If you could go back to the beginning of 2007, which stocks would you have bought from the Philippine Stock Exchange? Of course no one can go back in time. But it may be interesting for some people to see the effect of investing in different asset classes, even if we limit our options to just those listed on the Philippine Stock Exchange. For example, I took the monthly data for the Philippine Mining and Oil Index and the PSEi, and did a mean variance analysis. (E(R) here refers means, not expected return.)
The data shows that if I had invested all of my money in PSEi (or, stocks that constituted the PSEi) last year, I would have obtained an average monthly return of 1.76% (annual return of around 21%), whereas investing in the stocks that consituted the Mining & Oil Index would have yielded me 5.75% per month on average (annual return of nearly 70%), with a higher level of volatility. What if I was concerned about volatility, and wanted to find a way to reduce the volatility without sacrificing too much gain?
Using the formula for minimum variance, the optimal portfolio turns out to be about 60% in the Mining and Oil Index and the rest in PSEi. Such a combination would have given me an average monthly return of over 4% (nearly 50% for the year) and standard deviation of under 8%. Of course, with hindsight, I wouldn't be concerned about the volatility and would have just collected the higher return of M&O Index, but as we do not have the ability to predict future, most people would be more cautious. This example illustrates that, even with the limited investment vehicles available in the Philippines (no commodity futures, options, or exchange traded funds), one can still improve on the risk return characteristics of ones portfolio by combining stocks from different industries. Of course both PSEi and M&O Index are not tradable yet, and we have to buy the underlying stocks to mimic the returns of the indexes, and that is a little bit inconvenient.
However, if we do not strive to duplicate an index completely, we can buy the largest components of an index instead, as long as their performance is substantially in line with that of the index. For example, if we bought equal value amount of PLDT and Ayala Corporation in 2007, their combined monthly return achieves a correlation of over 0.8 with PSEi : in other words, they performed meaningfully similar. Ayala Corporation's return was similar to PLDT's and PSEi's last year, but it had much higher volatility, with a standard deviation of over 8%, while PLDT's was just over 3%. Combined, their standard deviation was 5.43% against PSEi's 5.08%.
As every one who is familiar with the stock market knows, no stock performs in the same way every year. The purpose of this article is of course not to recommend any single stock for the current year, but to make the point that even with a small number of stocks available for investing, we can still find ways to aim for our desired risk-return outcome.
(Chiu-ying Wong, CFA, 14 February 2008)