Investors and the Efficient Portfolios - Coursework Example

Investors and the Efficient Portfolios Task Introduction All the perceptive investors agree that returns are the driving forceof investments. Returns can be defined as the reward to investors for agreeing to part with their money. An investment is, therefore, a sacrifice to spend the money on other items. Investors, therefore, expect to be compensated for their sacrifice, thus, the genesis of the term returns. There are numerous investment vehicles beginning from the money market to the capital market. Investors are wise enough to choose assets that promise good returns. The paper presents an analysis of the famous work Capital Asset Pricing Model (CAPM) with respect to the investors’ preference to the most efficient portfolio (Markowitz 1952). Explain in detail what is meant by an efficient portfolio, and argue why a high risk-high return portfolio is not necessarily better than a low-risk, low-return portfolio. The concept of the efficient portfolio can be well understood after revisiting the preceding portfolio management theories. One such theory is the famous capital assets pricing theory (CAPM). The CAPM is a model that shows the association between the required rate of return and the risk on assets that are held in a portfolio that is well diversified. According to Fama and French (2004), the origin of the capital asset pricing model is the prominent work of William Sharpe (1964) and John Lintner (1965). The CAPM model is very useful in activities such as the determination of the companies’ cost of capital and in assessing portfolio performance. A portfolio is a group of assets (more than one asset) held by an investor (Sharpe 1964). The theory of portfolio attempts to guide investors on how to make the best combination of assets to optimise returns as well as minimise the risk associated with the investments. The commonly used CAPM equation is a follows: ER = Rf + (Rm – Rf)β, where Rf is the risk free rate, ER is the expected return on the portfolio, (usually denoted by the interest rate on treasury bills), Rm is the expected market return for the same period, and β is the beta, which measures the relationship between the portfolio performance and the market performance. In other words, beta indicates how sensitive the portfolio’s performance is to the variations in the market performance. The above equation shows that a portfolio’s return can be expressed in terms of the risk-free return, the risk premium and the beta. Based on the equation, which is a linear, it is revealed that the portfolio return is directly related to the risk. That is, the higher the portfolio risk, the higher the portfolio’s return. The CAPM theory brings us to another idea of the efficient portfolio. A portfolio can be efficient under the following two conditions: first, the portfolio generates an optimal return for a given amount of risk. Second, the portfolio has the minimum amount of risk at a given level of return. Therefore, an efficient portfolio is that which has the maximum return given a certain level of risk and a minimum risk at a given level of return. On the graph one below, portfolio C denotes an efficient portfolio. Figure 2 proves that the higher the risk, the higher the return (Fama & French 2004). The graph labeled one below shows portfolios ABCDEG and H. Portfolios BCD and E are the only ones considered as efficient. Portfolio A is categorised under low-risk low-return. On the other hand, portfolio E falls under the high-risk high-return category. Concerning portfolio E, there is a high chance that the portfolio actual return may vary from the expected return. That is; there is a high chance that investors in portfolio E will either experience loss or capital gains from the investment. A contrary argument is suitable for the investors in portfolio A. In addition, most high-risk, high-return portfolios are suitable for short-term investments because, in the long run, the economic factors such as the inflation rate have a tendency of reducing the value of investments. On the other hand, the low-risk low-return portfolio is suitable for long-term investments for the same reason as in the case of high-risk, high-return investments. From a different point of view, it can be argued that the aggregate return on a single long-term investment would equate the return on a short-term investment. Therefore, high-risk, high return portfolio is not better than low-risk, low-return investments (Granito 1999). Thoroughly evaluate whether a well-diversified portfolio is likely to be more efficient than individual stocks A risk is defined as the probability that the actual return will vary from the expected return with respect to the historical performance. All investors are advised to familiarize themselves with two types of risks. That is, the systematic risk (non-diversifiable risk) and unsystematic risk (diversifiable risk). Systematic risk is the type that affects the performance of all the portfolios and firms in the United Kingdom. That is; the financial stability of companies is shaken, and the performance of both money and capital market investments negatively impacted. One disadvantage of the systematic type of risk is that it cannot be diversified or eliminated. Examples of the systematic risk are the political instability, natural calamities (floods and earthquakes), corporate tax increase, economic conditions (increase in inflation rate, the great depression, and financial crises) (Nazarova 2013). Conversely, unsystematic risk (diversifiable risk) is the type that negatively influences the economic of an individual firm. The risk arises due to omission and commission with respect to the firm’s internal processes. The risk is caused by factors such as employee strikes, the exit a key member of the firm’s management, ineffective marketing strategies of the company, failure to embrace new and advanced technology in the firm’s operations etc (Jones 2001). As mentioned above, a portfolio comprises more than one asset. Different assets generate the different level of returns. Similarly, the risk associated with various assets is dissimilar (Statman 1987). Van Nieuwerburgh and Veldkamp (2008) content that the availability of information about assets affects the investor choice of assets, thus, affect the nature of the portfolio for the reason that different assets experience different levels of risks. The availability of sufficient information or the lack of it leads to over-diversification or under-diversification. Over-diversification is experienced when an investor holds exclusively negatively correlated assets whereas; under-diversification is experienced when an investor holds exclusively positively correlated or similar assets (Goetzmann & Kumar 2008). Positively correlated assets are those whose performances move in the same direction when compared against each other. For example, take that portfolio X has two assets A and B that are positively correlated. When either the systematic or nonsystematic risk strike, both the performance of the assets will decline. Positively correlated assets can also be either strongly or weakly correlated. A strong positive correlation implies that the performance of asset A and B will decrease almost in equal proportion. Conversely, a weak positive correlation implies that the performance of assets A and B will decline but one will be affected more than the other. Negatively correlated assets are those whose performances move in the opposite direction when compared against each other. That is, when the performance of asset A decreases, that of asset B increases. Just like in the case of positively correlated assets, negatively correlated assets can either be strongly correlated or weakly correlated. A weak negative correlation implies that when the performance of asset A decreases by say, 3%, the performance of asset B increases by 1.5%. On the other hand, a strong negative correlation signifies that when the performance of asset A decreases by 3%, that of asset B increases by 2.8%. Take the case of another investor who only has one asset (Asset B), whose performance has declined by 3%. The loss (3%) is bigger than the loss of the investor with two assets with strong negative correlation (3% - 2.8%) = 0.2%. Therefore, based on the analysis, it is clear that a well diversified portfolio is more efficient than individual stocks. Critically analyse whether a preference for efficient portfolios would lead all investors only to invest in a combination of available risk-free and the market portfolio It is true that all investors prefer securities that generate maximum return at a given level of risk or experience low level of risk at a given rate of return (efficient portfolio), which is the combination of the available risk-free and the market portfolio. An efficient portfolio is the best for the effect of systematic risk on them is insignificant. That is; the investments made in a well-diversified portfolio are safer compared to investments made both on a single asset and an under-diversified portfolio. Therefore, if all the investor had the capability in terms of resources, all would invest in the efficient portfolio. However, due to information asymmetry and other constraints such as availability of funds, age, and education level, it is not possible for all investors that prefer efficient portfolio to invest in a combination the risk free and market portfolio. Most investors will pursue investments that fit their level of wealth. Others will invest in assets about which they have sufficient information. When investors have enough information about an asset that particular asset becomes efficient (Buchholz & Musshoff 2013). Graph 1: The efficient market and the capital market line In the graph one above, the red line is the capital market line. The efficient frontier is denoted by portfolios BCD, and E. Portfolio C is the efficient portfolio (combination of the risk-free asset, represented by the capital market line and the market portfolio). Graph 2: The risk-return relationship List of References Buchholz, M. & Musshoff, O. 2013, "Risk-efficient portfolio crop choice with amended water and irrigation policies in northern Germany", Agricultural Finance Review, vol. 73, no. 2, pp. 373-388. Fama, E., & French, K 2004 “The Capital Asset Pricing Model: Theory and Evidence”, Journal of Economic Perspectives, Vol. 18 (3), pp. 25-46. Goetzmann, W., Kumar, A 2008 “ Equity Portfolio Diversification”, Review of Finance, Vol. 12 (3), pp. 433-463. Granito, M.R. 1999, "Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation", Financial Analysts Journal, vol. 55, no. 3, pp. 101-102. Jones, C.K. 2001, "Digital Portfolio Theory", Computational Economics, vol. 18, no. 3, pp. 287-316. Markowitz, H 1952 “Portfolio Selection”, Journal of Finance, Vol. 7 (1), pp. 77-91. Nazarova, V. 2013, "An Empirical Study of Unsystematic Risk Factors in the Capital Asset Pricing Model: the Case of Russian Forestry Sector", Entrepreneurial Business and Economics Review, vol. 1, no. 4, pp. 37-56. Sharpe, W 1964 “ Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk”, Journal of Finance, Vol. 19 (3), pp. 425-442. Statman, M 1987 “How Many Stocks Make a Diversified Portfolio?”, Journal of Financial and Quantitative Analysis, Vol. 22 (3), pp. 353-363. Van Nieuwerburgh, S., & Veldkamp, L 2008, Information Acquisition and Under-Diversification, viewed 3 April 2015, http://www.nber.org/papers/w13904.pdf Read More