Investment Education Series - 1/3: "Diversification - A Useful Tool, Until You Need It!"

Tuesday, April 6, 2010

   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!
By Sharath Sury 

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." 

Sharath Sury's Headlines of 2010 (Recent and Upcoming Events of Sharath M. Sury in Chronological Order)

Sunday, March 14, 2010

Sharath Sury's Headlines of 2010
(Recent and Upcoming Events of Sharath M. Sury in Chronological Order)

• January | 2010

• “Analytic Due Diligence Using an Alpha Cost Index,”
  •  by Sharath Sury and Manda Sury;
  • Published to SSRN/Social Sciences Research Network Sharath Sury is Named to Executive Advisory Group of the University of California’s Silicon Valley/School of Management Initiative

• February | 2010

• Sharath Sury has been Featured as One of “Chicago’s Leading Bachelors” at Starlight Foundation’s “Dream Date” Charity Auction in Chicago; Benefitting Hospitalized Children
  
• Professor Sury is Recognized for “Extraordinary Performance” by Santa Clara University’s Leavey School of Business.
  

• March | 2010

• Professor Sury to Speak at the Exclusive Family Office & Private Wealth Management Forum in Providence, RI
• Professor Sury to Speak at Opal’s Emerging Manager's Summit 2010 in Chicago, IL
• “Efficient Portfolio Management: A Guide to Effective Investment Supervision Processes,” 
  
  • by Sharath Sury;
  •  Published to SSRN/Social Sciences Research Network
• Professor Sury to Moderate “Government & Regulatory Panel” at the Real Estate Investors Summit: Dealmakers’ Conference
• The Highly Anticipated Anthology, “Essential Readings in Applied Financial Economics,” 
  • edited by Sharath Sury, 
  • published and distributed by Cognella Publishing.
• Sharath Sury writes the brief, "The Alpha: Revisited & Clarified" to help enthusiasts and students understand the intricate and sometimes controversial subject.

• April | 2010

• Professor Sury to lead advanced lecture (undergraduate and MBA) course in Applied Portfolio Management. 
  
• Professor Sury, Adjunct Professor of Economics at University of California, to Provide Leadership Guidance to New Center for Computational Finance & Risk Management at the University of California, Santa Cruz.

For the past 50 years, many financial economists and professional investment managers relied upon the concept of "mean variance optimization (MVO)" to design investment portfolios. The principle was simple: maximize mean return subject to a certain varian

Thursday, March 11, 2010

Risk Measurement - A Multi-Dimensional Concept!

By Sharath Sury

For the past 50 years, many financial economists and professional investment managers relied upon the concept of "mean variance optimization (MVO)" to design investment portfolios. The principle was simple: maximize mean return subject to a certain variance (risk); or minimize variance subject to a certain mean return.

While the MVO technique is well-intentioned, it suffers from an incomplete definition of risk. It has long been known that asset classes can be described using various degrees of specificity, sometimes known as "moments of the distribution." For example, the first moment of the return distribution of an asset class is its mean return. The second moment is known as variance. For a normally distributed asset class with well behaved properties, a variety of analytical techniques can be applied and conclusions drawn based upon these two moments alone (mean and variance).

Unfortunately, many asset classes do not behave according to what the normal distribution would suggest. Further, asset classes that exhibit "normality" for one time period may not exhibit it during other time periods. The incorporation of alternative asset classes (e.g., hedge funds, real estate, private equity) increases the likelihood that an overall portfolio will exhibit degrees of non-normality.

As a result, it is often important to consider at least two other "higher order" moments of the return distribution. The third moment is known as "skew" or asymmetry. It reflects the degree to which an asset class may have a higher proportion of negative (or positive) returns. Some hedge fund strategies are built and marketed explicitly on this notion: while they may exhibit low levels of variance (or standard deviation), they concomitantly exhibit high levels of negative skew (or returns which are asymmetrically biased to the downside).

The fourth moment of a return distribution is referred to as "kurtosis," or more colloquially as "fat tails." Kurtosis reflects the degree to which the return distribution may be subject to extreme events. Thus, the "fat tails" refer to the graphic representation of the returns as exhibiting a higher probability of extreme results than the normal distribution would suggest. As an example, higher levels of geopolitical uncertainty can increase the kurtosis of particular asset classes.

Thus, investment managers and asset allocators who rely solely upon the popularly employed MVO techniques may be missing key risk factors that can adversely affect a portfolio and may therefore provide solutions that are incomplete with respect to skew and kurtosis.

New methods for dealing with the shortcomings of MVO include the use of other constraints in the optimization. For example, the so-called "mean-conditional value at risk (MCVaR)" is a methodology which seeks to incorporate skew and kurtosis. CVaR essentially relates to the "area of the return profile" below which an investor is "at risk."

By maximizing mean return subject to an acceptable level of CVaR, an investment manager may be better able to capture the important risks of the portfolio. Recent (and repeated) empirical research has shown that-in hedge fund portfolios alone-the MVO methodology has underestimated the amount of risk (as defined by CVaR) by as much as 50%!

In the past few years, CVaR has been joined by other risk measures, such as "Omega," to help broaden the traditional definition of risk beyond the confines of simple variance or standard deviation. In the end, more complete definitions of risk should lead to more robust portfolio optimization solutions.

Sharath Sury - New, Official List of Speaking Engagements in 2010.

Thursday, March 11, 2010

Posted by SURYONLINE.NET at 3/9/2010 6:47 PM

The Following List Contains Sharath Sury's Tentative Speaking Engagements for 2010:

• Emerging Manager's Summit 2010
  

  • Sharath Sury to Moderate a Panel Discussion over the "Asset Allocation and Risk" 
    segment

  • May 12-14, 2010 at the Swissôtel Chicago in Chicago, IL

    • The Asset Allocation and Risk segment is scheduled from 9:45am - 10:45am

Diversification - A Useful Tool, Until You Need It! Read what they don't tell you!

Wednesday, March 10, 2010

Diversification - A Useful Tool, Until You Need It!
By Sharath Sury 

We have all been taught about the merits of diversification in investments. It is a variation of the old adage, "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.

In fact, assets that typically exhibit low correlation with one another can dramatically change direction and begin exhibiting increased correlation during periods of market distress. The increased correlation leads to a reduction in the power of diversification and thus to increased risk in the overall portfolio. Unfortunately, this upward shift in correlation happens at exactly the time when an investor needs correlation the most: market distress.

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.

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.

SOURCE: http://ezinearticles.com/?Diversification---A-Useful-Tool,-Until-You-Need-It!&id=3883169