0:00

[MUSIC]

Â So, point number one, the goal of diversification, the ultimate goal of

Â diversification is to maximize, to get the highest possible risk adjusted returns.

Â Point number two Point number two sort of follows from the first.

Â And that is that when I do diversify a portfolio, would I obtain as a result

Â is the possibility of choosing the combination that gives me the highest,.

Â Risk adjusted return.

Â So, not only the goal of diversification is

Â obtaining the highest possible risk adjusted return.

Â The result of diversification is obtaining that

Â highest possible risk adjusted return.

Â And I want to illustrate this by putting together an emerging market and

Â a developed market.

Â Spain as an example of a, a developed market.

Â And China as an example of an emerging markets.

Â And what we're going to do is we're going to look at this little picture.

Â And this little picture actually is built on the behavior of the Spanish market and

Â the Chinese market over the last ten years.

Â Between 2004 and 2013.

Â And so the numbers that you're seeing there, over the last ten years,

Â the Spanish market generated a mean annual return of 11.9%.

Â The Spanish market also generated a volatility of 28.1%.

Â The Chinese market generated a mean annual return of 19.6% and

Â the volatility of the market, over there, the Chinese market over that

Â period was about 39% So, look at the poem that is actually label Spain.

Â If I had put all my money in Spain, over the last ten years,

Â then my mean annual return would have been 11.9%.

Â And my volatility would have been 28%.

Â If I had put all my money in the dot in the point

Â labelled CHN China then my mean annual return would have been 19.6%,

Â and my volatility would have been 39 percent.

Â Now, we're talking about diversification.

Â And therefore what really matters is combining the Spanish market and

Â the Chinese market.

Â And for that, we need to keep one thing in mind,

Â which is what we talked before, correlation.

Â And if you look at the correlation there you see it on, on the screen as .6.

Â That is actually not an extremely high correlation.

Â But as we said before.

Â It's positive which means that in the long term Spanish market and

Â the Chinese market tend to move more or less together.

Â Not very closely.

Â Related but more or less in the positive direction.

Â And that means that both of them in the longterm they tend to go up.

Â Now again what we're saying, look at the blue line there.

Â That blue line is basically different combinations of the Spanish market and

Â the Chinese market.

Â So the first point to the left and above Spain is a combination in which

Â you invest 90% of your money in Spain, and 10% of your money in China.

Â That 90%, that 90 10% combination between Spain and China actually gives

Â you a return and a risk of that portfolio, and that is identified by that dot.

Â As we move, actually to the right and above, then we're basically decreasing

Â the proportion of Spain in the portfolio and increasing the portfolio of China.

Â So let's look now at the first point to the left and below the CHN point.

Â That is a portfolio that is invested 90% in Chinese market and

Â 10% in the Spanish market.

Â So all those infinite points in fact

Â Along the blue line are what we call feasible portfolios.

Â Are portfolios that I could have built,

Â that I could have had by combining the Spanish market and the Chinese market.

Â All right. Now let's look at a couple of

Â important points along that blue line.

Â Point number one, that I want to highlight is that one.

Â Now that one,

Â as your eyes could tell you, is the point that goes furthest to the left.

Â And if you look actually at the bottom line,

Â what we're measuring on the horizontal axis is risk.

Â And that means that the point that goes furthest to the left.

Â Is of all the possible combinations between Spanish market and

Â the Chinese market, we get the combination that gives me the lowest possible risk.

Â And in our case, that is the lowest possible volatility.

Â So for example, in that particular case that is 87% in Spain, and 13% in China.

Â If I had invested over the previous ten years 87% of my money in Spain,

Â and 13% of my money in China, that would have given me the combination between.

Â These two markets that would have led to the lowest possible risk measured in

Â terms, of volatility.

Â And that actually would have enabled me to let's say,

Â the Spanish investor, to reduce risk from 28.1% to 27.8%, a little bit.

Â A tiny little bit, not much, but it's a reduction in risk, and

Â notice that that reduction in risk came at the same time with an increasing return.

Â If I had been solely invested in Spain, my mean annual return would have been 11.9%,

Â but because I put 13% of my money in China,

Â my mean annual return was actually higher 12.9%.

Â So, if I'm a Spanish investor that diversified into the Chinese market,

Â and decided to put 87% of my money in Spain, and 13% of my money in China.

Â I won two ways.

Â I won because my risk is a little bit lower, and

Â I won because my return has actually been higher.

Â So I win in, in two different dimensions, I have lower risk, but

Â I also have a higher level of return.

Â Now, you can always find people that say look, I've been investing in

Â my own market forever, and I can take the volatility of that market.

Â I'm kind of used to the volatility of that market.

Â Well, that's not a reason for not diversifying.

Â And the reason for that is, let's look at this other green point.

Â That other green point is actually roughly 74% invested in Spain, and

Â 26% invested in China.

Â And by construction,

Â that particular portfolio has the same volatility as the Spanish market.

Â So that, what that means is that if I had had over the last ten years,

Â 74% of my money invested in Spain, and 26% of my money invested in China,

Â the volatility of that portfolio would have been 28.1%, which is exactly the same

Â volatility that it would have had if I had been fully invested in Spain.

Â But, you can see what the difference is.

Â The difference is that my mean annual return would have been 2% points higher,

Â 200 basis points higher by being properly diversified.

Â So this is like a free lunch.

Â In fact diversification is what sometimes we call in finance the last free lunch,

Â that you can find in markets.

Â Because in this case by going out of Spain and investing part of my money in China.

Â About a quarter of my money in China, and three quarters of my money in Spain.

Â I ended up with a portfolio that has, the same level of risk, but

Â a higher level of return, than putting all my money in, in Spain.

Â So this is a reason for diversifying.

Â We can get a little bit of a free lunch, and

Â it's easy to explain why the Spanish investor is always better off.

Â Because in the first point, he reduces risk and increases return.

Â And, in the second point he gets the same level of risk, and

Â gets a, a higher, an even higher return.

Â Now, it's a little bit more difficult if you look at

Â that picture to sell diversification to the Chinese investor.

Â And, the reason it's a little bit more difficult, it is because you cannot offer.

Â 7:57

The Chinese investor.

Â A way to win in both directions.

Â Notice that if we move from the point labeled CHN to the first point

Â to the left and below.

Â At that point what we're doing is yes we're reducing the risk of the portfolio,

Â but we're also reducing the returns.

Â And so now we face a trade off.

Â The Chinese investor can get actually, a lower level of risk by diversifying into

Â Spain, but it's the sacrifice of that the cost of that is expecting lower returns.

Â That didn't happen to the two points that we had seen before in Spain, you know in,

Â in the two points, in the two diversification strategies that we

Â have seen before this Spanish investor in one.

Â He won two ways, by reducing risk and increase in returns and in the other,

Â he was not wore soft in one way, in terms of risk, but

Â was much better off in terms of return, well unfortunately.

Â We cannot offer that for the Chinese investor.

Â Does that mean that there's no way to convince the Chinese investor that he

Â should diversify in Spain?

Â No, it doesn't mean that.

Â And the reason is, let's look at these numbers here.

Â Now, let me be clear about what we have here.

Â The first two columns are proportions of

Â our money invested in the Spanish market and in the Chinese market.

Â And notice that if you go line-by-line,

Â all those first two weights always add up to one.

Â So in the first case, I have all my money invested in Spain and nothing in China.

Â In the last case I have all my money invested in China, and nothing in Spain.

Â And then in the second case, if I have 90% of my money invested in Spain then I

Â have 10% of my money in China.

Â Whatever I don't invest in one market, I invest in the other.

Â So the sum of those two weights is always going to be equal 1.

Â Which means my portfolio is always fully invested.

Â The next two columns return and risk are the numbers that

Â generated the blue line in the picture that we have seen before.

Â So, that blue line that you're seeing now again has been generated from the two

Â numbers, that we labelled return and risk in this particular picture.

Â So that's another way of saying that is that, each portfolio each

Â combination of the Spanish market, in the Chinese markets gives me a return and

Â a risk that is consistent with that particular portfolio.

Â Now, what's really important for

Â us now, because remember how we got to these numbers and to this picture.

Â We were thinking about ways of convincing the Chinese investor that he needs to

Â diversify, too.

Â Now, the last column.

Â Is basically the third column divided by the fourth.

Â So for example if I divide 11.9 by 28.1 than I get 0.424.

Â If I divide, I'm going to the very end now, 19.6% by 39%.

Â I get 0.503.

Â So, if I divide the return column by the risk column,

Â I get the last column which RAR.

Â And that RAR is basically risk adjusted return.

Â Very quick and very direct way of calculating risk adjusted return.

Â Again there are much more technical and better ways of looking at

Â risk adjusted return but by putting one divided by the other, we're basically,

Â basically getting a measure again, quick and dirty, of risk adjusted return.

Â And remember, what investors want at the end of

Â the day is to get the highest possible risk adjusted return.

Â Well, that's where you have it.

Â In this particular case, if you put 40% of your money in the Spanish market, and

Â 60% of your money in the Chinese market, then you actually will maximize.

Â The combination between risk and return of the Spanish market and the Chinese market.

Â Now here comes the interesting thing.

Â I could show you mathematically that you will never find that

Â maximum risk adjusted return, by putting all your money in Spain, or

Â by putting all your money in China.

Â In other words, if you try to find the highest possible risk

Â adjusted return it's always going to be somewhere in between.

Â And being somewhere in between,

Â means that you're splitting your money between the two markets.

Â And basically it means that you're diversifying.

Â It's a very important result.

Â If I'm combining two assets, and the correlation of those two assets is

Â any number lower than one, and remember that in this case is .6, I will never get.

Â The highest risk adjusted return by putting all my money in one market or

Â by putting all my money in the other market.

Â I will always find the highest risk adjusted return by putting my

Â money somewhere in between and in this particular case, it happens to be,

Â 40 60 in some other cases maybe 90, ten or 25, 75, it doesn't really matter.

Â But it's never going to be all my money one market, and

Â no money in the in the other market.

Â [MUSIC]

Â