The Core Objective of Portfolio Investment Is to Minimize Risk - Literature review Example

The Core Objective of Portfolio Investment Is to Minimize Risk The financial market, in spite of its numerous rewards and benefits is an industry that is distinctly volatile that often requires critical analysis in an effort to effectively evaluate the risks relative to the returns. This in turn helps in the adequate evaluation of the decisions regarding participation in the industry. This paper therefore seeks to examine the statement that ‘the objective of portfolio investment is to minimize risk’ giving examples and discussing the differences between systematic and unsystematic risk. Investment portfolio often provides guidance on the manner in which an individual investor or financial planners allocate their money and other capital assets within an investing portfolio. An investing portfolio is characterized by long term goals independent of the fluctuations that occur daily within the market (Choueifaty & Coignard, 2008, pp. 40-41). As a result of these goals, investment portfolio seeks to provide investors or financial planners with the requisite tools to enable them to accurately estimate the expected risk and the return that is linked with investments (Peters, 2008, pp. 56-57). The recent financial crisis impacted on many investors and led to extreme losses attributed to the distinct lack of sufficient portfolio protection. The crisis also brought to the fore the application of portfolio optimization does not provide sufficient protection of the portfolio from high losses especially in the instance that systematic risk is occurring (Qian, 2006, pp. 41-42). Financial theory argues that risk can be broken into systematic, undiversifiable risk on one hand and diversifiable risk on the other hand. In definition, an investment strategy is defined by a distinct set of rules, behaviors and procedures that are meant to guide the decision on the type of investment portfolio. In many instances, the strategy is designed around the risk return trade –off profile of an investor (Foresti et al, 2010, p. 34). Within a dynamic context, portfolio management is a type of sequential process that provides an investor with the chance to revise his investment with any changes that occur on the financial markets (Blichfeldt & Eskerod 2008b, pp. 357). In an effort to control systematic risk, portfolio insurance is often applied on the investment strategy over the period of investment. Portfolio insurance is made up of strategies that aim to systematically adjust the portfolio asset allocation (Sabbadini, 2010, pp. 120-121). Portfolio management is often based on both technical as well as core analysis of investment alternatives where thereafter an individual is able to make appropriate decisions concerning both long and short investment positions(Chandra & Shadel, 2007, pp. 346-347). Creating an investment portfolio helps in providing a reflection of the transformation that the economic environment is going through. By increasing on the number of securities found within the portfolio subsequently helps in the unsystematic risk reduction component leaving the systematic risk component as unchanged (Goetzmann & Kumar, 2008, pp. 433). Presence of an investment portfolio helps an investor to diversify on their investments across numerous assts which in turn helps to reduce on risk. While this does not produce protection against loss, diversification within a portfolio ensures that the investor is in a position to reach his long term financial goals while at the same time reducing on risk. In setting up a portfolio, an investor can be in a better position to eliminate diversifiable risk since he is combining all his assets into one distinct portfolio (Wagner, 2006, pp. 373-374). In holding only one asset or assets within the same distinct industry, then it is possible to expose the investor to risk that could be diversified away. For portfolios that have been effectively diversified, unsystematic risk is very small and there the total risk present within a diversified portfolio is distinctly equivalent to the systematic risk (Acharya 2009, pp. 224-225). With an investment portfolio that is diversified, risk is distinctly reduced as a result of the fact that different stocks often rise and fall independent of each other (Bartram et al, 2007, pp. 835). On a wider scale, different combinations of investment might cancel out fluctuations in price and subsequently reduces on the overall risk. One of the core goals of a diversification strategy is to distinctly improve on performance of an investment while at the same time reducing on the risk (Bartram et al, 2007, p.837). An investment portfolio helps to reduce risk by relying on the distinct lack of a distinct relationship among the various types of assets. In diversifying one’s portfolio of assets, an investor often loses out on the chance to experience a return that is linked with having invested only in a single asset with the highest return (Arnoldi 2009, pp. 33-34). On the other hand, it also ensures that one is in a position to avoid experiencing a return that is linked with having only invested in the asset that has the lowest return. Consider as an example the case of an individual who purchases 60 corporate bonds from one company. This individual will receive a certain yield that is founded on the price of purchase (Damodaran, 2008, pp. 45-46). In the instance that business risks that were not expected come up and lead to issues with liquidity, the company that he bought the shares from might find itself facing bankruptcy and therefore be forced to default on its loans. In this instance, the investor will lose his entire investment (Hillson & Murray-Webster, 2011, pp. 29-30). On the other hand if the investor chooses to purchase one bond from 50 distinct corporations which are characterized by the same credit ratings, then in the instance that one of these companies goes into insolvency, this will have far less of an impact on the overall portfolio of the investor(Hillson & Murray-Webster, 2011, p.31). In a scenario where all these 50 corporations were given a lower credit rating due to the risk that they present to the overall market, the individual will still find himself at risk with regard to losing some if not all of the investment that he initially put into the corporation’s (Landier et al, 2009, pp. 454-455). This is the type of risk that cannot be diversified and this is what is referred to as systematic risk. This is also the portion of the risk that pays out the risk premium due to the fact that the risk that is linked with this particular market is tighter than the risk of the entire market. It is important to note that systematic risk is often present irrespective of the amount of diversification that the investor might choose to make (Acharya, 2009, pp. 229-230). Whereas all investments distinctly display a type of risk, it is often believed that investors generally get rewarded for taking on risks. However, some of this risk is not always rewarded which is the reason why investors need to take firm control or take away risks which they might not get any type of reward from their investment portfolio(Sabbadini, 2010, pp. 125). It is important to note however that while diversification does help an investor to reduce on instances of unsystematic risk, it does not protect this investor from events such as inflation, war or a fluctuation in the interest rates as these aspects often impact on the entire economy and not just one distinct firm or industry (Goetzmann & Kumar, 2008, p.437). In this regard, diversification does little to eliminate the risk that comes with these events which are referred to as un-diversifiable risk (Chandra & Shadel, 2007, pp. 349-350). This particular type of risk is what makes up the large amount of the risk that drives portfolios that have been well diversified which is referred to as systematic risk. However, the expected returns that come with these investments often provide investors with the patience to endure systematic risks (Sabbadini, 2010, pp. 129). In other instances, investors can be encouraged to take risks since it is assumed that they will get higher returns but it is not always the case that these risks provide potential rewards. In this regard, an investment portfolio that has been well diversified is what provides an investor with the protection that he will need from these risks and the impacts that accompany them (Wagner, 2006, pp. 380-381). It is important to note that market risk is a critical aspect for all investors as it plays a significant role in pricing assets since it is the risk that investors expect to be rewarded for taking. However, a significant part of the riskiness that accompanies the average stock can be done away with by having a portfolio that is well diversified. This is because it provides investors with the chance to focus on the aspect of the risk that cannot be done away with since this is the risk that should be priced within the financial markets (Bartram et al, 2007, pp. 840-841). Conclusion For every investor, risk is an aspect that they would wish to completely eliminate which is the reason why a well diversified investment portfolio is seen as critical towards ensuring that risk is reduced for the entire investment. By allowing the investor to diversify, the portfolio ensures that systematic risk is significantly reduced. Reference List Acharya, V. V. 2009, “A theory of systemic risk and design of prudential bank regulation,” Journal of Financial Stability, 5(3), pp. 224–230 Arnoldi, J. 2009. Risk. Cambridge: Polity Bartram, S., G. Brown, and J. Hund, 2007, “Estimating systemic risk in the international financial system,” Journal of Financial Economics, 86(3), pp. 835–841 Blichfeldt, B.S., Eskerod, P. 2008b. Project portfolio management—theres more to it than what management enacts. International Journal of Project Management 26 (4), 357–358 Chandra S, Shadel WG 2007. 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