A question for the financiers among you

[daveco]

Currently reading about diversification for college, and I get why for a portfolio of stock it would be a wise decision to diversify and why it wouldn't make sense for a firm to do it, as a firm would only take on new investments if they increase cash flow, and not investments that are negatively correlated to their other investments...

However, a passage in the chapter on the subject of risk has thrown me off;
"If diversification is an appropriate corporate objective, each project has to be analyzed as a potential addition to the firm's portfolio of assets. The value of the diversified package would be greater than the sum of the parts. So present value would no longer add."

Which has me scratching my noggin. They imply the diversified package would be greater than the sum of its parts; i.e. worth more as a package than individually so the rule of value additivity would no longer apply. Surely the package would have a discount rate itself so it would be possible to get a PV? I don't get how the package is greater than the sum of its parts when the risk of a portfolio is a product of its parts?

Edited by daveco on Tuesday 17th September 11:52

[Simpo Two]

Not my department - but are risk and value correlated? I could envisage both low and high risk investments being 'valuable' depending on market sentiment.

[daveco]

Simpo Two said:

Not my department - but are risk and value correlated? I could envisage both low and high risk investments being 'valuable' depending on market sentiment.

Returns on an investment are correlated with risk. I don't think value is? I need to put this book down...

[Simpo Two]

daveco said:

Returns on an investment are correlated with risk.

Well... I could put £1,000 into a high risk investment and it might double, or it might halve - so I don't see the correlation. But I'd conclude that risk is correlated to amplitude (upness/downess).

Then again I know nothing and am merely being philosophical

[BIRMA]

Have you read Zen and the art of buying and selling shares?

[CaptainSensib1e]

It sounds like they are alluding to the benefits of vertical integration.

[jeff m2]

While the ROI on each portion may be the same, as those portions are grouped together the rsik is reduced.
eg
Ten rentals may have occupancy rates of 100% 90% 80% etc.
One large rental of similar value can only have an occupancy rate of 100 or 0%

So as the unit number increases the risk decreases, if all other variables are the same value will be increased due to decreased risk. Or in fact a better product.

(Think of risk in it's purest sense, ie something to be avoided)

[daveco]

jeff m2 said:

While the ROI on each portion may be the same, as those portions are grouped together the rsik is reduced.
eg
Ten rentals may have occupancy rates of 100% 90% 80% etc.
One large rental of similar value can only have an occupancy rate of 100 or 0%

So as the unit number increases the risk decreases, if all other variables are the same value will be increased due to decreased risk. Or in fact a better product.

(Think of risk in it's purest sense, ie something to be avoided)

Cheers. If we know the risk of the portfolio why can't we obtain a present value for it?

[jeff m2]

daveco said:

jeff m2 said:

While the ROI on each portion may be the same, as those portions are grouped together the rsik is reduced.
eg
Ten rentals may have occupancy rates of 100% 90% 80% etc.
One large rental of similar value can only have an occupancy rate of 100 or 0%

So as the unit number increases the risk decreases, if all other variables are the same value will be increased due to decreased risk. Or in fact a better product.

(Think of risk in it's purest sense, ie something to be avoided)

Cheers. If we know the risk of the portfolio why can't we obtain a present value for it?

I guess because risk is open to individual perception.
Except in maybe money stuff where risk has a number.
Example; High yield has a default rate of under 2% (historically pretty good)

At this point I should add, I am not a financier, this only my own personal take.

At the risk of complicating things
I would add that from a business position, my thoughts would be smooth uninterrupted cash flow. One unit of something would not get me much sleep.

[NorthernBoy]

Simpo Two said:

Well... I could put £1,000 into a high risk investment and it might double, or it might halve - so I don't see the correlation. But I'd conclude that risk is correlated to amplitude (upness/downess).

Then again I know nothing and am merely being philosophical

Investors require a higher expected return in exchange for a higher level of risk. In most ways of measuring these quantities, risk is the only measure that affects outperformance of the risk-free rate.

To be clear, it's related to forward-looking expected return. It brings greater variance, too. Some risky investments, as you point out, tank. Hat's the nature of a risky investment.

I put 100% of my pension into China in 2004...

[fandango_c]

daveco said:

Simpo Two said:

Not my department - but are risk and value correlated? I could envisage both low and high risk investments being 'valuable' depending on market sentiment.

Expected Returns on an investment are correlated with risk. I don't think value is? I need to put this book down...

EFA

[Simpo Two]

NorthernBoy said:

Investors require a higher expected return in exchange for a higher level of risk.

Ah yes I see - in other words the Dragon says 'This is a risky business so I want 90% of the company'.

100% China eh? Well you're a braver man than me. Can you get it out if it hits the fan?

[fandango_c]

daveco said:

Currently reading about diversification for college, and I get why for a portfolio of stock it would be a wise decision to diversify and why it wouldn't make sense for a firm to do it, as a firm would only take on new investments if they increase cash flow, and not investments that are negatively correlated to their other investments...

However, a passage in the chapter on the subject of risk has thrown me off;
"If diversification is an appropriate corporate objective, each project has to be analyzed as a potential addition to the firm's portfolio of assets. The value of the diversified package would be greater than the sum of the parts. So present value would no longer add."

Which has me scratching my noggin. They imply the diversified package would be greater than the sum of its parts; i.e. worth more as a package than individually so the rule of value additivity would no longer apply. Surely the package would have a discount rate itself so it would be possible to get a PV? I don't get how the package is greater than the sum of its parts when the risk of a portfolio is a product of its parts?

Edited by daveco on Tuesday 17th September 11:52

My take on this is as follows:


1) A firm can calculate it's current PV using a Risk Discount Rate based on what the firm believes it's risk to be.

2) In assessing a potential project, the firm can calculate the PV of the project based on what the firm believes the risk of the project to be.

3) If the firm decides to go ahead with the project and assuming the project offers diversification against the firms other projects/assets, then when firm wants to calculate it's PV including the new project, anew Risk Discount Rate that is different to that used in 1) and 2) would be appropriate [expected cashflows would remain the same as in 1) plus 2)]. Hence the lack of addivity.

I think that "The value of the diversified package would be greater than the sum of the parts" will almost always be the case, but it's I think it's possible in some very unusual circumstances not to be true.

Edited by fandango_c on Saturday 21st September 23:01

[daveco]

fandango_c said:

daveco said:

Currently reading about diversification for college, and I get why for a portfolio of stock it would be a wise decision to diversify and why it wouldn't make sense for a firm to do it, as a firm would only take on new investments if they increase cash flow, and not investments that are negatively correlated to their other investments...

However, a passage in the chapter on the subject of risk has thrown me off;
"If diversification is an appropriate corporate objective, each project has to be analyzed as a potential addition to the firm's portfolio of assets. The value of the diversified package would be greater than the sum of the parts. So present value would no longer add."

Which has me scratching my noggin. They imply the diversified package would be greater than the sum of its parts; i.e. worth more as a package than individually so the rule of value additivity would no longer apply. Surely the package would have a discount rate itself so it would be possible to get a PV? I don't get how the package is greater than the sum of its parts when the risk of a portfolio is a product of its parts?

Edited by daveco on Tuesday 17th September 11:52

My take on this is as follows:


1) A firm can calculate it's current PV using a Risk Discount Rate based on what the firm believes it's risk to be.

2) In assessing a potential project, the firm can calculate the PV of the project based on what the firm believes the risk of the project to be.

3) If the firm decides to go ahead with the project and assuming the project offers diversification against the firms other projects/assets, then when firm wants to calculate it's PV including the new project, anew Risk Discount Rate that is different to that used in 1) and 2) would be appropriate [expected cashflows would remain the same as in 1) plus 2)]. Hence the lack of addivity.

I think that "The value of the diversified package would be greater than the sum of the parts" will almost always be the case, but it's I think it's possible in some very unusual circumstances not to be true.

Edited by fandango_c on Saturday 21st September 23:01

Cheers