Risk Tolerance & need to diversify - Research Paper Example

Large Company stocks, also referred to as blue-chip stocks or large-cap stocks, refer to the stocks of large publicly traded companies (Leach and Melicher, 2011, p.249). Long term corporate bonds in most cases refer to debentures which offer a higher yield compared to other investments but investors of such bonds are prone to interest risk and credit risk. Long term government bond refers to those bonds which mature in more than 10years. US Treasury bill is a transferable debt contract issued by the US Government that ensures trust and fulfillment of claim of receivable return at the end of the period.

Such investment is made for a period of one year or less than one year, and is exempt from local and state taxes (Boston Institute of Finance, 2005, p.105). If my decision is to invest in the current portfolio of mix of stock, bonds and treasury bills in equal proportions, despite of the divisions between fixed earnings and volatility of earnings of the securities, the entire portfolio would give an average (avg.) expected return of 14.78%, with risk of 8.88% associated with it, as per time horizon and risk tolerance.

Impact on future Investment Decisions The decision of future investment and formation of portfolio with diversification depends on the characteristics of the investor, the characteristics of the securities in the portfolio and its risk return trade-off which will determine the proportion of investment to be made in each security, observation of the historical performance of the securities, and the time horizon of investment. An investor can be broadly classified into risk averse investors, risk prone investor, and risk neutral investor, based on their degree of risk preference.

Risk averse investors prefer security to earnings than risk accompanied by high returns. Such investors prefer to invest more in bonds and treasury bills which will carry a guarantee of return at the end of period with low risk; as such investors try to avoid risks. Some investors who prefer to bear risk and avail the high return associated with it belong to a class of risk prone investors. Such investors prefer to invest in risky securities with high returns, such as equity, so as to avail the benefit arising out of it.

There is another class of investors known as risk neutral investors, as they do not make any differentiation between debt and equity and opt to invest equal proportion in each (Haslem, 2009, p.158). If I am a risk averse investor, I shall prefer maximum investment in treasury bills and bonds, as this will assure a fixed percentage of returns at the end of the period with low risk associated with it. Thus, 80% of the investment is to be made in treasury bills and bonds, and 20% in company stocks.

The proportion of investment in long-term corporate bonds differs from long term government bonds and US Treasury bills, as because long term corporate bonds is a bit risky than the others. If I am a risk neutral investor, I shall prefer equal proportion of investment in both stocks and bonds (i.e. bonds and treasury bills), with an expectation that if return from stock is higher I shall benefit from my investment, and, if investment in stock fails to provide return, then benefit earned from the fixed income bearing securities would help to offset some portion of the loss.

If I am a risk prone invest