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Portfolio Theory and Investment Analysis - Essay Example

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Portfolio Theory and Investment Analysis

A good investment strategy is one that earns the investor an expected return that is at least equal to or higher than what comparable investments would earn (Sharpe, 1991).
The goal of any investment strategy is to maximise the value of the investment by getting the highest possible expected return for a given level of risk. Every investment involves risk, which is the possibility of losing money if the investment decision turns out to be a wrong one. According to normal human behaviour, the higher the risk, the higher should be the expected return. Different investments have different levels of risk. For the UK charity, the safest investment, which also gives the lowest return, is to buy UK government bonds because the government always pays its debt obligations. Other investments, such as metals, a start-up business, or equities have higher levels of risk, and according to studies such as one by Barclays (2007), equities have consistently given higher returns compared to bonds or metals. Thus, investing in equities is a good first step in the investment strategy. The next question is to choose which stocks to buy and how much of the fund would be spent for each stock. Answering these questions requires knowing how risk is measured and is affected by portfolio diversification.
The risk level The risk level of investments in equities is measured by beta (Black, 1993), which shows how the value of the investment moves compared to the FTSE All Share Index, a composite number that represents the investment return of the UK equities market. The Index measures the daily values of all shares traded in the London Stock Exchange. If this index went up from 6,131.50 to 6,554.90 in the last 52 weeks, then the return on an investment, also called the market return, in all the shares included in the index would be 6.91% and a 10,000 investment 52 weeks ago would now be worth 10,691 excluding fees and commissions (Economist, 2007).
A beta of 1.03 means that the value of the investment portfolio moves very close to the market but is slightly riskier than the market and therefore gives a slightly higher return compared to the market. Thus, if the market returned 6.91% in the last 52 weeks, the portfolio returned 1.3 x 6.91% = 7.12%. A 10,000 investment would be 10,712 or better than the market. However, higher risk also means higher loss than the market if the Index dropped.
The correlation coefficient measures how the prices of the stocks in the portfolio move against each other. The figure is always between +1 (perfect correlation) and -1 (negative correlation) or zero (independent correlation). Perfect correlation means all stocks go up or down together; negative correlation means that some stocks go down when others go down; and zero or independent correlation means that the stock prices move independently of each other.
A good portfolio is one where the correlation is as close as possible to -1 because this totally eliminates risk, but this does not happen in real life. The correlation coefficient of the stocks in the portfolio is 0.64, which is close to 1, therefore adding a risk factor to the portfolio. If the board decides to do so, the financial manager must find a way to reduce the correlation coefficient, and this would affect beta since coefficients are used in computing for beta ...Show more


This paper acts as a briefing paper on three issues related to the portfolio investments of a UK charity, details of which are contained in the assignment brief: (1) diversification and the stock composition of the investment portfolio; (2) international investments; and (3) derivatives.
Author : dereckhermiston
Portfolio Theory and Investment Analysis Essay
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