By: Steve Rubis
A favorite buzz word of finance professionals is diversification. This word seems to be over used in the current financial lexicon. Jim Cramer contends that his game “Am I Diversified: is the latest craze to sweep America. He is right, since he has at least two or three people call in with their portfolios for his review. The problem is that Mr. Cramer is doing a disservice to the novice investors watching his program. His game merely consists of listing the stocks in the caller’s portfolio and then decides almost arbitrarily whether they are diversified or not. It is our contention that the quick and dirty analysis often provided by Mr. Cramer is hardly correct.
First, let us review the rules of the game. There is a particular segment which occurs a few times a week called “Am I diversified”. During the segment, Mr. Cramer takes a few calls and reviews the stocks in each caller’s portfolio. He merely writes down the names and decides whether or not the caller is diversified. Since the decision is made in less than 30 seconds, it can be said that Mr. Cramer bases his decision solely on sector or industry.
The problem is that such advice is financial legerdemain at its best; Mr. Cramer’s statements seem to be more harmful than good. Any finance professional knows that diversification is based on risk. For all novices, there are two types of risk: (1) systematic and (2) unsystematic. Systematic risk is synonymous with the entire market and cannot be eliminated; however, unsystematic risk is the risk associated with a specific stock and can be limited with a well diversified portfolio. The crux of the diversification issue revolves around the CAPM (Capital Asset Pricing Model), since it mathematically assigns risk to every stock using a variable called Beta (Investors can find Betas for most stocks at Yahoo Finance).
At this time we would like to use an example to prove that Mr. Cramer’s analysis is not telling us whether we are diversified or not. Consider the following portfolio: (1) NABI Pharmaceuticals (NABI); (2), Pozen Pharmaceuticals (POZN); (3), Neurocrine Biosciences (NBIX); (4), NPS Pharmaceuticals (NPSP); (5), Jos A. Banks Clothiers (JOSB); (6), Rite Aid (RAD); (7), Grey Wolf (GW). At this time, we assume that our portfolio value is $7,000, with the following dollar amounts:
NABI = $700
POZN = $700
NBIX = $1,000
NPSP = $500
JOSB = $3,000
RAD = $500
GW = $600
In order to determine the riskiness of each position we need to know each stock’s beta, which can be found on Yahoo Finance and are as follows for the sample portfolio:
NABI = 1.05
POZN = -0.49
NBIX = 2.36
NPSP = 1.97
JOSB = 1.12
RAD = 2.69
GW = 1.04
Now we determine the weightings of each stock in our portfolio. The equation is simply:
Dollar Amount for Specific Stock / Total Portfolio Value
Our weights:
NABI = 10%
POZN = 10%
NBIX = 14%
NPSP = 7%
JOSB = 43%
RAD = 7%
GW = 9%
Now to determine the beta for the entire portfolio we multiply the weight of each stock by it’s respective beta. Our portfolio beta and calculation is as follows:
1.05(0.1) + (0.49)(0.1) + 2.36(0.14) + 1.97(0.07) + 1.12(0.43) + 2.69(0.07) + 1.04(0.09)
Which simplifies to:
0.105 + (0.05) + 0.33 + 0.14 + 0.48 + 0.19 + 0.09 = 1.285
The sample portfolio has a beta of 1.285 or approximately 1.29. In reality we have a slightly risky portfolio. The over all stock market has a beta of 1, so any stock or portfolio with a beta higher than 1 moves up or down faster than the market, and if it is less than one moves up or down more slowly than the market.
Our sample portfolio is very interesting because it contains two stocks with betas higher than 2 and one that is negative. If this portfolio was analyzed by Mr. Cramer he would immediately state I am not diversified. The reason for his answer is that the model portfolio has 4 biotech companies, which means we are biotech heavy. Nevertheless, in a mathematical and financial sense we are diversified, because our beta is highly reasonable at 1.29.
Readers should make the following conclusion: diversification should not be based on industry but on the risk of each particular stock in your portfolio. Please note that the sample portfolio beta will change based on our weightings and the respective betas. Nevertheless, our analysis shows that Mr. Cramer needs to go further in his analysis by trying to get a sense of the size of each position in each caller’s portfolio.
Thursday, July 06, 2006
Subscribe to:
Post Comments (Atom)
3 comments:
Beta by definition is market risk that you cant diversify away. Diversification is about correlation. Not volatililty.
There are so many things wrong here it's numbing.
There are plenty of reasons to invest based on simple sectorial analysis. What happens to countercyclical, negative beta stocks in a down market? What about ETFs that follow industry sectors? What even is the point of diversification if not to take advantage of the different strengths of different industries in different markets? Cramer recognizes that diversification isn't just about spreading risk. He certainly wants you to know that. But he knows his audience isn't the most saavy.
If you diversify down to zero, you make no returns, bub. Furthermore, a rational investor would never choose a portfolio with a weighted-average beta less than one; (s)he would be better off investing in the underlying benchmark, right? But what about your highly-reasonable beta of 1.29? Highly reasonable to whom? How can you talk about what's reasonable or not when you don't know the risk profile of the person to whom you're recommending the portfolio?
Beta isn't simply a measure of risk. In fact it's a very simple, general statement to say beta = risk. And you're just dead wrong when you say a portfolio with a certain beta is diversified. Beta isn't a measure of diversity--not in any sense. Never, ever think that again. Beta is a multiplier, a measure of the systematic risk you spoke of. It measures systematic risk, and in point of fact, a security's "reaction" to changes in systematic risk. Did you know that a beta is actually quite arbitrary? It is based on an underlying index, some benchmark. All I have to do is change the benchmark and your high-beta stock becomes a dud.
When you're weighting betas, you're taking an average, right? Multiplying by the percentages, the weights of certain items in an overall bundle, is the equivalent of taking an average.
In dealing with weights, what you're trying to talk about is some sort of expectation, some average. In weighting the betas, you're coming up with an overall beta for the portfolio which accounts for the varying percentages of the securities in you portfolio. It will tell you how that portfolio reacts systematically to changes in the market. You mistake this as a measure of diversity. It is not. It is, to skip a whole bunch of intermediate steps, a sketchy measure of risk-adjusted return. You can theoretically "diversify" your beta down to zero if you had the mind to. But it is not that beta that is measuring your diversity.
Just as there is no basis for return without accounting for risk, there is no risk without adjusting for return. And based on your description of Jim Kramer, I fear you're in above your head.
Diversification doesn't "revolve around CAPM". And it certainly isn't the crux of the CAPM. Often in M&A analysis or pro forma models, beta is simply estimated at one. That beta you regard so highly is based on historical returns. It's technical analysis. It is an extremely prevalent and important piece of technical analysis, but it is inherently flawed, ipso facto.
Markets are driven by expectations. How does your beta account for a natural disaster or a terrorist attack? How does it account for an options backdating scandal or the recall of a whole product line? I can cheat the beta of my portfolio simply by buying 99% of one security and spreading the remaining 1% across 12 other stocks. Plug that into your example; what's that tell you about diversity? How about if I buy 15 biotech stocks, all of them with betas of 1.29 (they are, after all, in the same industry, and might CO-VARY). Is that diversification? What happens when you own a high beta stock and a low beta stock, both in the same industry, both canceling each other out in terms of weighted-average beta, and then a new product comes along that renders both companies obsolete?
Kramer was a successful hedge fund manager. I'm not sure you quite grasp what it means to be a successful hedge fund manager. It means knowing the capital markets, the financials, even the technical analysis so well that arbitrage and event-driven strategies become 2nd nature. His recommendations, though flashy and off-the-cuff, should no-doubt be heeded because he's literally memorized half the equity market, not to mention the countless number of other securities out there that you may not have even heard of. His show works because of that fact. People understand that they're throwing out portfolio combinations to a guy who, in this particular field, is a savant. My sense is that the split-second judgments of a successful hedge fund manager are more correct than incorrect.
Wow, a testimonial to your own ignorance. No thought given at all to covariance. I sure hope you are out of the investment advice game.
Post a Comment