Why Investors Should Establish Portfolios - Assignment Example

? Portfolio Theory's underpinning principles need to be uncovered before appreciating the creation of capital asset pricing model (CAPM), Evaluate the reason why investors should establish portfolios. Contents Contents 2 Introduction 3 Principles of portfolio 3 Theoretical background of portfolio management theory 4 Net present value method 5 Evaluation of risk with large portfolio 6 Systematic risk 7 Market return on systematic risk 8 Measurement of systematic risk 8 Conclusion 9 Reference 9 Introduction Portfolio can be described as the group of assets or pool of securities in which money is invested. There is a famous saying that one should not place all the eggs in one basket. The concept of portfolio also came from this saying which means that one should not make all the investment in one asset or security and should diversify the investment by investing in a group of assets so that the loss from one security can be compensated by the gain of the other security. The gain achieved from one asset can offset the loss incurred from the other only if both the assets are negatively correlated. In this project the basic principles of the portfolio theory or the portfolio management theory has been discussed along with the theoretical aspect of the portfolio management theory. The investment viability criteria have also been discussed along with the other basic conditions like risk and return which should be considered before making any investment. The need of diversification of the portfolio has also been discussed along with all the risks associated with the diversified portfolios. Principles of portfolio As per Lonestreth Bevis portfolio can be described as a mixture of investment which is held or will be held by the investor. This means a portfolio is a collection or a group of two or more assets or securities held by the investor to gain maximum return while setting off the risk associated with one stock with the return of the other. The investment portfolio is guided by a number of principles. The decision regarding the portfolio will comprise of the decisions regarding the securities held in that portfolio. If the investor is expecting more return then he have to bear more risk too. This means that high return comes with higher risk. The risk of the variability of a particular asset held in the portfolio depends on when the investor will liquidate or sell it. Diversifying the investment will lessen the risk associated with the portfolio. Therefore diversification will help to reduce of the variability of the return associated with the portfolio. The portfolio should be formed as per the need and the risk tolerance level of the investor (Periasamy, 2009, p.7.10). One of the important principles regarding the portfolio is efficient allocation of assets in the portfolio. Moist of the performance of the portfolio depends upon the correct allocation of securities in the portfolio. The securities which are to be included in the portfolio the portfolio should be properly analysed in term of the expected return and risk associated with them and should be allocated in the portfolio according to the most appropriate weightage in order to achieve desired return from the portfolio. This could be done by analysing the historical prices and the performance of the portfolio (Ambrose wealth management, No Date, p.10). Theoretical background of portfolio management theory The portfolio management deals with the formation and performance of the portfolio. Theoretically the portfolio can be managed in five basic steps. The first step of managing the portfolio is to analyse the securities which are available for investment. This step includes accessing the various securities available to the investors. The securities which are available are analysed on the basis of the risk and return of those securities. The securities can range from the stocks to fixed deposits to risk free assts like treasury bills. The second step is to form different portfolios and analysing them. This is done by analysing the various portfolios as pert the risk and return criteria. After analysing the various portfolios which can be formed from the available securities the next step is to select the best portfolio. This is done on the expectation of the investor and the risk tolerance level of the investor. Optimal portfolio is generally selected as per the Markowitz’s model that is selecting the efficient portfolio which gives maximum return at a definite level of risk or minimum risk at a definite level of return. Once the optimal portfolio is selected, the performance of the portfolio is measured with the help of many ratios like Sharpe ratio, Treynor ratio, Jenson’s alpha etc. The last step is to revise the portfolio as per the liquidity and other needs of the investor and the market conditions (Kevin, 2006, p.2). Net present value method A portfolio of investors may include number of assets like corporate of government bonds, risk-free assets and equity etc and each of these assets have different level of risk and return. On the other hand, many of assets may offer multiple cash flows apart from wholesome return at end of maturity or till the holding period. Managing all these assets for gaining higher return with lower risk level is the prime objective of portfolio management. The process of portfolio management also includes evaluate the future cash flows earned through each of the assets. The value of the money determines by a number of factors like inflation and interest rate, and this considers the time value of money. Therefore, using time value of money, it is necessary to evaluate the effectiveness of earnings generated by maintaining a portfolio using financial evaluation techniques like ‘Net Present Value’ (NPV) that also takes the time value of money into account. NPV evaluation technique pulls back the future cash flows to present value and it become easier to determine that whether a portfolio or an asset is viable (Hoose, 2010, p.143). For example, suppose a portfolio is made of a bond and equity whose total worth at present is $5000 and investors wants to know whether net effect of future cash flow and the whole return is higher than its present of investment (cash outflow) after 5 years. In this process, it is necessary to determine cost of expected rate and future cash flows. Suppose, from equity, regular yearly dividend is expected to be $200 per year and yearly coupon earnings on bond is $100 per year. At end of 5 years due to due to increase in expected equity price and bond price, the value of portfolio will reach up to $8000. The cost of equity and bond (discounting factor) is 16%. Based on the above information calculation of NVP is given below. Figure 1: NPV Calculation As per above analyses based discounted cash flow, the portfolio is not viable and hence, investors must avoid the investment for this portfolio. Evaluation of risk with large portfolio It has been explained that a portfolio may includes a number asset and each single types of assets are unique as they have their specific risk and return. There are number of risk associated with a portfolio. There are certain factors that influence the return of each asset. For example, reinvestment risk, interest risk, liquidity risk, credit risk, etc. However, all these types of risk are mainly determined by the nature and characteristics of every assets that have includes in the portfolio. The primary basis of managing portfolio is to measure the underlying risk and return associated the portfolio. In this respect statistical techniques like mean, standard deviation, correlation coefficient, covariance etc the basic methods (Chandra, 2008, p.215). It has been empirically, proved that with more inclusion of assets which are negatively correlated with other can lead to reduce the unsystematic risk. Unsystematic risk is specific risk associated with each asset. The modern portfolio theory explains the diversification of specific risks by include including other assets having very low covariance. This can be explained using the following formula. In case of a large portfolio, the calculation of variance is given below. (Source: Lynch, n.d. p.8) Here, the fist value (1/N* ? 2) is individual investments’ average variance and the second value {(N-1)/N*Cov(Ri,Rj)} is the average covariance. As effective of increasing number of assets i.e. N, the first value will reduce and on the other hand, second value will move towards average covariance (Lynch, n.d. p.8). Systematic risk Risk can be classified into two categories namely systematic risk and unsystematic risk. Systematic risk is the risk which is generally found in the most diversified portfolio too. Unsystematic risk is the risk which can be minimised and to an extent can be eliminated by diversification. This type of risk includes business risk, financial risk, default risk etc (Ross, Westerfield and Jordon, 2008, p.416). This type of risk is associated to a company and therefore it can be avoided. On the other hand systematic risk is the risk which cannot be controlled like the market risk, inflation, interest rate risk etc. This risk is generally borne by all types of investors. These are not firm specific (Jonathan, DeMarzo and Thampy, 2010, p.310). Market return on systematic risk Most of the big stock exchange has the market index where the different securities which are trade in the stock exchange are listed. Therefore the return of this index is considered as the market return as most of the securities are listed in this index. The return of this index varies from time to time. The market return is given only on the systematic risk because the market index is well diversified as the market index consists of numerous securities which are from various sectors of the business and different industries therefore the index return hardly contains any unsystematic risk and the only risk which is associated with the index return is the systematic risk. Hence the market return is affected of only the systematic risk. Measurement of systematic risk The systematic risk associated with an investment portfolio is measured through beta. Beat coefficient measures the market volatility of the stock or any other security. It is a measure of systematic risk. Beta coefficient basically measures the sensitivity of the return of the security to the market return. If the beta coefficient is 1 then it can be said that the stock return will move exactly with that of the market return. If the beta is less than one then it can be said that the stock return is less sensitive to the market return and vice versa (Faerber, 2007, p.58). The security market line shows the relationship of the stock return with that of the systematic risk (Beta) associated with the stock return (Gitman, 2007, p.218). Conclusion The portfolio is basically formed to reduce the risk associated with the investments with the help of diversification. To reap the benefits from the diversified portfolio it is very important to construct the portfolio in an effective manner so that the objective of the investment can be achieved. The investor must evaluate the expected return and the risk associated with the investment to check the financial viability of the investment before investing in it. Reference Ambrose wealth management. ( No Date). 7 Principles of Portfolio Management. Available at: http://ambrosewm.com/documents/7PrinciplesofPortfolioManagement-fortheweb.pdf. [Accessed on August 31, 2011]. Faerber, E. (2007). All About Stocks 3rd ed. USA: McGraw-Hill Professional. Gitman, L. J. (2007). Principles of Managerial Finance 11th ed. India: Pearson Education India. Hoose, D. V. (2010). The Industrial Organization of Banking: Bank Behavior, Market Structure, and Regulation. Springer. Jonathan, B. DeMarzo, P. and Thampy, A. (2010). Financial Management. India: Pearson Education India. Kevin, S. (2006). Security Analysis and Portfolio Management. India: PHI Learning Pvt. Ltd. Lynch, P. (No date). The Risk and Return Relationship. [Pdf]. Available at: http://www2.accaglobal.com/pdfs/studentspdfs/portfolio_part1.pdf. [Accessed on August 31, 2011]. Periasamy, P. (2009). Financial Management 2nd ed. India: Tata McGraw-Hill Education. Ross, S. A. Westerfield, R. and Jordon, B. D. (2008). Fundamentals of corporate finance 8th ed. India: Tata McGraw-Hill Education. Read More