FX International Payments
By Bill Camarda
Companies can’t eliminate risk completely, and wouldn’t want to try: profit rarely comes without it. The question is, how can a business select the best risks to take? That’s where portfolio theory may be helpful.
Discussions of portfolio theory can easily get lost in a thicket of mathematics. But corporate decision-makers needn’t dive into abstruse formulae to see why it might be useful to them. Nobel Prize winner Harry Markowitz and other pioneers in modern portfolio theory began with some simple assumptions: investors hope to maximize returns while minimizing risk, and won’t accept more risk unless they can reasonably expect higher returns.2These are assumptions that are familiar to executives who must choose new research projects or business initiatives; potential mergers, acquisitions or divestments; or markets to invest in for international trade – or to depart from.
Given these and other portfolio theory assumptions, the theory’s creators showed that it’s mathematically possible for an investor to define the level of risk he or she is willing to accept, and then build an optimal portfolio of investments that maximizes profits given that risk level. Or, conversely, she can define a profit level and build an optimal portfolio of investments that minimizes risk given that profit goal.3
What makes it possible to optimize a portfolio for a specific risk or profit level? Diversification. The theory says investors can build portfolios with overall lower risk than that associated with each individual asset, and that it’s essential to consider each investment’s risk in context of the overall portfolio.
The risk of individual investments contains two components, according to portfolio theory. First, systematic risks such as global recessions that will likely affect many or all investments, and can’t be easily avoided. Second, specific risks associated only with the individual investment. For a company’s stock, a specific risk might be a massive hacking attack that compromises the company’s secrets or takes its e-commerce business offline for an extended period. For a corporate strategist involved in international trade, it might be a revolution that empowers a local government which confiscates assets, or the collapse of one nation’s currency, with the attendant exchange rate and business complications.
There are clear similarities between these scenarios in investment planning and corporate strategy for international trade. Portfolio theory tells companies to build diverse portfolios of assets with “negative covariance.” This simply means businesses should invest in opportunities and initiatives that tend to move in opposite directions in response to the same events. For example, when a systematic event occurs that is likely to influence profits in one investment to decline, profits in another should be more likely to rise.
One common example would be choosing a mix of countercyclical and cyclical businesses. Another might be choosing a mix of markets for international trade, in order to protect against risks in just one or a few of them.
From an equity investment standpoint, in the early 21st century it was widely observed that asset classes which traditionally behaved differently were increasingly moving in tandem.4 This, of course, makes diversification with negative covariance more difficult. But individual international trade markets may still diverge based on many different risk factors. For example, individual nations may have significantly different risk profiles from industry to industry, even if located in the same region. NTI Consulting calls attention to this in comparing the widely different characteristics of Libya, Nigeria, Angola, and Congo from the standpoint of oil and gas investment.5
By combining corporate investments (including trade in international markets) that are high-risk/high-return with others that are low-risk, low-return, it may be possible to optimize total return consistent with the amount of risk an organization is prepared to assume.6
General Electric famously combined diverse businesses such as finance and transportation.7After earning strong profits from finance prior to the Great Recession, it then saw its locomotive business grow substantially after the recession, when finance became far less profitable.8GE has explicitly used portfolio theory in its energy business, balancing investments in renewable and conventional forms of energy.9
Portfolio theory isn’t the only consideration in planning corporate investments. If diversification alone was sufficient, as Malcolm S. Salter and Wolf A. Weinhold pointed out way back in 1978, early conglomerates such as Gulf & Western might have been more successful. 10 In deciding what to keep or divest, McKinsey & Co. notes, a company should consider its long-term strategic intent and current capabilities. She points to the “best-owner principle”: is the current owner best positioned to maximize the asset’s profitability? Or would another owner be, based on its “unique skills, governance, insight… connections to other businesses… and access to talent, capital, or relationships”?11 These are issues largely separate from portfolio theory.
Finally, as FTI Consulting notes, “in a financial market, an investment manager can sell a security in an exchange to reduce a portfolio’s exposure; it is much harder for an operational manager to close an office or move equipment out of a market.” FTI’s takeaway is that managers should take a longer-term view as they balance geomarkets to mitigate overall portfolio risk, but that it is worth doing.12
Notwithstanding caveats, portfolio theory offers a useful tool for thinking about risk. And these days, as companies navigate increasingly challenging global markets and international trade environments, they need as many useful tools as they can get.
By diversifying the way investment planners do, companies may be able to manage their risks more effectively – including risks associated with developing markets and international trade.
Bill Camarda is a professional writer with more than 30 years’ experience focusing on business and technology. He is author or co-author of 19 books on information technology and has written for clients including American Express Private Bank, Ernst & Young, Financial Times Knowledge and IBM.
1. Maximize Growth and Minimize Risk by Managing Business Strategy Like an Investment Portfolio, TwentyEighty Strategy Execution; https://www.strategyex.com/knowledge-center/whitepaper/maximize-growth-and-minimize-risk
2. A Simplified Perspective of the Markowitz Portfolio Theory,Global Journal of Business Research; https://www.pnc.com/content/dam/pnc-ideas/articles/D+H-US-Real-Time-Payments-and-Settlement-whitepaper-coauthored-PNC-TCH-15-April%202016.pdf
4. "Why Have Global Correlations Increased?,",Morningstar; http://www.morningstar.co.uk/uk/news/96521/why-have-global-correlations-increased.aspx
5. “Geomarket Risk Management: How to Balance Risk Holistically, Globally,”, FTI Consulting; http://www.fticonsulting.com/insights/fti-journal/geomarket-risk-management
6. Maximize Growth and Minimize Risk by Managing Business Strategy Like an Investment Portfolio, TwentyEighty Strategy Execution; ; https://www.strategyex.com/knowledge-center/whitepaper/maximize-growth-and-minimize-risk
7. "Major Strategy Frameworks: Portfolio Theory,"Cleverism; https://www.cleverism.com/portfolio-theory-major-strategy-frameworks/
9. “With the Utility Regulators, Day 2: Portfolio Theory Makes Wind and Solar More Valuable,”Green Tech Media; https://www.greentechmedia.com/articles/read/With-the-Utility-Regulators-Day-2-Portfolio-Theory-Makes-Wind-and-Solar-M
10. "Diversification via Acquisition: Creating Value", Harvard Business Review; https://hbr.org/1978/07/diversification-via-acquisition-creating-value
11. “Strategic portfolio management: Divesting with a purpose,”, McKinsey & Co.; http://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/strategic-portfolio-management-divesting-with-a-purpose
12. "Geomarket Risk Management: How to Balance Risk Holistically, Globally", FTI Consulting; http://www.fticonsulting.com/insights/fti-journal/geomarket-risk-management