Investment Analysis and Portfolio Management - Literature review Example

Student Name Professor Name ID # Date Assignment-2 1. Risk Aversion The basic concept of the Risk Aversion is given by Friedman and Savage (1948), ‘the investor will always select an asset with low level of risk while choosing among two assets with different risk levels but similar returns’[Cri05]. The literature evidenced that the investors are normally risk averse, as [Fri75] estimations suggest that investors tend to invest more in the less risky assets and very few in risky ones. In practice, the investors generally prefer the secure investments with a minimum level of risk that give them a fair amount of returns, but it depends on the investor’s wealth, its individual characteristics, and many other factors, for example a retiree would always be a risk averse who would not let his retirement income to be wasted[Vas15]. 2. Markowitz Portfolio Theory The Markowitz portfolio theory gives a way to assess how much a portfolio is profitable, centered on the variances and means of assets’ returns within a portfolio. It has following assumptions; I) Investors tend to optimize their utility within a certain amount of income and behave rationally. II) Investors have an easy approach to reasonable and accurate data regarding the risks and returns of assets. III) The data is taken up rapidly and flawlessly, as the markets are considered highly efficient. IV) Investors are generally risk averse, where they tend to increase the return with the least level of risk. V) The decision by investors is made on the basis of the means of the expected returns and variances. VI) For a specific level of risk, the investors give priority to higher-returns than the low-returns[Mar52]. 3. Risk and its Measures Risk can be defined as a chance of a negative happening or getting a loss, for instance the chance of getting a lower actual return on any investment than the expected return is a risk in financial terms. Risk measures are evolved in a number of years. In earlier times, the risk was measured through gut feeling, but then researchers started to calculate probabilities and then sample based probabilities[Rei12]. Nowadays, the risk is measured from a number of alternative ways, for instance, probability distribution, computing variance and standard deviation of the returns’ distribution, measuring VaR (Value at Risk), and the market beta or beta ratios. Among these, the beta ratio is the most current way, in which the risk is measured corresponding to the risk of a similar market standard investment. 4. CAPM The Capital Asset Pricing Model has following basic assumptions [Wat07]. I. Investors have diversified portfolios, meaning that the investors have eliminated the unsystematic risk, so they need only return for the systematic risk. II. There is a single period transaction where the returns can be compared with other investments, like a 6-months period return is not comparable with the 1-year return, thus it supposes a uniform holding period. III. The investors can make transactions on the risk-free rate of return, which is the least level of return, and it has been assumed in portfolio theory. IV. It also assumes a perfect Capital Market, where the assets are accurately valued, no taxes, transaction costs are incurred, accurate data is guilelessly accessible to the investors, many buyers and sellers are there, and the investors are rational, risk-averse, try to optimize the utility. 5. Risk-Free Asset The risk free assets are those which have a definite return in the future that is guaranteed and have minimum risk, for instance, the Treasury bills are an example of a risk free asset as they are financed by the US Government and are secured[Sch15]. The characteristics of the T-bills or the risk free asset include; the return is certain and assured, they are supposed to have zero risk of defaulting as they are guaranteed by government, they are sold at discounted prices from its par value and are traded at public sale in competitive bidding, no interest payments are to be paid, they are sold at many term periods in the value of 1000$, and the individuals can buy these from governments directly[Sch15]. 6. Portfolio Management Portfolio management is a way to make decisions regarding the combination of different investments in which the investments are harmonized with the objectives and the risk is balanced with the return. This theory explains the subsequent return and risk of a grouping of individual investments, where basic aim is to find out an efficient asset mixture in which the risk is diversified[Gri99]. The diversification of a portfolio can be measured by performing the correlation analysis, where the main idea in this analysis is that the volatility of a portfolio is constantly less than the weighted average volatility of every security in the portfolio on the assumption that the assets in the portfolio are not perfectly correlated. This means that the diversification would be higher as much as the correlation between assets is lower[For98]. 7. Systematic and Unsystematic Risk Unsystematic risk or called as diversifiable risk is the risk that is linked with the company or industry where the investment has been made. While the systematic risk or market risk is a risk associated with any market movements, and it is innate in whole market. It comprises of daily variations in the share prices. Both of the risks have their high effects on businesses, where the unsystematic risk comes from the industry or company issue and these can be lowered or eliminated from diversification, but the unsystematic risk comes from the market movements, which cannot be reduced from diversification. Systematic risk is associated with macroeconomic factors that cannot be controlled by any company[Wat07]. 8. Goals of Passive/Active Portfolio managers The goal of an active portfolio manager is to get an excessive return that overtakes the return on a passive benchmark portfolio by deducting the transaction costs and adjusting the risk also. While the passive equity portfolio manager aims to purchase and hold the securities for a long time period and normally traces an index over time, where the manager aimed to correspond with the market performance. Also, a passive portfolio manager is judged by looking how well the manager can trace the besieged index. The efficient market assumption is believed by passive manager, while the active manager does not believe in it and relies his own strategies[Rei12]. References Cri05: , (Paun, Musetescu and Brasoveanu), Fri75: , (Friend and Blume), Vas15: , (Vasigh, Fleming and Humphreys), Mar52: , (Markowitz), Rei12: , (Reilly and Brown), Wat07: , (Watson and Head), Sch15: , (Schmidt), Gri99: , (Grinold and Kahn), For98: , (Ford), Wat07: , (Watson and Head), Read More