Diversified Portfolios vs Individual Stocks - Essay Example

Efficient Portfolios Efficient Portfolios Efficient portfolio is a kind of portfolio that gives the best expected return for a defined risk level. This is the same as; a portfolio that offers risk at a lowest level of a defined expected return. The efficient portfolio can be mathematically determined and plotted with the X- axis representing the risk, while the y- axis, the expected return (Markowitz, 1952: 82). It is also known as the optimal portfolio. Markowitz (1991) suggests that one with an efficient portfolio cannot diversify further to increase the return rate without agreeing to higher risk amount. Similarly, decrease in risk exposure will proportionally decrease the return that is expected from the investment. Scott (2003) defines an efficient portfolio as an investment combination that offers either possible highest yield at a defined risk level or possible lowest risk at a given level of yield. The efficient portfolios can be determined through the mean- variance analysis process. ‘High Risk- High Return’ vs. ‘Low Risk- Low Return’ Portfolios A ‘high risk – high return’ portfolio may be worse than a ‘low risk- low return’ portfolio due to the fact that in a ‘high risk- high return’, in case of risk occurrence the loss is great. According to Simpson (2012), the ‘low risk- low returns’ portfolio is accompanied by high chances of success of the business. This is because the risk is more limited compared to the ‘high risk- high returns’ portfolio. Though the profit margin might be small, there are higher chances that the loss will not be experienced thus surety. The two portfolios are what form the mean-variance efficiency level. Diversified Portfolio’s vs. Individual Stocks The understanding of individual stocks and diversified portfolios can be better done through then mean- variance analysis. A stock portfolio risk depends on the risks that are associated with individual stocks proportions. A change in the individual stocks will therefore automatically lead to change of the portfolio risk. The diverse the portfolios of equal proportions the lesser the risk; this is as the stocks number increases. The same way, random selection of stocks for combination in equal proportions declines the portfolio risk. The divers the stock in a portfolio, the lower the risk level of the portfolio (Statman, 1987: 353). An Increase in the number of stocks rapidly reduces the risk effect, thus can be reduced to the most insignificant level. The benefits that are associated with diversification re normally exhausted when a given portfolio has ten or more stocks. “…51 percent of a portfolio standard deviation is eliminated as diversification increases from 1 to 10 securities. Adding 10 more securities eliminates an additional 5 percent of the standard deviation. Increasing the number of securities to 30 eliminates only an additional 2 percent of the standard deviation.” (Satman, 1987: 354). According to AAII (2015), even though diversified portfolios have some disadvantages, they are better than individual stocks. It reduces the risks that are associated with both the portfolio and the stocks that form it. The only challenge that comes is when it comes to decision making since there may be several organizations that someone does not even know that well. Goetzmann & Kumar (2008: 433) believe that portfolio diversification can be used to reduce idiosyncratic component that are large. They suggest that diversified portfolios can be used to eliminate or reduce risks that are not compensated. They also prove that diversification helps in the pricing of securities. Comparison of the two should also be made in terms of marginal costs and marginal benefits so as to help determine the production or consumption levels that are optimal. To ensure much gain, diversification should be stretched to the limit so long as the marginal costs don’t exceed the marginal benefits. The unsystematic risk is eliminated almost completely when the portfolio contains approximately 10 to 100 stocks. The major benefits that are closely associated with diversification is reduction of risks. Diversification may have a limit since the increase in marginal costs is normally higher compared to marginal benefits as portfolio diversification increases (Statman, 1987: 354). Preference for Efficient Portfolios Mean- variance analysis helps in the determining of the kind of efficient portfolio to go with. Risk is a major issue of concern when it comes to investment with the investors preferring a market portfolio with an asset that is risk- free (Rayland, 2009: 69, AAII, 2015). According to AAII (2015), it is important to note that there is nothing like ‘no- risk’ since they are just carried forward and can be experienced in long term as inflation or income risk. Risky free assets are often defined by use of treasury bills. There are always insights that come from the traditional investment models when it comes to certain conditions. The risks associated with financial transactions have introduced pervasive influence in the market, thus the development of models that are a bit more pervasive. The fact that the risk premium in the market can be mathematically determined will make people to invest in the areas of low risk. The mathematical identification of prices of capital assets starts normally be interest rates that are purely at equilibrium. This leads to a later assertion that a risk premium of the market is determined. This method provides the both the “price of time” and “the price of risk” (Sharpe, 1964: 425). This makes it easier to determine the risk associated with the asset and the market, thus going for one with lower risks. There are several normative models that have been formed to help in deciding when it comes to risk conditions (Sharpe, 1964: 426) By use of this model the investors will be able to identify areas of asset and portfolio of free risk. This is due to the fact that the importance of business is normally to ensure that profit is maximized. Markowitz Model, for example, has two parts: one showing the ‘unique optimum combination’ and the other is dealing with fund allocation in a riskless manner. Investors often make investment choices considering the choices under which the investment can get dichotomized (Sharpe, 1964: 427). There are several works that shows investors preferring the areas of low to free risk. Portfolio Theory and Diversification Mean- variance efficiency can be determined though the mean- variance analysis process. To ensure great understanding of the concept, relevant graphs are important for analysis. Below is discussed the graph of expected return against portfolio and graph of return against risk. Graph of Expected Return against Portfolio All the efficient portfolios literally lie on the efficient frontier. But a combination of efficient portfolio that has risky asset only with asset that are risk- free, makes efficient portfolio not to lie on the efficient frontier (curved). A combination of asset (risk- free) with the portfolio of risky- asset instead leads to realization of enhanced frontier that is linear efficient. This linear efficient frontier is called: Capital Market Line (CML). There is only a single CML in theory, that is, the CML is the one that intercepts the expected return (vertical or y) axis at the Rf point. The Rf point can termed as the ‘risk- free rate’ (Periasamy, 2009: 12) The CML then extends linearly to a point where the CML is tangent to the efficient frontier. This point is referred to as the market portfolio. The market portfolio includes all risky assets (and only risky assets). The market portfolio contains only systematic risk; all non-systematic risk has been diversified away. The riskier assets are included in proportion to their market value, however, only risky assets with a positive market value are included (i.e., those assets for which there is a demand). There are no risk-free assets in the market portfolio. Presumably, each and every investor wants to invest in market portfolio so as to buy more risky- assets. The investment can be in the form of lending (for example, purchasing of treasury bills) or borrow cash at a rate that is risk free. If the combined portfolio is in contact with the CML in the area between ‘risk- free rate’ (Intercept Rf) and the point of Market portfolio, it means the portfolio of investor comprises of T- bills and some quantity of ‘risky assets.’ If the portfolio of the investor on the beginning point of CML; at a market portfolio or above, then the portfolio of the investor is I made of only risky assets. At the market portfolio point (tangency point), there is no utilization of leverage. Movement beyond the tangency point (Market portfolio) means that there is a utilization of leverage. The risk preference of the investor will determine the position of portfolio that the investor is on the Capital Market Line (Periasamy, 2009: 13). Graph of Return against Risk Source: Investopedia The risk is directly proportional to the investment returns; that is, low risk levels lead to low returns (potential). High uncertainty levels (high risks) are linked to high level of potential returns. The return or risk tradeoff is the equilibrium between the desire for lowest uncertainty levels and highest level of returns from an investment. The higher the standard deviation, the higher the risk, that is, they are directly proportional. In the graph, the standard deviation is the same as the risk associated with the investment. The higher risks give the possibility of higher returns, there are no guarantee though (Brigham & Ehrhardt, 2013: 990). References AAII (2015) The Role of Diversification in an Individual Stock Portfolio [Online], Available: http://www.aaii.com/financial-planning/article/the-role-of-diversification-in-an- individual-stock-portfolio?adv=yes [22 March 2015] AAII (2015) The role of risk- free asset in your long- term portfolio [Online], Available: http://www.aaii.com/journal/article/the-role-of-risk-free-assets-in-your-long-term- portfolio.touch Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: theory and practice, Ohio: South-Western. Goetzmann, W.& Kumar, A. (2008) ‘Equity Portfolio Diversification’, Review of Finance, Vol. 12, No. 3, March, pp. 433-463 Markowitz, H. (1952) ‘Portfolio Selection’, Journal of Finance, Vol. 7, No. 1, March, pp. 77-91. Markowitz, H. (1991) Portfolio selection: efficient diversification of investments, Cambridge: B. Blackwell. Periasamy, P. (2009). Financial management. New Delhi, Tata McGraw-Hill. Rayland, P. (2009) Essential Investment: an A- Z Guide, New York: Bloomberg Press. Scott, D. (2003) Wall Street Words: An A to Z Guide to Investment Terms for Todays Investor, [Online], Available:  http://financial-dictionary.thefreedictionary.com/Efficient+Portfolio [22 March 2015] Sharpe, W. (1964) ‘Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk’, Journal of Finance, Vol. 19, No. 3, September, pp. 425-442 Simpson, S. (2012) Low vs. High Risk Investment for Beginners [Online], Available: http://www.investopedia.com/financial-edge/0512/low-vs.-high-risk-investments-for- beginners.aspx [22 March 2015] Statman, M. (1987) ‘How Many Stocks Make a Diversified Portfolio?’, Journal of Financial and Quantitative Analysis, Vol. 22, No. 3, September, pp. 353-363. Read More