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Hi,
The existence of equity markets in different countries affects the
potential extent of portfolio diversification by traders and hence
the required rate of return to compensate for risk.
Considerable evidence has been produced which shows that the ability
to buy stocks (or trade indices, sectors) in different countries
allows the formation of portfolios with lower risk and thereby
reduces the expected yield that companies must offer on stock.
Risk reduction via diversification is generally considered in
connection with decision on equities. However, because of exchange
rate risks, default risks, and risks to bond values from changes in
interest rates, risk reduction via diversification can easily applied
to bonds. Whenever there is some independence of returns on
different securities, risks are reduced by maintaining only a portion
of wealth in any asset. This will mean missing the maximum overall
expected rate of return, because some wealth will be invested in
assets with lower expected yields. However, given some degree of
risk aversion on the part of a trader, having less risk will
compensate for lower expected returns. This is an established part
of portfolio theory orignially developed separately by Harry
Markowitz and James Tobin. (See Harry Markowitz, Portfolio
Selection: Efficient Diversification of Investments, John Wiley &
Sons, New York, 1959, and James Tobin, "Liquidity Preference as
Behavior toward Risk," Review of Economic Studies, vol. 25, February
1958, pp. 65-86.
Correlations exist that show the presence of some independence
between markets of different countries with correlations as low
as .335 in the case of the U.S. and the Euro market. We should
expect clear gains from a diversified stock portfolio.
An indication of the size of the gains from including foriegn stocks
in a portfolio has been provided by the Research of Bruno Solnick.
(See Bertrand Jacquillat and Bruno H. Solnik, "Multinationals Are
Poor Tools for Diversification." Journal of Portfolio Management,
winter 1978, pp. 8-12. Solnick computed the risk of portfolios of n
securities for different values of n in terms of the variance of
these portfolios. The variance of a portfolio was compared with the
variance of a typical stock, and it was found that the risk declines
as more stocks are added. Solnick discovered that an international
portfolio of stocks from numerous markets has about half as much risk
as a portfolio of comparable size of only U.S. stocks. The risk of
U.S. stokcs for portfolios of over about 20 stocks is approximately
20 percent of the risk of a typical security, whereas the risk of a
well-diversified international portfolio is only about 12 percent of
the risk of a typical security. When Solnick considered other
countries which have far smaller markets, he found however, that the
gains from international diversification were, not surprisingly, much
larger. The gain from diversification from holding equities of
different countries turned out to greatly exceed the gain from
holding different equities within a single country.
The independence of the markets of different countries can be
valuable in portfolio management.
The ability to more effectivley allocate wealth when more investment
opportunities are available allows investors to reduce the risk they
must bear. In the standard theory of finance the unavoidable risk is
known as the undiversifiable or systematic risk. If the risk that
must be borne is reduced, the equilibrium yields required on the
securities will be reduced.
The risks faced with foreign investments that are not explicitly
faced with domestic investments are those from foreign exchange and
political events. These risks, like business risk, can be
diversified if a trader invests in a portfolio of securities of
differenct countries which are denominated in many different
currencies. This means that the risk premium on the discount rate
which reflects only the systematic risk might not be very large.
Regards,
Pal
(Closing the gap, one step at a time...)
--- In amibroker@xxxxxxxxxxxxxxx, Kevin243@xxxx wrote:
> Trading say twenty stocks or one hundred stocks does not protect
you from
> the overall market risk (systematic risk). But trading twenty
stocks does
> protect you from unsystematic risk. (eg. the company cooked the
books and the
> story broke over night, the stock gaps down from a close of $98 to
an open of 90
> cents.) In this case, you have essentially lost only about 5% of
your
> portfolio (1/20) if you diversified over 20 stocks. If you bought
only one stock,
> like a friend of mine did a few years ago, options actually on
Oxford Health a
> few days from when its story broke...... well he is still working
for living,
> because he really did bet his retirement. It's obvious that
betting
> everything on one stock is stupid, but what is the right number?
I'm comfortable with
> twenty and can sleep at night, even when leveraged. If you trade
long
> enough, you will get bit hard by one of your stocks, somewhere,
sometime, when you
> least expect it. Been there, done that.
>
> I agree that in general, most stocks move in the same direction as
the
> market, so that owning a hundred stocks or even 10 won't protect
you from market
> risk. You would have to diversify into something like pork bellies
or cotton, to
> have a truly uncorrelated investments. But you better really
measure the
> correlation yourself. Mutual funds are similar. Why have three
mutual funds
> that are almost perfectly correlated?
>
> Kevin Campbell
>
>
> In a message dated 9/23/03 9:14:21 AM Central Daylight Time,
psytek@xxxx
> writes:
>
> >
> > MONEY MANAGEMENT, ahh such a sweet controversial topic :-)))
> >
> > Can somebody enlighten me?
> >
> > 1) With an avarage of 1% per trade (why per trade and not per
position?), do
> > we have to trade 100 stocks? Anybody on this list having 100
actively-traded
> > stocks in their portfolio?
> >
> > 2) At 1% per position one needs a sizable portfolio... 100 stocks
priced at
> > an average of $20 and 500 shares would add up to $1,000,000 of
actively
> > traded dollars. How many on this list do that? No answer
expected :-)
> >
> > 2) If you have 1% invested in 100 stocks and the whole market
dives, so will
> > your portfolio, i.e. if 50 stocks track the market you'll be down
50%. So
> > how does this 1% protect you against whole market dips?
> >
> > The answer to the above is probably that 1) you must diversify in
> > stocks/sectors that make opposite moves but this is probably more
difficult than money
> > management, 2) that your perfect trading system should get you
out of the
> > market in time. Doesn't this mean that 1) and 2) are
prerequisites to MM and
> > most be solved before the application of MM?
> >
> > Now, this doesn't mean I do not agree with money management :-)
just that
> > that the way it is presented doesn't help the small tarder very
much. Small
> > (limited budget) traders need to develop different typ of MM.
What are the MM
> > rules for small traders?
> >
> > For short term trading I like to think along these lines:
> >
> > 1) Use the best system possible; never stop trying to improve it.
Aim for a
> > high % winners: it will keep you trading.
> > 2) Start each new stock small, a sudden large investment
represent the risk
> > of a sudden large loss
> > 3) Use maximum loss stops that prevent you from ever dipping
into your
> > initial equity.
> > 4) use profit stops, they can really improve system performance.
> > 5) reinvest profits to reach maximum positionsize gradually
> > 6) increase your position size in small increments by increasing
the
> > Positionsize with 1-2% extra cash with each trade
> > 7) use all the tools available to you: know your trader
workstation and
> > order types, use conditional orders.
> > 8) diversify over sectors and stocks
> >
> > With AB version 4.5 we will probably see w whole new range of MM
topics
> > surface, hopefully some that can be backtested better.
> >
> > Happy trading,
> > Herman.
> >
> > Ps. Yes, I have read some of the books on this topic but they all
appear to
> > be written for fund managers, not for the small trader.
> >
> >
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