Modern corporate portfolio analysis theory centers around the reduction of the risk associated with a basket of investment securities while simultaneously maximizing the return from the same basket of securities. Corporate portfolio analysts are primarily concerned with downside risk, or the risk that the portfolio will decline in value, either in nominal terms or relative to a market index.
The basis of modern corporate portfolio analysis is found in diversification. Portfolio diversification theory states that when investments are randomly added to a portfolio, the average expected return of a portfolio remains the same no matter how many investments are added, but that the risk in the portfolio decreases.
As an example, assume that the average return for all stocks in the S&P 500 was known to be 10 percent; an investor randomly picking a stock from the index would expect, on average, a 10 percent return. That investor, however, would have a high level of risk that the actual return on that single stock may deviate from the 10 percent average. An investor, however, that owned all 500 stocks in the S&P 500 would be guaranteed that 10 percent return. There would be no risk that return (as we're assuming it's already known) would deviate from the 10 percent average.
Modern corporate portfolio analysis works through the statistical concept of correlation. In finance, correlation is a measure of how closely the returns of two or more investment securities respond to each other. Most stocks are positively correlated to each other, as they tend to increase and decrease together. When the market increases as a whole, most (but not all) individual stocks will also increase. When the market declines as a whole, most (but not all) individual stocks will also decrease. Many stocks and bonds tend to be somewhat negatively correlated — when stocks increase in value, bonds are more likely than not to decline in value.
Because of the effects of correlation, portfolio managers attempt to hold as many negatively correlated instruments as they can. In practice, this is often difficult to do while maintaining the portfolio's investment objectives. As a result, managers tend to settle for instruments that are imperfectly correlated. Imperfect correlation means that even though there's a relationship between the price movements of two securities, the price movements of the two securities won't always move in tandem. It is through these imperfectly correlated securities not moving in tandem that the effects of diversification are explained.
Portfolio managers, in their search to reduce risk while maintaining returns, often utilize hedging within their portfolios. Hedging typically involves the use of financial derivatives, which may be perfectly negatively correlated to positions held within a portfolio. For example, if a portfolio holds a large ownership interest in Stock XYZ, and the portfolio manager wishes to reduce the risk of the holding without selling any portion of it, the portfolio manager may purchase a negatively correlated derivative instrument, such as a put option on Stock XYZ. When the price of Stock XYZ decreases, the value of the put option would increase, thereby reducing risk within the portfolio.
- "Financial Institutions Management"; Anthony Saunders, Marcia Millon Cornett; 2008
- "Options, Futures and Other Derivatives"; John C. Hull; 2009