An Important Way of Managing Risk in a Portfolio - Essay Example

Financial information management Table of Contents Introduction An important way of managing risk in a portfolio is through diversification. The inclusion of a variety of asset classes in a portfolio spreads out the risk and thus is effective for the purpose of hedging. This is because the fluctuation of one security does not have a significant impact on the value of the portfolio. A portfolio can comprise of various assets like equity, options, futures, bonds, real estate etc. With growing globalization the portfolio can also include overseas security. This is done by investing in equities and other assets of a foreign country. For instance due to financial crisis many western countries invested a significant portion of their funds in the equities of growing Asian countries like China and India. This is known as international diversification and enables an investor in tackling the country specific risk. The integration of the global financial markets has facilitated the creation of international portfolio which besides mitigating the risk factor helps in taking advantage of the markets of the developing economies. A share portfolio generally comprises of securities of various sectors. For effective diversification the sectors should be non-related such as oil refining companies and automobile. A rise in the price of oil is beneficial for the oil refining company but this can adversely impact the sales of the automobile company. This will push up the share price of the oil refining companies but will batter the share price of the automobile companies. Thus the value of the portfolio will remain protected as the fall in its value due to a fall in the share price of automobile company like Rolls Royce will be compensated by the rise in the price of the oil refining company. This highlights the advantage of investing in a portfolio. Selection of stocks The share portfolio that has been constructed comprises of securities belonging to varied sectors like pharmaceutical, healthcare, food & drug retailers, financial services, software etc. By including the stocks of different sectors, the risk of a fall in the portfolio value has been minimized. Any adverse, ‘sector specific’ news will only affect the shares of that particular sector, without influencing the share price of the other sectors. This will keep the portfolio value intact which is the ultimate aim of investing in a portfolio. In the IT industry the stock chosen is Autonomy Corporation. The company features among the top Software 500 companies published by Software Magazine (Financial Express, 2009). This ranking is based in terms of revenue generated by the company in a year. Moreover the software industry of Britain is expected to perform strongly in the coming years. Buoyed by the trends in the software industry 3 shares of Autonomy Corporation Plc (AU) was bought at the price of £1210 on 13 February 2009. One share of Legal & General was also purchased as the company is a reputed insurance service provider in UK. The shares of Legal & General (LGEN) were trading at their lowest levels of £49.50. The stock of the company was trading at the lowest price over the last two months making it an attractive buy. It seemed that the price of the company had already bottomed out and therefore this will move up from here. For this reason the company was included in the share portfolio. Home Retail was included in the share portfolio. One share of this company was bought at a price of £229.5 on 13 February 2009. The company is the market leader in retail sales in the country dealing in home products like furniture, consumer electronics, jewellery, toys etc (Yahoo Finance-a, 2010; Yahoo Finance-b, 2010). Morrison Supermarket (MRW) and Sainsbury Plc (SBRY) were included in the portfolio as the companies are engaged in the retail of food products and other items. As the companies deal in consumer products their share price remains immune from wide market fluctuations. This is also evident from the low beta of the two stocks of 0.60 for MRW and 0.55 for Sainsbury Plc. It makes the two stocks defensive bets. Investing in the defensive stocks is done when the market trend is not clear. This situation existed in the first half of 2009 when the markets had a downward bias. Moreover the companies dealing in consumer products remain immune from market movements as they provide utilities or basic necessities the demand for which is not significantly impacted by an economic event thus keeping the revenues flowing. A flowing revenue keeps the share price of the company stable thus making it an attractive investment in an uncertain market scenario. For the same reason the shares of ABF were included in the portfolio as the company specializes in a vast variety of food products. Its beta is 0.43 making it a defensive investment. The low market beta of the company ensured that in the event of a fall in the market, the fall in the share price of the company will be less as compared to the market. Like consumer products another sector that remains immune from an economic downturn is health and pharmaceutical sector. For this reason investment was made in the shares of Astrazeneca Plc (AZN) and Smith & Nephew (SN). The low beta of the two companies of 0.33 and 0.39 respectively indicate defensive investment. As the companies deal in necessary goods their performance is not much affected by the market conditions. Barclays and Aviva Plc were also included in the portfolio. Both the companies have very high beta. As most of the stocks in the portfolio have low beta the gains from an unprecedented rise in the market can be tapped by the inclusion of aggressive stocks having high market beta. For this reason the shares of Barclays and Aviva Plc were included in the share portfolio. In the event of a rise in the market the share price of the two companies will rise more than in proportion to the market enabling to take an advantage of an upswing in the market index. Therefore the share portfolio is an ideal mix of stocks of different sectors and market beta. In the event of a fall the defensive stocks like pharmaceutical, consumer goods will keep the portfolio value stable whereas a rise in the market index can be exploited using the high beta stock of financial services companies. Portfolio Value The investment corpus of £10000 has been spread across different sectors. On account of good growth prospects of the software industry 3 shares of Autonomy Corporation Plc (AU) were purchased at a price of £1210 on 13 February 2009. One share each of Home Retail and MRW was bought at the market price of £229.5 and £258.75 on the same date. Shares of Sainsbury Plc, belonging to the food retail industry, was also bought on the same date at a price of £327.75 (Yahoo Finance-c, 2010; Yahoo Finance-d, 2010). Barclays and Aviva Plc belonging to the financial services sector were purchased at a price of £100.5 and £297.52 respectively. 14 shares of the former were bought whereas for Aviva Plc the exposure was limited to one share. One share of Legal & General, an UK based insurance company was also bought at a price of £49.5 on 13 February (Yahoo Finance-h, 2010; Yahoo Finance-i, 2010). The pharmaceutical and health care stocks like Astrazeneca Plc (AZN) and Smith & Nephew were also purchased at a price of £2563 and £552.5 respectively (Yahoo Finance-e, 2010).One share of ABF was added at a price of £664.5 on the same date in the portfolio (Yahoo Finance-f, 2010). The value of the portfolio on 15 February 2009 was £9980. On the purchase or sale of a share an investor has to pay transaction cost of 0.45 basis points for each trade upto £2.5 billion (Trade News, 2010). Therefore for the purchase of the shares, transaction costs of £44.91 were incurred. The beta of some of the individual stocks were very high like in the case of Barclays and Aviva Plc, but with the help of effective diversification the beta of the overall portfolio was brought down to 0.81, thereby reducing the risk of investing in high beta companies. Between the period of 15 February and 31 March the prices of all the companies witnessed frequent ups and downs. The volatility in the share price was particularly high in the case of Aviva Plc and Smith & Nephew (Yahoo Finance-g, 2010). Aviva Plc was trading at a price of £297.52 on 13 February and this scaled down to £203.73 on 31 March marking a fall of more than 40 percent. Similarly the price of Smith & Nephew was £552.5 on 13 February and this moved down to £432 on 31 March, a fall of more than 20 percent. Autonomy Corporation Plc and Barclays reported a rise in the market value of the shares. The share price of Autonomy Plc climbed up by nearly 10 percent from £1210 on 13 February to £1305 on 31 March. During the same period the share price of Barclays jumped up be nearly 50 percent from £100.5 to £148 (Yahoo Finance-k, 2010). As a result of the rise recorded in the share price of these companies the total value of the portfolio on 31 March 2009 reached to £10550.48. Benefits of diversification of the portfolio The benefit of portfolio diversification is that the risk of investing in single stocks is minimized. Investing all the funds in a single stock exposes an investor to financial risks. There can be a significant fall in the price of that particular stock due to the happening of certain unforeseen events. Like a rise in the excise duty on cement can adversely affect the performance of the cement stocks in the market. For this reason a rational investor can reduce the impact of any adverse announcements by spreading the investment fund across various sectors. The adverse news relating to one sector can be nullified by a positive announcement for another sector. Thus this reduces the severity of the adverse impact on the investment portfolio. This is the main reason that the portfolio that has been created has outperformed the market index. During the investment horizon of 13 February to 31 March, the FTSE 100 reported a negative monthly return of 5.17%. In the same period there was a monthly gain of 5.19% on the share portfolio (Yahoo Finance-j, 2010). This highlights the benefit of spreading the funds across various assets instead of ‘putting all the eggs in one basket’. The beta of individual stocks like Barclays and Aviva Plc is high at 2.52 and 2.55 respectively. By diversifying the investment across the low beta stocks like Astrazeneca Plc (AZN) and Smith & Nephew, the beta of the overall portfolio has been reduced significantly. Beta is an indicator of market risk. Higher the beta higher is the risk associated with the investment. In the event of wide fluctuations in the market index especially in the case of downward movements, the high beta stocks are the worst affected. Stocks with a beta of more than 1 say 2.5 are the most vulnerable in the event of a collapse in the market. Again they are the ones that will give the highest returns in the event of a rise in the market. But this is more likely to be true in a favourable market scenario. However the financial markets across the globe were highly uncertain in the last few years. Therefore by reducing the beta of the portfolio to less than one, it has been to an extent immunized from a sharp fall in the market. The low beta of the market portfolio has reduced the unsystematic risk of the portfolio. Risk mainly comprises of systematic and unsystematic risk. Unsystematic risk is the risk relating to a specific stock. This can be reduced by taking the necessary exposure in varying sectors. Systematic risk on the other hand is the market risk and this cannot be eliminated. By increasing the number of stocks it is possible to eliminate the unsystematic risk completely but the same cannot be done for systematic risk. An effective portfolio is one that reduces the unsystematic risk to the minimum levels. Conclusion The integration of the worldwide markets has made the equities of the overseas countries accessible across the globe. In a portfolio the assets are no more limited to stocks of the domestic country rather an investor can opt for international portfolio investment thus eliminating the risk associated with investing in a particular country. By way of this he can also take advantage of the growth opportunities in the overseas country. Like many US and European investors are investing their funds in the growing economies of Asia. The markets in the western countries are yet to recover from the recent financial crisis. Thus by investing in the stock of the developing economies the investors are able to exploit the gains in the overseas economies. So a portfolio now comprises of domestic as well as overseas assets thus minimizing the risk associated with single stock investment. This also takes care of the country specific risk of making an investment. Reference Financial Express. 2009. Autonomy ranked as one of the Worlds Largest Software Companies by software magazine. Available at: http://www.investegate.co.uk/Article.aspx?id=200909210900022641Z [Accessed on April 13, 2010]. Trade News. 2010. Rolet hails LSE’s cut in total trading costs. Available at: http://www.thetradenews.com/trading-venues/exchanges/4389 [Accessed on April 13, 2010]. Yahoo finance-a. 2010. Historical Price. AUTONOMY CORP. Available at: http://finance.yahoo.com/q/hp?s=AU.L&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-b. 2010. Historical Price. Home Retail. Available at: http://finance.yahoo.com/q/hp?s=HOME.L&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-c. 2010. Historical Price. MORRISON SUPERMKTS (MRW.L). Available at: http://finance.yahoo.com/q/hp?s=MRW.L&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-d. 2010. Historical Price. Sainsbury Plc. Available at: http://finance.yahoo.com/q/hp?s=SBRY.L&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-e. 2010. Historical Price. ASTRAZENECA. Available at: http://finance.yahoo.com/q/hp?s=AZN.L&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-f. 2010. Historical Price. ASSOCIAT BRIT FOODS. Available at: http://finance.yahoo.com/q/hp?s=ABF.L&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-g. 2010. Historical Price. SMITH & NEPHEW. Available at: http://finance.yahoo.com/q/hp?s=SN.L&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-h. 2010. Historical Price. AVIVA (AV.L). Available at: http://finance.yahoo.com/q/hp?s=AV.L&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-i. 2010. Historical Price. Legal & General. Available at: http://finance.yahoo.com/q/hp?s=LGEN.L&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-j. 2010. Historical Price. FTSE 100. Available at: http://finance.yahoo.com/q/hp?s=%5EFTSE&a=01&b=13&c=2009&d=02&e=31&f=2009&g=d [Accessed on April 13, 2010]. Yahoo finance-k. 2010. Historical Price. Barclays. Available at: [Accessed on April 13, 2010]. http://finance.yahoo.com/q/hp?s=BARC.L Annexure- Reflective Report The share portfolio has been constructed by investing in the shares of various sectors like food & drug producers, pharmaceutical, health care, financial services, software companies etc. In the financial services sector the companies chosen includes Barclays, Aviva Plc and Legal & General. Among the pharmaceutical companies the stock selected includes Astrazeneca Plc (AZN) and Smith & Nephew. All the stocks that have been selected for the portfolio are listed under FTSE 100. The historical share price of the companies has been obtained from Yahoo Finance. The daily movement in the FTSE 100 has also been obtained from the same source. On the purchase of shares the transactions costs have to be paid. The rate of this charge is obtained as 45 basis points from Trade News site. At first the covariance of the stocks with the index was calculated using the excel function. The standard deviation of the market index for the same period was also calculated using the same function. This was then squared to obtain market variance. The beta of the stock is obtained by the formula- β = Covariance (x,y) / Variance of market. The individual stock betas are then adjusted with the weights of the respective stocks in the portfolio to obtain the market beta of the portfolio. The beta of the individual stocks like Barclays and Aviva Plc was high but this has been reduced by including the low beta stocks in the share portfolio. The low beta stocks are defensive stocks whereas high beta stocks are aggressive stocks. By making the portfolio beta less than one the market risk of the portfolio has been reduced significantly. This has been achieved through effective diversification of the investment corpus across various sectors which ultimately raised the value of the portfolio at the end of the investment horizon. Read More