As the local market hemorrhage goes on unabated, market players continue to watch helplessly from the sideline and every now and then when opportunity abounds they still find time to pay homage to the god of diversification; which for them perhaps is the only game in town. Every so called “market expert�, in the midst of whining about market conditions, consoles themselves that this is a global phenomenon and then caps it up by putting emphasis on the need for diversification – what a contradiction! Mainstream thinking is busy preaching that even though diversification has proved superfluous in dealing with negative asset returns, it is still the best investment strategy.

 However, this is the only thing most investment practitioners know, it is what was rammed down their throats in the financial prep schools. They had to eat, drink and breathe Markowitz – a “beta pill� in the morning, at lunch and one before bed time! These cramming schools did their very best to impose on their students a half baked farce that is portfolio diversification and the students have stuck to this prescription of “strong medicine�. Now the cracks have turned into crevices, the veil is off; the emperor of portfolio diversification is naked! He has nowhere to hide, as our “learned friends� point out – this is a global phenomenon of falling asset prices …then again this scenario was not in the syllabus.

 The portfolio theory revolves around the idea that to ensure stability of returns one must invest in many stocks and in several classes of assets. This theme revolves around an “animal� called beta which is supposed to gauge the volatility of asset returns vis-à-vis the overall market returns. The more volatile the stock the greater the expected returns by the investor as follows:

                        Expected Returns = Risk Free Rate + Market Premium (Discount) × βeta

 The approach assumes stable risk free rates and market premiums, which is hardly the case, leaving stock beta to be the main determining factor of risk. Consequently, diversification helps to stabilize the investment portfolio given that individual stocks will register varying volatilities vis-à-vis the market i.e. volatility equates to risk. Once diversification achieves a stabilization of beta (read: risk) at around 1.0, as indicated by the average beta in the graph below, then the returns of the portfolio will largely depend on the market premium.  

 

Source: FinLab © 2009

 The diversification of stocks and other assets is said to reduce the impact of any negative stock specific attributes that may arise in the future in form of declining earnings prospects or other misfortunes  faced by a particular company; KQ recently announced a profit warning. Accordingly, if the investor had invested in KCB, EABL and KQ they would be able to limit their downside as opposed to one who solely invested in KQ. Simply put diversification theory is about not putting your eggs in one basket.

 In this investment strategy, the investor stabilizes volatility, by among other things investing in several stocks, but lends themselves at the mercies of general market trends that determine the market premium such that the returns on the investment portfolio are directly linked with those of the general market. Consequently, contrary to theoretical assumptions, the return on the market will not always be generally positive and as a result the market premium will from time to time be replaced with a market discount; more so when the market is headed south as is the case today.

 This is what they left out of the finance syllabus, that market risk is equally as severe as stock specific risk (beta) and it is almost always expressed in the form of declining liquidity which in turn leads to market discounting. Hence in the event of declining liquidity, as indicated by the graph below, portfolio theory becomes redundant and it is no surprise that students of the diversification school look like they have never been to school. They are now comparing amongst themselves to see who has the best negative returns and forget that the main purpose of stock investing is to maintain both present and future purchasing power by beating inflation. Thus there is no such thing as a better negative return!

 

Source: FinLab © 2009

 The liquidity (LQD) index, as developed above, indicates that the market had generally been over priced for the most part of 2008 and stable pricing conditions only resumed in November (week 44). This excess liquidity phenomenon has tended to hold the general price level way above fundamentals and as a result it fomented a general price bubble, which was burst by three subsequent events.  The first was the Safaricom IPO refund bungle; second, the withdrawal of foreigners prompted by the global credit crunch and finally the loss of market confidence, mainly by retail investors, arising from uncertainty in stock brokerage operations. Indeed, as far back as August it was clear that declining liquidity was the underlying force behind the market retreat, but the students of finance remain in denial of this diagnosis and will probably not augment the “beta pill� with a “liquidity pill�.