Portfolio Management Theory and Applications - Assignment Example

The paper “Portfolio Management Theory and Application" is an informative example of an assignment on finance & accounting. Particularly, it concerns the expected return on the new portfolio including the ABC stock. The total amount invested is equal to $900000 +$100000 = $1000000. Proportion of fully invested amount = (900000/1000000) = 0.9. The ABC invested proportion = (100000/1000000) = 0.1. The expected return for the investment will be computed by taking the proportion invested then multiply by the expected monthly returns (0.9*0.67) +(0.1*1.25) = 0.728%

ii). The covariance of the ABC stock returns alongside the returns of the original portfolio.

The aggregate covariance is found by multiplying the correlation coefficient of ABC stock and original returns of the portfolio which is 0.4 with the monthly standard deviations of returns of the original portfolio which is 2.37 and ABC stock which is 2.95. The covariance

 = 0.4(2.95*2.37) = 2.79.

iii). The expected standard deviation

The standard deviation is computed by adding the standard deviation of ABC stock adding to the standard deviation of the diversified portfolio then adding the total to the covariance between the diversified portfolio and ABC stock.

(4.5497+0.0870+0.504)^1/2 = 2.27%

B.

i). the new expected return on risk-free government security

(0.9*0.67)+ (0.1*0.42) = 0.645%

ii). The expected covariance of government security is zero since government security is risk-free.

= (0.37*0) = 0

iii). The expected standard deviation of government security

(4.5497+0+0)^1/2 = 2.13%

In portfolio management, beta is used to measure the volatility that certain security has in relation to its risk likelihood. The government securities are risk-free since there is no default of the government to the investors. The risk-free securities have a zero standard deviation that is used to lower the uncertainty of the investors. In the computation of beta, the standard deviation is one of the key variables. The higher the standard deviation, the higher the beta value whiles the lower the standard deviation, the lower the beta. The new portfolio of the government securities will, therefore, have a lower beta than the original portfolio.

The husband’s comment is incorrect. In the decision whether to invest or not is justified by the evaluation of the expected returns that a given investment opportunity will yield and on the other hand determination of the variations or possible deviations of a given investment. In a scenario where Grace will invest in the common stock, the expected return on the investment will be (0.1*1.25) = 0.125%. The standard deviation will be (0.1*2.95) =0.0295. Considering that she will keep the money. The standard deviation for such will be zero. Therefore it would have been wise for the husband to advice Grace to keep the money because there is no possibility of a loss being occurred than to simply say it does not matter. This is in some loose sense called a reckless statement that has no grounds to sustain the validity.

The weakness of using standard deviation is that it is incapable of quantifying the behavioral facet of investing risk.  The standard deviations are calculated at one point at a time and therefore, affected by stochastic business factors that affect the portfolio. Additionally, the standard deviation is computed based on historical data and hence cannot be used to make future decisions as far as risk and returns are concerned.

I will not believe that the diagram is an efficient frontier of the group of shares he analyzed. Pursuant to the Markowitz efficient frontier theory, it should be a graphical representation of a set of portfolios that give the highest returns expected with varied expected risks. Such a diagram lacks one combination of the shares that yield the highest returns expected and this is inconsistent with the efficient frontier theory. The graph does not guarantee the selection of a portfolio that can give the highest return. Though the diagram is curved as the theory dictates, such a curve does not give light to know how the diversification can let an investor enhance the reward-risk proportion. The diagram is somehow misleading and cannot be based on investment decisions.