Risk in Portfolio Context - Literature review Example

Risk in Portfolio Context (Judging the Risk by Portfolio) In the stock market, the risk is one of the natural and unknown qualities that an investor must be ready to face. It means, therefore that, when an investor decides to put his money in the stock market, they need to be aware of the risk involved. This is because it is very easy for the stock market to record a poor performance, and when this happens, the investor’s money may not make a positive return. It is therefore very hard to avoid risk completely, other than judge it. It is absolutely true that risk is best judged in a portfolio context in finance. This is so , because the possibility that many companies will get poor performances that will make their stock to go down as compared to just one company, is low. This essay is therefore aimed at discussing more reasons why the portfolio context is the best way to judge the risk in the financial market. In the first part, the basic theories of portfolio will be introduced. The second part will contain the methods of measuring risk and the value of the portfolio, which will demonstrate why it is wise to select portfolios. An example will be given in part three of family grouping based on performance on portfolio selection in Hong Kong Stock exchange market. This will then be followed with a conclusion of this essay. To begin with, we must discuss the theory of portfolio and the five suppositions on portfolio selection. The portfolio theory can be described as that containing various securities and other assets in a collection of the investor. Out of this collection could reach the highest return in a particular level of risks, or a minimum risk for a particular level of return. This group could be referred to as efficient portfolio. Portfolios do not only have the characteristics and the risk and return for a particular stock, but also the peculiarity of returns and risks of the relationship existing between the stocks. Apart from the meaning of the portfolio theory, there is a need to mention the five suppositions which are the premises of the premises of portfolio theory. The first supposition states that the investor’s assessment of the stock and portfolio depends on the expected risk and the return. Second supposition is that the investors are considered to be irrational. This hypothesis has two sides; one aspect is that the investors are said to be unsatisfied since they would always want to get more returns other conditions remaining constant. This means that, if presented with two portfolios with different standard deviations, the investor will obviously choose the one with higher returns. The other aspect of the hypothesis is that, the investors are tired of risks and are not ready to lose their investments to it. The investors do not want to see the big difference between the actual and the average returns. In other words, investors prefer more stable portfolios. This shows clearly that, investors will choose less risky portfolios than others among portfolios of the same returns. The third hypothesis states that investors hold the assets only for a given period. The fourth supposition is about the measurement for assessing the information. This means that, with the same information about the portfolio, all the investors will have the same expected return and the same risk level. The fifth and last supposition is that which states that the market is frictionless. On this supposition, transaction costs such as the tax and handling charges will be slight. All the stocks can be divided into any number and the information will be available. According to (Markowitz 1952), the portfolio theory is developed on these five suppositions. Whether the portfolio could reduce the level of risk is a fact that cannot be proved by mere speaking or speculations, but by calculations through special measurements, to provide evidence. The special measurements such as value at Risk (VAR), is a methodology used to measure portfolio risks. The largest loss that can be suffered by a portfolio through all exceptional periods can be estimated through the use of VAR. A VAR can also measure the potential loss of a portfolio of an asset. One portfolio can include various different assets such as bonds or stocks. However, in our case, the portfolio will just contain two stocks in order for us to get the idea clearer. First, there is a need to estimate the volatilities of returns on each stock. This is because the volatilities of the portfolios relate to the volatilities of the two stocks in the portfolio. However, stock returns are not always constant, this means they co-vary at times. In some instances, the covariance of the two stocks may become negative. In such cases, the return on one stock will go up while the return on the other stock will go down. Each stock normally has its own level of volatility, for this reason, there is no one point when the volatility of one will be the same to that of the other. When two stocks are put together, the effect will be that, the swing in return will be inhibited. This explains the reason why the volatility in the portfolio is lower than the volatility in each stock in the portfolio. Therefore, the more the stocks that are in the portfolio, the less the volatility of the portfolio and vice versa. There is a requirement of the covariance between the stocks to be used with volatility in the calculation of the volatility of the portfolio, and the VAR will also be found. To illustrate by calculation, we can assume that, if X invests $1 in stocks 1, 2 & 3, and the daily volatility of portfolio is as follows; Volatility (portfolio) = volatility (stock 1) + volatility (stock 2) + volatility (stock 3) +2xcovariance (stock 1, stock 2) +2xcovariance (stock 2, stock 3) +2xcovariance (stock 2, stock 3) In the formula above, if the covariance (stock 1, stock2), covariance (stock 1, stock 3) and covariance (stock 2, stock 3) were zero, then the volatility of the portfolio would be the result of collecting each stock’s volatility together. Therefore, the VAR of the portfolio is the sum of each stock’s VAR. but in real sense, it does not follow that the covariance is always zero, therefore, the VAR of all the portfolio could not be calculated by simply adding up the VAR of each stock together. The co-variances between assets needs to be estimated and the constant volatility, or the time-varying method can be used to calculate the VAR (Hopper 1996). One of the best examples of putting the portfolio theory in practice is by using the family portfolio in Hong Kong. In Hong Kong, many companies belong to families and these companies are controlled by one business conglomerate. The local journalists and newspaper reporters of Hong Kong normally keep a close watch on the ownership of these families. For example, some stocks are referred to as ‘falling into the Li Ka Shing stable’, or the Y.K. Pao stable etc. (Lam 1994). Mok et al (1992) was the first person who discovered that the price of constituent stocks controlled by a family tend to move together more than the price of stocks owned by different families. This opinion was arrived at after the factor analysis of 48 stocks. From his studies, Mok et al (1992) he discovered a case that the mean residual return of correlation (0.161), is more than 3 times (3.3 times) higher than the mean average number (0.049) of residual return correlation of between family groups. In particular, a family is said to manage stocks in a new way to organize homogeneous stock groupings. This can lead to a good selection of portfolio. This fact was investigated in a study carried out by Kin Lam, Herry M. K., Iris Cheung, and H.C. Yam, in 1994. They used different models like the Full Historical model, the overall mean model, the single-index model and the multi-index model. These are conventional models or approaches used in forecasting future correlation matrix and the establishment of the portfolio to promote usefulness of the family group. The family group can be able to choose a sizeable portfolio together. This group is affected by the relationship between the various individual family members. The family members can range for a bigger portfolio than that of one individual investor. Therefore, the member can easily control and manage the risk based on the trust on each other. Many decision maker normally love when there is trust, this provides the investors with more confidence needed to survey the risk from multiple aspects which helps in making the right and final decision (Middleton 2008). In summing up this discussion, portfolio theory is a concept that is affecting the current investment with a stronger vigor. Most of the investors and companies manage their risky assets using the portfolio context. There are more than one form of assessing the risk and benefits of a portfolio. Since when this theory was worked out in 1956 by Markowitz, the step of chasing the greatest return with less risk has never stopped. From the use of the mean-variance model to the multi-index model, approaches founded and used by Markowitz, it is evident that more and more evidence can offer the benefit of the portfolio selection. Through the efforts of this scholar, different types of investments were developed and more efficient were discovered to make the theory and make it more advanced. In conclusion and summary, it is without any doubt that the portfolio context is so far the best choice to judge the financial risk so far. Reference Hopper, G. P., (1996), Value at Risk: A New Methodology for Measuring Portfolio Risk, Business Review. Lam, K., Henry M.K., Mok et al, Cheung, I., and Yam, H.C., (1994), Family Groupings on Performance of Portfolio Selection in the Hong Kong Stock Market, Journal of Banking and Finance. Markowitz, H. M., (1952), Portfolio Selection, Journal of Finance. Middleton, C. A. J., (2008), An Investigation of the Benefits of Portfolio Investment in Central and Eastern European Stock Markets, Research in International Business and Finance. Read More