In Finance, Risk Is Best Judged in a Portfolio Context - Essay Example

In finance, risk is best judged in a portfolio context." Is this true? Why? "In finance, riskis best judged in a portfolio context." Is this true? Why? Risk is uncertainty that investors face when making their investment decisions and they face a situation where not every risk can be diversified or mitigated. In other words, it can be said that risk is the uncertainty of returns on the amount that has been invested in the stocks. Therefore, they have to accept a certain level of risk in their investment portfolio where it is a set of assets and liability that an individual holds or is liable to. It is therefore, important to assess the aggregate risk in portfolio that can be faced by an individual. The aim of this paper is to critically assess the aspect of risk associated with investment and its judgment to be best in a portfolio context. This paper takes an argument to prove that individual stock cannot allow investors to help judging the overall risk associated with investment on shares. A critical criticism context will also be introduced in the paper later on to justify the argument regarding risk being judged better in a portfolio of stocks. It will not be incorrect to state that investors of stock market are directly associated with the risk which is not avoidable. These risks can be variable in types such as short-term risk or portfolio risk. For the focus of this paper, portfolio risk is being discussed in a contextual manner. It should be noted that portfolio risk is relatively low in accordance to the movements within the stock market. Herein, the process or concept of aggregation is considered for calculating risk associated with an asset or for valuing a company. It is due to this reason that individual investors are suggested to manage their portfolio risk because their individual transactions are aggregated. This denotes that investors tend to diversify their assets in order to judge the risk of security (Brealey, et al., 2010). It is not being proven here that by taking an aggregate of the risk of in a portfolio can eliminate risk. Portfolio of stock allows the investors to understand the associated risk in accordance of variation in all levels of the market. There is an underlying condition associated with portfolio risk. As a matter of fact, risk can be best judged in a portfolio context, as diversified stocks can have reduced risk. The underlying condition is that the return which is received by the investors is less than one. In this case, it is stated that diversification will remain beneficial or the investors (Brealey, et al., 2010). Risk or systematic risk is interlinked with the changes that may occur in the market. The risk is applicable on all the individuals associated with the portfolio of stocks. There can be some of the factors that would influence the portfolio risk such as global downturn, national economic chaos etc. Therefore, it can be said that the investment value of any stock can decrease readily when there are a number of differential measures of risk. Consequently, investors would like to diversify their stocks in such a way that they are moved together within a market to ensure that they can easily response to the market crisis. Economic analysts have maintained the idea that standard deviation of a portfolio which has been diversified greatly in an effective manner will always remain proportional to its risk measure (Brealey, et al., 2010). It is the need of risk management that different models and approaches have been framed for investors. Economic analyst have experimented with different formulas and calculations that provides ways of investing in a stock which will be high on his return value and lower in terms of risk. As a matter of fact, such an ideal situation is complex to find out. Among these approaches, Modern Portfolio Theory is best for investors to manage their portfolio risk. The approach was derived from the basis of risk modeling by Harry Markowitz. In order to diversify the portfolio risk, Harry came up with certain approaches (Brealey, et al., 2010). As mentioned in the above discussion and the statement of MPT theory, it becomes evident to note that investors must assess the risk and return but not on an individual level. By making sure that the investment has been done on various stocks, it can easily be noted that the diversification can be achieved. This approach has been states as not putting all of your eggs in one basket in the field of finance. In order to understand the implication of the theory, let us take an example where an investor values a stock or invest on a stock during a rainy day while other investor invests on a day when it did not rain. In a collective manner, both the stocks will pay off by covering the risk associated with one stock by the other one which does not have the risk associated with it (Brealey, et al., 2010). Thus, it is suggested that the investors are able to invest in stocks in an aggregated manner. One should not look for the stocks that are individual but those that are in collective portfolio. It is due to this reason that investors have now been able to look at the stocks that are diversified in nature. MPT in particular had a great impact on the investors in perceiving the risk associated with investment in stocks. Many organizations in the current business setting are making use of the theory in a continuous manner (Brealey, et al., 2010). Along with the aligned benefits and theoretical grounds of MPT, number critics have claimed that there are some of the shortcomings of MPT that cannot be avoided at any cost. Some of the critics claim that the situation that is presented by the theory of MPT does not align with the real world setting. In simpler words, it can be well stated that the assumption on which the theory has been presented is not close to practicality. As per the investigation in this context, it has been observed that there are issues of instabilities that may occur on the penalty term. Also, there are large swings in the measure of standard deviation among different stocks. The distribution of the risk from each stock will never be same when it comes to real world practice because of the mean-variance (Brealey, et al., 2010). Another aspect which has been raised as a concern by the critics regarding MPT is that the correlation between different assets would remain fixed. Along with its constant values, thee assets are more likely to be distributed on a random basis. This notes that correlation between the stock values will be dependent upon the assets. In a condition where there is an economic downturn is observed in a country, it is expected that all the assets would go down together. Therefore, their correlation is more likely to become positive in nature. In such condition, MPT does not react to the situation making the investors vulnerable to get protection from the risk noted on the whole board (Brealey, et al., 2010). In addition, it is observed that MPT is not able to assess the behavioral economics which means that investors may not act rational in most of the situation where they have to take a decision regarding investing in stocks. There is no way in which MPT ensures that informed knowledge of the stock value may help investors. Other than that MPT has another shortcoming of spreading the idea that by selecting the stock portfolio, anyone can save themselves from the unrated value of stocks and risk associated with it. It should be noted that stock market is a pool where different investors come to make sure that they can invest in stocks that are higher in return. This means that investing by following MPT may not be fruitful for everyone to gain higher value ends and secured returns because of overall or aggregated risk (Brealey, et al., 2010). In order to draw a line to prove that risk can be best judged in a context portfolio, it can be well stated that the elements and factors that are variable in nature will produce higher statistics of risk on an individual stock level. This is a generally accepted belief of finance. Be it CAPM or MPT, any theory of model can be used to differentiate between the advantages of portfolio context and individual stock to determine the risk (Brealey, et al., 2010). Through the above analysis and arguments, it comes to understanding that risk is unavoidable. Investors may will for investing in stocks that are higher in terms of return and with lower risk rate associated with them. However, the situation is too good to be true therefore, it is suggested that investors are looking for stocks that are present in a collective or portfolio manner. In this way, it is expected that the risk associated with the stocks will be less and cover individual stock risk with the help of another stock. Thus, finally it can be stated that the best way to judge risk is in the context of portfolio. References Brealey, R., Myers, S. & Allen, F., 2010. Principles of Corporate Finance, Latest edition, McGraw-Hill International.. Latest ed. New York: McGraw-Hill International. Read More