was very hard to imagine that a giant corporation like Enron could go under. I can’t blame the
employees for putting all their hopes in Enron only that if they could have diversified their
investments to other small cap investment opportunities or in bond issues or even in other
savings accounts then they could have at least salvaged part of their investments. (Eun, Huang &
Lai, 2008)
The capital asset pricing model (CAPM) calculates an average expected rate of the cost of capital
or return for each investment and the rate of risks involved. According to this model, the
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investments average cost of capital is relatively lower if it basically offers better diversification
returns for a particular investor has the overall market portfolio minus the required benefit for
risk contribution.
Projects that have higher risks (market beta) will generally have higher rates of expected returns
for them to be attractive to investors while less risky projects also have lower expected rates of
return. This is the relationship that CAPM model portrays.
Enron returns were very high as one of the leading corporations at the time of its peak in 2000; it
was one of the most stable companies financially in the USA.
Beta is used as a rate of measuring the risks in investments portfolios. A company’s Beta of 2
means that the volatility of a company changes by 2% when the market’s benchmark changes by
1%. (Fama & French, 2004)
For example, using the CAPM formula, if the risk free rate is currently 3% and the current
expected rate of return is 7%, the CAPM formula states that;
r1 = 3% + (7% – 3%) x beta = 3% + 4% x beta (Black, Jensen and Scholes, 1972, p.79)
= rf +(x (rm) –rf) x beta where rf and rm are the risk free rate and the expected market rate of
return respectively. If the project or company has a beta of 0.5 then its cost of capital is equal to
3% plus 4% x 0.5 = 5% while a project with a beta of 2 is supposed to have a cost capital of 3%
plus 4% x 2 = 11%. These means that a company that has a beta of 2 must have an expected
average rate of return of 11% or more. If the expected return is less than 11% then the
investment is not viable hence the project should be discarded. (French, 2003)
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To conclude, the employees of Enron should have definitely calculated the nature and level of
risks that their investments were exposed to and diversified their portfolios to reduce the impact
of risks involved but they were blinded by the success of Enron that made them to be assured of
their investments. It was a wrong decision and the more successful a company is the more the
investments need to be diversified.
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References
Black, F., Jensen, M.C. and Scholes, M. (1972) “The Capital Asset Pricing Model: Some
Empirical Tests,” in Studies in the Theory of Capital Markets. Michael C. Jensen, ed.
New York, NY: Praeger, 79–121.
Eun, C., Huang, W., & Lai, S. (2008). International diversification with large- and small-cap
stocks. Journal of Financial & Quantitative Analysis, 43(2), 489–523. Retrieved from
Business Source Premier database.
Fama, E. F, French, K. R (2004). “The Capital Asset Pricing Model: Theory and
Evidence”. Journal of Economic Perspectives 18 (3): 25–46.
French, C. W. (2003). “The Treynor Capital Asset Pricing Model” Journal of Investment
Management 1 (2): 60–72.
Markowitz, H. (1959) Portfolio Selection: Efficient Diversifications of Investments. Cowles
Foundation Monograph No. 16. New York, NY: John Wiley & Sons, Inc. pp. 77 – 91.
