Why Home Bias Limits Investors Portfolios Essay

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asset classes, setting out their characteristics and risks.

Australian shares are shares in the market of publicly traded companies that range from small to medium to large-cap stocks. Shares can or cannot provide dividends to shareholders, depending on their makeup. Shares can increase or decrease in value, depending on a number of factors ranging from fundamental valuation to market or sector conditions, to laws of supply and demand to market psychology, momentum and stop-hunting algorithms. Trading shares in today's market conditions can be viewed as more perilous than ever before because of the inherit risk of losing to HFTs, of improperly hedging one's investment and being exposed to downside risk, and of improperly diversifying or investing in the wrong sector or company at the wrong time (for example, as it is poised to pull back, collapse, or be diluted through toxic debt).

Australian bonds can come in the form of corporate or government debt that is offered to investors in exchange for yield. Today, yields across the globe are turning negative (in Japan, for example, and in Europe too). Traditionally, bonds have been viewed as wealth preservers with low-risk, but as more retail investors come into the market to buy bonds, the volatility of values has increased, and with government and corporate debt increasing exponentially in recent years, the likelihood of later offerings (with increased yields, per se) could negate the value of current bondholders. Thus not all bonds are created equal.

Cash may be one of the best asset classes to be in, in today's market, as volatility increases in markets around the world and stocks pull back from all-time market highs. However, the "war on cash" (Thomas, 2016) may also be a going concern for some as well as the "exportation of deflation" of countries like China (Durden, 2016). Deciding what to do with cash and how long to hold and whether inherent value will be lost by maintaining are some of the risks of this position.

International shares are like Australian shares except they are part of companies that are based in foreign countries. The same risks and characteristics apply. Social, political and economical consideration should be given these investments, as events can trigger both gains and losses in price per share. For example, El Dorado gold mining company lost value as a result of its having a mine in Greece, where political, social and economic turmoil caused investors to doubt the stability of the project there. On the other hand, Harmony gold gained value because of its projects in South Africa where the rand has become cheap allowing costs associated with the mine to drop considerably. Foreign exchange risk is also another consideration.

Listed Property Trusts (A-REIT) is a portfolio of property assets that is formed into a single unite through the combination of multiple units and listed on an exchange such as the ASX. Known as LPTs prior to 2008, the new A-REIT moniker is more in line with international coinage. A-REITs typically include large property portfolios too big for individual retail investors; therefore, they are divided into small units and sold to retailers, who then are said to be unit holder. This form of investment is an alternative to direct property investment and is desirable for several reasons, not the least being that it provides a much more liquid market than the actual housing market, which is considered very illiquid. Risks inherit in this asset class consist of interest rates movement: if rates go up, demand for A-REITs typically goes down (though the explanation for this does not necessarily provide an adequate justification, as one would think that in a strong economy, occupancy would increase, thus giving better returns). Another associated risk is in holding an A-REIT that is exposed to a sector that is in decline (such as the suburban mall). Thus societal trends can impact the listed property trust asset class as much as they can the other classes.

b. Calculate the AM (Arithmetic Mean) and GM (Geometric Mean) measures of the average annual yield on each of these asset classes during the period 1983-2003. Contrast the resulting measures of average yield for each asset class.

GM of Australian Shares (1983-2003): 1.15987 or 15.987%

GM of Australian Bonds (1983-2003): 1.17173 or 17.173%

GM of Cash (1983-2003): 1.09173 or 9.173%

GM of International Shares (1983-2003): 1.12532 or 12.532%

GM of Listed Property Trusts (1983-2003): 1.13635 or 13.635% AM of Australian Shares (1983-2003): 1.159857 or 15.9857%

AM of Australian Bonds (1983-2003): 1.

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149857 or 14.9857%

AM of Cash (1983-2003): 1.92476 or 9.2476%

AM of International Shares (1983-2003): 1.148857 or 14.8857%

AM of Listed Property Trusts (1983-2003): 1.142714 or 14.2714%

c. What would be the main problems you would encounter if you tried using the efficient frontier you have identified for portfolio selection purposes?

As Chen, Chung, Ho and Hsu (2012) observe, a Markowitz portfolio indicates that when you put assets into a portfolio of investments, the risk (calculated by the standard deviation of return) goes down -- "but the expected return of the portfolio is a weighted average of the expected returns of the individual assets. In other words, by investing in portfolios rather than in individual assets, investors could lower the total risk of investing without sacrificing return" (p. 212).

This means that portfolio holdings should be the focus of an investor rather than individual holdings because the sum of those parts add up to equal a more stable, less volatile (when taken as a whole) investment with less risk as a result of the diversification of assets.

The main problem with this theory would be that there is more to investment strategies than a simple correlation of assets, which is essentially what the efficient frontier is all about. Attempting to discern the "relationships between securities to maximize the return obtainable for a given amount of risk" is like attempting to gauge what the market will without reading the headlines of the world's newspapers. It is an attempt to quantify a world that contains not just quantitative data but also qualitative data. The efficient frontier discounts the qualitative role of social, political and economic data and effects a "low-risk" return based on the relationships of assets in the portfolio. Is this a limited risk strategy? In a world where "quants" are given special praises for rigging (or attempting to rig via the application of algos) the system by defining these relationships, it may seem as such. But what happens when the algos fail to account for political unrest, social uprising, and economic collapse (after years of flat-out governmental fraud and malfeasance)? They may attempt to adjust accordingly, but a qualitative analysis of the global market might have allowed adjustment to occur earlier and with more favorable returns.

For example, given the above, a qualitative assessment of the global marketplace (given China's crashing economy, the West's utter inability to fix its economic policy any other way than by attempting to patch the gaping hole using QE and (perhaps?) NIRP, which will only forestall the inevitable for a short while), is already being deemed a disaster by the average person on the street: hence the long queues in Britain and elsewhere as people line up to put their money in precious metals (Anderson, 2016). They may be reacting merely to the numbers of a falling (fraud) market -- or they may be, like David Collum (2015), doing their own qualitative assessment of the situation and, after looking at a gold chart (say, going back 30+ years) noticing that the last time gold behaved in this manner an 800% gain followed. Who, therefore, would not want gold in his or her portfolio? And yet in this assessment, it is not even discussed as an asset class. In this sense, efficient frontier is not particularly helpful for portfolio selection purposes and a qualitative method would be welcomed.

d. How does foreign exchange risk contribute to the risk of international investments? Is it worthwhile to hedge exchange rate risk?

It is absolutely worthwhile to hedge exchange rate risk. FX risk contributes to the risk of international investments because the values of currency go up and down and are never stagnant. Especially in the current era, when currency wars are being conducted around the world, it is important to hedge this risk (say, for example, an international investment not purchased through an ADR but rather as an asset on its own, sits in a portfolio for a year or two and then is sold -- a conversion will have to occur. If the exchange rate has fluctuated significantly, this could be a substantial risk due to the loss of value when one currency is converted to another -- especially if one or the other is in free-fall).

Hedging can be performed in a number of ways, whether through a currency ETF (which would provide good liquidity) or through options, futures and forwards.....

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