The cost of connections

The cost of connections
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First Published: Fri, Oct 23 2009. 09 04 PM IST

Updated: Fri, Oct 23 2009. 09 04 PM IST
Portfolio diversification has long been touted as the most important means to lower risk. Most studies have shown that not more than 30 securities are required to adequately diversify risk. Ah, but the question is: How do you choose that diversified portfolio? Do you choose them at random, or select them yourself or ask a fund manager to pick them for you?
Don Chance from Louisiana State University, Andrei Shynkevich from Kent State University and Tung-Hsiao Yang from National Chung-Hsing University, Taiwan, conducted an experiment using MBA students who were asked to select securities at random. The participants were all familiar with the theory of portfolio diversification and they had been told that the purpose of the experiment was to verify the well-known fact that the volatility of a portfolio declined as the number of stocks increased. Students were free to choose any number of stocks. Logically, the risk of the portfolio should have declined as new stocks were added. But here’s the rub—the study showed that “about 23% of the 30-stock portfolios had greater risk than the five-stock portfolios and about 26% had greater risk than the 10-stock portfolios. About 38% of 30-stock portfolios had greater risk than 15-stock portfolios”. In short, the?researchers found that “a significant percentage of individuals, choosing portfolios somewhat randomly, achieved virtually no diversification by adding stocks”.
Illustration: Jayachandran / Mint
How could they get such a vastly different result from that predicted by the theory? The reason is simple—the portfolios were not really chosen at random, but had subtle biases. One reason could be that people tend to choose stocks with which they are familiar. This is what the authors conclude: “Clearly, human beings selecting apparently random portfolios impose an unconscious bias. They tend to choose large cap, well-known companies and companies more correlated with their existing portfolios than the typical stock that might be chosen at random or even by the proverbial monkey throwing darts at the stock pages of a newspaper. Thus, when human beings attempt to diversify by choosing stocks at random, they impose a subtle bias that can limit their ability to achieve diversification with a relatively small number of stocks.” The moral of the story is that you have to ensure your portfolio is selected truly randomly. Perhaps it’s best to employ a monkey throwing darts for the purpose.
Politicians at work—The private returns and social costs of political connections, by Federico Cingano and Paolo Pinotti, Banca D’Italia.
Political connections are a very valuable commodity, especially in countries such as Italy and India. Their help in getting licences and contracts and in tweaking policies to one’s advantage is inestimable. Obviously, this private gain also has a social cost. Researchers Federico Cingano and Paolo Pinotti from Banca D’Italia attempt to quantify these returns and costs by poring over the records of Italian firms and identifying people in those firms who held posts in local government. They then try to find out what impact that had on their firms.
Illustration: Jayachandran / Mint
Their results show that “access to political connections increases firm revenues by approximately 5%, yielding to an almost equivalent change in current profits. These gains only accrue to firms establishing a connection through politicians appointed with the party (or coalition of parties) that won the elections: Firms connected through other politicians see no increase in market shares, just as non-connected firms”. It’s important to back the winning party.
Also, the research says it wasn’t higher productivity that led to the higher returns, but revenues rose because of greater sales to the local government. Cingano and Pinotti add that the returns from political connections gets “larger (up to 25%) in areas characterized by high public expenditure and high levels of corruption. These findings suggest that the gains in market power derive from public demand shifts towards politically connected firms. We estimate such shifts reduce the provision of public goods by approximately 20%”.
For India, a mere 5% increase sounds terribly low. Similar research in this country should reveal the “political connection premium” at much higher levels.
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First Published: Fri, Oct 23 2009. 09 04 PM IST