Portfolio Risk Management - Term Paper Example

Portfolio Risk Management Executive Summary This report has been prepared to highlight the risk-return positioning of portfolios with and without considering the real estate investment directly or indirectly. Additionally, in general, investor is risk adverse and they like to select the investment proposal that provide maximum return in relation to minimal amount of risk to them. Moreover, portfolio is regarded as a process through, which investor can diversify their allocation of budget in different securities that will help them to minimize the possibility of risk while investing in single security. In this relation the overall comparison of the risk and return from the different investment alternatives that comprise of real estate investment and portfolio without real estate investment and correlating the same with the current weighing of investment certain result has been derived. In this relation, making the portfolio of investment through 10% investment in real estate along with 41% in SCS and 49% in LTGB is regarded to be highly efficient investment alternative or portfolio, as the relative return of such portfolio is 2.61 and risk is 4.50. Moreover, the overall analysis reveals the fact that different portfolio provides different risk and return scenario but investing the RE with relative weighting of 0.10 in RE, 0.41 in SCS and 0.49 in LTGB will provide relative lower amount of risk and higher return over the similar risk category. This is why the particular portfolio has been mentioned. Table of Contents Executive Summary 2 Introduction 4 Real Estate Investment 5 Risk versus Return 6 Historical Scenario of Different Securities 7 Portfolio without Constraints 7 Scenario of Portfolio without Real Estate Investment 8 Scenario of Portfolio with 10% investment in Real Estate 11 Scenario of Portfolio with 10% investment in REITs 14 Conclusion 16 References 17 Bibliography 19 Introduction Portfolio is an important concept of financial management, which refers to the combination of various investment tools including stocks, bonds, shares, mutual funds, and cash that varies based on the income, budget and period of the investor (Reilly & Brown, 2011). Additionally, the art of selection of appropriate investment approach in terms of minimal amount of risk along with maximum return is regarded as the approach of portfolio management. Moreover, the key importance of portfolio management is to derive superior investment plan for the investors. Furthermore, managing the entire budget of investor based on the different alternative will enable them to minimize the risk in comparison to investing the fund in single investment proposal and increase the likelihood of profitability. In relation to the portfolio theory, it has been assumed that investor is risk adverse and they like to select the investment proposal from the given set of investments with equal rate of return having minimal amount of risk. The ability to combine and form the investment based on the combination of risk verses return is the prior reason to invest in portfolio for investors. The ideal role of portfolio management is to develop optional portfolio based on the risk-return opportunities in particular risk constraints (Lee, 2014; Kevin, 2008). Correspondingly, the report developed compares return, risk, and other related factors in the portfolio comprising ‘real estate investment’ and ‘without real estate investment’.Furthermore, the analysis helps to explore that real estate investment in order to maximize the return or add significant risk in portfolio. Real Estate Investment Prior to the period of 70’s investment in commercial real estate security did not exist and institutional investors portfolio comprises of stocks, bonds and cash. However, the scenario changed in the 1970s, when real estate was included in institutional investment asset class. Moreover, during the scenario, of 80’s investing in property had significantly lost its attractions in institutional investors due to significant loss in real estate. The prior reason being, low returns and recognition that arises because of high management and transaction costs, lower level of liquidity along with large lot sizes. Furthermore, it has been reflected that in short run investing or inducing the REITs in the portfolio will likely move along with equities. However, in long run, REITs acts like an indirect investment in the real estate. Its returns are positively correlated with return of real estate and are negatively correlated with returns of equity. Furthermore, for investor it has been quite difficult to determine the optimal portfolio, the different institutional investors will significantly have different set of investment objectives. In the context, taking the instance of investment objectives large life investors in comparison to the small occupational pension fund varies from each other. On the other hand, many investors develop their optimal portfolio through taking into concern the future liabilities rather than optimizing over the risk in particular period. In this context, real estate investment allows the investor to diversify the ranges of portfolio with the hope of reducing level of risk (Hudgins, 2012). Correspondingly, investing in real estate market is categories in two different parts including direct and indirect. Direct includes investing in retails, office, industrial and residential securities on the other hand, indirect includes property companies, unlisted funds, funds of funds, and REITs funds. Furthermore, the major advantage of investing in direct real estate is that it allows providing comparative return to investors as investing in stock and bonds with relatively lower level of risk. In addition, it also allows hedging with inflation (Blake et al, 2011). REITs are perceived to be the investment under real estate, which are operating companies managing the working of commercial real estate. Thus, the approach of investing in REITs is regarded to be effectively tax transparent for the investors like investment in real estate business (Lee, 2013; Mladjenovic, 2005). Risk versus Return The reason for investing in the diversified securities through using the approach portfolio is to develop the optimal portfolio based on risk constraints.Besides, in relation to determining the risk, standard deviation measure has been utilized to derive aspects related with accurate results. An investment is expected to provide different return depending on the diversification of portfolio. For instance the portfolio investment A consist of four different securities with likely return of 10%, 12%, 15%, and 19% along with relative probability of 0.2, 0.3, 0.4, and 0.1 respectively. Then, the expected return in the portfolio is 11.52% with relative risk of 2.66 %. On the other hand, the two investment suppose A and B provides same expected return of 9% with relative risk of 2.5 % and 4.0 % respectively. However, since both the investment proposal provides the same return, then the rational investor will likely to select in the investment A, due to its lower level of risk in comparison to investment B. In this context, it can be affirmed that in the real scenario, some investors are completely risk averse and on the other hand other are likely to take some risk in expectation of better profitability and expected return for the risk (Lee and Lee, 2010; Shim and Siegel, 2007). Historical Scenario of Different Securities The analysis of historical indices of different securities reveals the information that since early 90’s the net property index reflect positive trend apart in the scenario of September 2008 till December 2009, which likely reveals the relatively positive return and lower risk in this investment alternative. Additionally, the index of REITs reflect relative positively index in different point of scenarios. On the other hand, Large Capital Stocks (LCS), Small Capital Stocks (SCS), Long Term Government Bonds (LTGB), Long Term Corporate Bonds (LTCB), and Intermatiate Government Bonds (IGB) the other investment alternative have relatively showed high level of fluctuation that reveal high risk in investment in such alternatives. Portfolio without Constraints The analysis of the portfolio without any constraints i.e. there is no limitation regarding the allocation of overall fund in different securities reveals the fact the investing the overall fund in the SCS will provide the maximum return to investors. On the other hand, investing 1% allocation in SCS, LTCB, and INGB respectively and rest 97% on the CASH will relatively helps to minimize the risk from the portfolio. Furthermore, the analysis reveal the fact that portfolio 7 of will relatively been the efficient portfolio for the investor based on which the fund will be allocated 17% in real estate, 39% in SCS and 45% in LTGB with relative risk of 4.48 and return of 2.61. Rationale that portfolio 7 will be highly efficient because in comparison to the risk and return position in such portfolio is lower than current allocation. Scenario of Portfolio without Real Estate Investment The portfolio of investment without real estate investment consist of securities that includes, 60% investment in stocks i.e. 40% in the large cap stocks, along with 20% in the small cap stocks. Moreover, the rest 35% of the total fund are allocated in bonds, which includes 15% long term Government bonds, 15% intermediate bonds as well as 5% in long term Corporate Bonds and relative the rest 5% in cash T-bills. From the analysis of the data, it has been revealed that investing in small cap stocks is perceived to provide maximum return to investor but the risk of investing in such security is relatively much higher. Correspondingly, the portfolios without real estate security investment can relatively be formed with the combination of different investment alternatives. In this regard, risk and return of different alternatives has been analyzed in maximum to minimum risk scenario. Besides, in this regard, portfolio comprises investing the entire fund in small cap stocks security, which will provide the return of 3.55 with relative risk of 11.55. In the scenario, portfolio comprises of combination of small cap stock and long-term government bonds in around 80% and 20% ratio will provide relative return of 3.23 and 8.96 respectively as per the calculation. However, if the ratio of investment in small cap stock reduces to around 80% to 60%, on the other hand investment in LTGB from around 18% to 38% than the relative return will also been decrease to 2.91 and risk of 6.57. Apparently, the portfolio comprises of around 43% of small cap stock and 57% of long-term government bonds will probably provide the return of 2.60 and risk to be around 4.64 as per the calculation. Notably, through addition more investment alternatives in the portfolio including long cap stock, small cap stock, long terms government bonds, and intermediate government bond in the ratio of around 8%, 27%, 47% and 18%, the risk-return position of portfolio will be 3.57 and 2.28. Furthermore, in the regard it is worth mentioning that portfolio comprise of 100% of cash investment that is perceived to be of high risk avoidance portfolio with relative risk and return position of investment to be 0.54 and 0.71 as stated in the calculation. Contextually, in comparison to portfolio without investment in real estate, combinations of different alternative have been considered. This implies that portfolio without RE have the risk and return combination, which is relatively lower than without constrains curve. Furthermore, it has been ascertain from the scenario that current allocation of portfolio was LCS, SCS, LTGB, LTCB, INGB and CASH in the weight of 0.4, 0.2, 0.15, 0.05, 0.15, and 0.05 respectively, which will provide return of 2.35 and relative risk of 5.01. In this relation, it can be argued that portfolio without real estate investment through investing in SCS, and LTGB in the ratio of 43% and 57% respectively will provide the return of 2.60, which is higher than the current weighing and regarded relatively risk of 4.64 that is relatively lower than 5.01 risks in current investment alternative. The analysis critically argued that investing in portfolio without considering real estate investment is highly profitable when the overall all allocation of fund has been invested in LCS, SCS, LTGB, and INGB. Furthermore, the allocation of fund will be made in LCS, SCS, LTGB, and INGB in the ratio of around 8%, 27%, 47% and 18% will also provide somehow similar return in comparison to current weighting with lower level of risk. Besides, it has been revealed with the calculation that risk in such portfolio will be 3.57 and return around 2.28, which is comparatively receive to have lower risk lower than current allocation with more or less similar return. Scenario of Portfolio with 10% investment in Real Estate As per the analysis inclusive of real estate, investment in portfolio need to satisfy and provide incremental reward and opportunity to diversify the portfolio in the asset class work so that it will provide maximum return to the investors. Investors intend to maximize their profit on a continuous basis with less risk. The below table reflects the allocation in real estate investment and marginal risk and return impact with under the nine different investment horizon. In similar respect, the portfolio with 10% investment in real estate security has also been analyzed with different investment alternative in terms of maximum return to minimum risk. In this regard, it can be affirmed that the return through keeping the portfolio with 10% of real estate investment as constant the return will be maximum when the rest 90% of the investment is invested in SCS, to attain a return of 3.44 and risk of 10.67. On the other hand, the risk is minimal in portfolio when the portfolio will comprise of the investment alternative including 10% in real estate, 4% in LTCB, 4% in INGB, and around 82% in cash. The relative poor performance and fluctuation in the equity market position in the international market has relatively provided the opportunity to investors to make their allocation of fund in real estate. Besides, the portfolio in the analysis include following: Equities 41 percent Bonds 49 percent Commercial Real Estate 10 percent The study explores that equities lie around 41 percent of the total allocation in SCS, bonds around 49 percent in LTGB and 10 percent in real estate will led to minimize the overall risk and enhance the overall return in comparison to the current weighing. The analysis revealed the fact that the investing in real estate is perceived to provide significant opportunity to the investors, as the entire alternatives of investing the fund in different ratio through considering real estate investment in 10% provide efficient risk and return scenario. On the other hand, it can be critically argued that 10% of RE investment, 41% of SCS, and 49% in LTCB investment will provide efficient return. Correspondingly, in relation to analysis of the portfolio 8 of RE investment with the efficient frontier keeping the 10% of investment in RE reflects the portfolio 8 of RE will give the return of 2.89 with relative risk of 6.28. On the other hand, portfolio 8 of efficient frontier will provide return of 2.92, which is slight higher than portfolio 8 of RE investment with high risk of 6.55. Thus, based on this analysis investor can take rationale approach through investing any of these portfolios. Relatively, the comparison of portfolio 4 in both the scenario reveal that RE portfolio is relatively efficient than the efficient frontier portfolio 4 in relation to return, as investing in portfolio 4 of RE will provide return of 1.78, which is higher than 1.68 of portfolio 4 of EF. However, investor wants to relatively minimize the risk than they can invest in portfolio 4 of EF because it is less risky than portfolio 4 of RE. Scenario of Portfolio with 10% investment in REITs In this regard, the calculated data reveal the fact that the portfolio with 10% of REITs investment along with 90% in SCS will provide maximum return to the investor but with relatively high level of risk in such investment. On the other hand, if the investor is likely to build their portfolio with relatively lower level of risk then they can invest and prepare their portfolio that include 10% of REITs, 4% of LTGB, and rest 86% investment in CASH that will likely to prove return of 0.97 with relative risk of 1.06. It critically justified with the portfolio comprise of 10% of REITs, 40% of SCS, and 50% in LTBG securities or 10% of REITs, 7% of LCS, 23% of SCS, 53% LTBG, and 8% in INGB will be regarded to be efficient investment alternatives portfolios in terms of risk and return. This study examines the effectiveness of investment real estate directly and indirectly with the context of mixed-asset with risk and return constrain. In this relation, from an analytical perspective direct investment in real estate rather than indirect investment in real estate will enrich the return of investor with relative lower risk in comparison to portfolio without real estate investment. Conclusion From the overall discussion, it can be revealed that allocation of fund using the approach of portfolio will provide significant opportunity to investors to diversify or minimize the possibility of losses that is perceived to arise because of investing in some specific class of assets. Correspondingly, since 70’s real estate investment provides significant opportunity to the investor to diversify their allocation though investing in real estate market. Besides, the overall comparison of the risk and return position of the portfolio with and without real estate investment it has been revealed that managing the portfolio through including real estate in the investment portfolio is likely to be an efficient approach for minimizing the risk and increasing the return in comparison to current weighting of portfolio. References Blake, N., Goodwin, A., McIntosh, A. and Simmons, C. (2011). Property and inflation, Investment Property Forum, pp. 6-57. Hudgins, M. C. (2012). The role of REITs in a portfolio a “core plus plus” real estate allocation, JPMorgan Asset Management, pp. 1-10. Kevin, S., (2008). Security analysis and portfolio management, India: PHI Learning Pvt. Ltd. Lee, S. (2014). Portfolio risk management: risk reduction and diversification, Cass Business School, City University, pp. 1-77. Lee, S. (2013) Portfolio risk management: indirect investment, Cass Business School, City University, pp. 1-72. Lee, C. and Lee, J. (2010). Handbook of quantitative finance and risk management, UK: Springer Science & Business Media. Mladjenovic, P.(2005). Stock investing for dummies, USA: John Wiley & Sons. Reilly, F. and Brown, K. (2011). Investment analysis and portfolio management, UK: Cengage Learning. Shim, J. K. and Siegel, J. G. (2007). Handbook of financial analysis, forecasting, and modeling, India: CCH. Bibliography Levine, H. A. (2010). Project portfolio management: a practical guide to selecting projects, managing portfolios, and maximizing benefits, USA: John Wiley & Sons. Read More