What Is the Relevance of Portfolio Theory to an Investor or Fund Manager in a Typical Equity Market - Research Paper Example

Introduction The expression equity also refers to common stock and these are securities representing a corporation’s ownership. Usually, bonds are senior insofar as equities are concerned, which means that in case of bankruptcy of a firm they have the first priority and equities follow in claim. Thus, equities are residual claims after loans; bonds as well as other contractual obligations have been catered for in a claim. A good illustration to equities is the 2005’s presentation of the world’s markets of equity, (that is, in billion US dollars). Table 1: Presentation of world equity markets (in US$) Japan 7,542 US 17,001 Eurozone 6,925 UK 3,058 The rest of Pacific 2,157 The rest of Europe 1,271 Canada 1,482 Developed 39,427 Developing 5,023 Total Global 44,450 The table (Table 1) shows the sum of the global equity market’s value in year 2005, which was US$44.5 trillion. It is also essential to note that equities have a limited liability, in that what most stakeholders can end up losing is their original investment. Therefore, they are not similar to to the unincorporated businesses’ owners if such businesses turned bankrupt. (Jorion, 2007 pp209, 210) This study is going to focus on equity markets and more specifically there will be vivid answers provided to the study questions. The questions are; “What is the relevance of portfolio theory to an investor or fund manager in a typical equity market? and What is the relevance of Capital Asset Pricing Model (CAPM) to an investor or fund manager in an equity market?” These questions are going to be tackled in the order in which they are presented. Body Portfolio Theory Prior to the modern portfolio theory, management of investments was a process of two dimensions with a fundamental focus on return and volatility characteristics of stocks individually. Subsequently, the work conducted by Harry Markowitz resulted to stakeholders realizing the essentiality of the relationship among stocks belonging to a given portfolio. The theory of modern portfolio brought in a third dimension with regards to management of portfolio, which evaluates a given stock’s diversification impact upon a portfolio. Diversification impact is the effect of including a specific asset or class of stocks to the return as well as volatility characteristics of the portfolio in entirety. Modern portfolio theory therefore brought into focus the consideration of the whole portfolio as opposed to individual stocks. Thus, the idea of diversification had to be reconsidered at the same time. The notion of optional diversification, which is usually used under the stock’s diversification, surpasses the idea of simply utilising a number of stock baskets to getting baskets which are specifically different from each other. This is of ample importance since a basket’s unique returns’ pattern specifically offsets the returns of the others, which results to the smoothing the volatility of the overall portfolio. A capital market that is efficient has fair prices for its stocks. With this consideration, therefore, the point stressed by modern portfolio theory is that it portrays wisdom to make investments in a vast array of investments that are diverse. (Gibson, 2000 p8) Under the modern theory, the portfolio’s expected return is simply the individual asset’s weighted average returns of a whole portfolio combined. The weight of a specific stock is the portfolio’s total value percentage dedicated to the investment of the particular security. For example; take a portfolio to illustrate this argument; it has two stocks, (namely; X and Y). Value of the portfolio = $4,000 + $10,000 (rx) return of stock X= 14% (ry) return of stock Y= 6% The expected return of this portfolio can be computed as follow: (wx) weight of stock X= $4,000/$10,000= 40% (wy) weight of stock Y= $6,000/$10,000= 100%-40%= 60% Expected return of the whole portfolio= Expected return (stock X) + Expected return (stock Y) Therefore; Expected return stock X= 40% ×14%= 5.6% Expected return stock Y= 60% ×6%= 3.6% Expected return of the portfolio 9.2% (Hartviksen, 2007) A portfolio is also not without a risk component. There are usually two types of risks to a portfolio. These are; the unsystematic risk and systematic risk. An unsystematic risk refers to the component of a given asset’s risk that can be eliminated by way of diversifying the portfolio. On the other hand systematic risk is that risk part that cannot be done away with (in other words it is inherent in the equity market). While computing the risk of a given portfolio, there are often three relationships that may be to the portfolio’s securities or stocks. These include a perfectly competitive correlation, perfectly negative correlation and zero correlation. A perfectly positive kind of correlation occurs where the returns of X and Y vary in a pattern that is identical. Thus, there is a scenario of a risk-return relationship that is linear between two stocks. It therefore follows that under perfect correlation the risk of the entire portfolio XY is the weighted value of both stocks’ σ. Where; σ is the variance. In such a case; σp= wx2σx2 + wy2σy2+2wxwyσxσyρxy here; wx= weight of stock X wy= weight of stock Y σx= variance of X σy= variance Y ρxy= correlation coefficient of X and Y σp= portfolio risk. Using the previous example and assuming σx= 0.10 σy= 0.20 ρxy= 0.20 σp= 0.16(0.01) + 0.36(0.04) + 2(0.40)(0.60)(0.10)(0.20)(0.20) σp= 0.0016 + 0.0144 + 0.00192 = 0.01792 = 1.792 % A zero correlation means that a stock X is fully unrelated to Y in terms of return. With such type of a correlation, then a significant amount of risk reduction can be realised by way of diversification. Using the same example; σp= wx2σx2 + wy2σy2 σp= 0.0016 + 0.0144 = 0.016= 1.6% A negative type of correlation means that the returns of X vary perfectly with those of Y, but inversely. The entire portfolio’s variance is usually at the least amount of risk, despite the amount of each stock’s value. The same example will be used to illustrate this; σp= wx2σx2 + wy2σy2+2wxwyσxσyρxy = 0.16(0.01) + 0.36(0.04) + 2(0.40)(0.60)(0.10)(0.20)(-0.20) = 0.0016 + 0.0144 - 0.00192 = 0.01408 = 1.408% (csus.edu, 2009) The main notion in Markowitz’s work is that nobody had made attempts to understand the essence of risk in a process of investment. As at the particular point in time the investors had concentrated on the returns of an investment in totality. But if such investors believed in the idea that there were unidentified aspects of risk, then a given investment would not form part of a portfolio. He (Markowitz) had clear understanding that returns and risk go tandem. From this idea, thus, investors always seek maximisation of returns while at the same time wanting to reduce or minimise risks. Thus, the sole importance of portfolio theory to investors is improving the performance of their investments through the optimisation of the trade-offs existing between returns and risk. (Herner, 2006 p207) Usually, equity fund managers fall into two broad categories. Those that seek to maximise a capital’s returns as per the fund’s charter. The charter serves in specifying a particular market as well as the securities in which such a security can invest and those that are obliged to provide some income element on behalf of investors. (management-hub.com, 2009) From this it is subsequent that the relevance of a portfolio to fund manager is similar to that of an investor. Capital Asset Pricing Model In an equity market that is efficient, it is only a situation of higher risk that investors can maximise their returns. The CAPM- Capital Asset Pricing Model serves in showing that the correct magnitude of the risk of a stock is its return’s correlation with the entire market (this is referred as beta). It is possible to estimate Beta using historical data, and it shows the basic risk of a stock’s return which is not possible to do away with in a portfolio that is properly diversified. For the same stock, it is a must to compensate investors. Where beta is more than a unit, the given stock requires a higher return than that of the market and where it is lower than one, the stock requires a lesser return. A risk which is unsystematic does not call for a higher return. The CAPM as well as “efficient market hypothesis” were the basis of the analysis of a stock’s return in the 1970s through 1980s. (Siegel, 2007 p140) The CAPM is utilised as a model of valuing stocks as well as other investment types. It does this using discounted cash flow with a discount rate that is risk adjusted. To compute the discount rate that is appropriate, CAPM uses the beta of an investment as mentioned earlier. Beta is usually denoted using β, which is a Greek letter. The discount rate utilised by CAPM is calculated as follows:- Where; rm= the market’s expected return β= stock’s or cash flows beta rf= risk free rate of return r= required return rate rm- rf is known as the risk premium. Thus, the stock being valued has a risk premium being represented by β× (rm- rf ). β adjusts the rate of discount for the cash flows being valued correlation as well as the market’s volatility. This approach to risk measurement is essential since it puts into account the risk element, which cannot be diluted through diversifying stocks. (moneyterms.co.uk, 2009) To compute CAPM, the first stage is to approximate the stock’s involved standard deviations (σs) as well as that of the market (σm). Then, calculate the coefficient of correlation for both (ρsm). Therefore, the stock’s beta is; β= (σs/ σm) ρsm Using an example to compute β; Estimated value Standard deviation of a typical stock (σs) 0.15 Standard deviation of the market (σm) 0.10 Return of the market (rm) 0.22 Coefficient of correlation (ρsm) 0.9 Risk- free rate of return (rf) 0.02 First stage; Compute β β = (0.15/0.10)× 0.90 = 1.35 Last stage CAPM using the same data = 0.02 + (1.35 × (0.20)) = 0.29 or 29% (Groppelli and Nikbakht, 2000 pp201, 202) The main idea under CAPM is that whatever an investment’s rate of return, that should be achieved with the least risk level. The other notion is that high risk level should go tandem with a correspondingly high return rate. (businessdictionary.com, 2009) Scholars have merited CAPM for one major reason. It divides risk into two main components; a risk that is diversifiable and a risk that is not diversifiable. Thus, an intimate relationship is established between the individual stock’s return and that of the market. It has therefore been considered to be highly efficient by the scholars since it puts into account all the available information. (Groppelli and Nikbakht, 2000 pp94, 95) CAPM is merited for its simplicity in that it is simple to follow and understand as a strategy. It tells about the return and the risk associated with a given stock, portfolio or market. It also serves to detect any over or under-pricing of a stock. It thus helps investors to make informed decisions particularly when screening the stocks which give sufficient returns for the risk that has been taken by such an investor. (investorsbase.com, 2008) An essential advantage associated with CAPM is that it is very straightforward with regards to application from the statistical perspective. Because of this, it is very important for derivatives’ pricing in a market that is deemed incomplete. By being incomplete, this refers to there being a predicament that is unresolved. To an investor a risk associated with stock can be eliminated with totality, thus. (actuaries.org, 1995) Generally, to an investor and a fund manager alike, CAPM has an advantage of being a model that is simple while approximating as well as when being applied, but it is only applicable where an asset is not very sensitive to the economic factors that are not fully represented in an index of a market. For instance; such a situation like a maize company stocks which usually derives the risk of the stocks from the piece of maize movements, have a tendency of having minimal betas and the expected returns as well. (Damodaran, 2002 p76) Conclusion The conclusion to the study is that prior to the March 1952 article in the Journal of Finance courtesy of Harry Markowitz, modern portfolio theory did not hold any meaning to many investors. (Hagstorm, 2001 pp148, 149) But as time passed it gained significance and in the 1970s though 1980s, it reached its peak in terms of importance. On the other hand CAPM is a method utilize by investors to compute a desired rate of return of an asset or portfolio while putting into account both systematic and unsystematic risk. This is while trying to give a comprehensive answer to the study questions, “What is the relevance of portfolio theory to an investor or fund manager in a typical equity market? and What is the relevance of Capital Asset Pricing Model (CAPM) to an investor or fund manager in an equity market?” Reference list: Actuaries.org. (1995). CAPM, Derivative Pricing and Hedging. Retrieved October 26, 2009 http://209.85.229.132/search?q=cache:kvM5bTtucQYJ:www.actuaries.org/AFIR/colloqu ia/Brussels/Hurlimann.pdf+ADVANTAGES+of+CAPM+TO+AN+INVESTOR&cd=95 &hl=en&ct=clnk&gl=ke Articlesbase.com. (2008). Capital Asset Pricing Model Investing Strategy. Retrieved October 26, 2009 http://www.articlesbase.com/investing-articles/capital-asset-pricing-model- investing-strategy-674080.html businessdictionary.com. (2009). Capital Asset Pricing Model (CAPM). Retrieved October 26, 2009 http://www.businessdictionary.com/definition/capital-asset-pricing-model- CAPM.html csus.edu. (2009). Portfolio Analysis. Retrieved October 26, 2009 http://209.85.129.132/search?q=cache:t7gTdxKopocJ:www.csus.edu/indiv/k/kuhlej/fall0 0/mgmt135/135chp13.ppt+calculating+risk+of+a+portfolio&cd=2&hl=en&ct=clnk Damodaran, Aswath. (2002). Investment Valuation: Tools And Techniques For Determining The Value Of Any Asset. John Wiley and Sons. Edition 2, illustrated. p 76. Gibson, Roger C. (2000). Asset Allocation: Balancing Financial Risk. McGraw-Hill Professional. Edition 3, illustrated. p8. Groppelli, Angelico A, and Nikbakht, Ehsan. (2000). Finance.. Barrons Educational Series. Edition 4, illustrated. pp 94-202. Hagstrom, Robert G. (2001). The Essential Buffett: Timeless Principles For The New Economy. John Wiley and Sons. Edition illustrated. pp148,149. Hartviksen, Ken. (2007) . Portfolio Theory. John Wiley & Sons Canada, Ltd. Retrieved October 26, 2009 http://209.85.129.132/search?q=cache:52uY24NxJpQJ:foba.lakeheadu.ca/hartviksen/203 9/Chapter%25208%2520- %2520Risk,%2520Return,%2520and%2520Portfolio%2520Theory.ppt+portfolio+theory +illustrated&cd=11&hl=en&ct=clnk Hebner, Mark T. (2006). Index Funds: The 12-Step Program for Active Investors. IFA Publishing, Inc. Edition illustrated. p 207. Jorion, Philippe. (2007). Financial Risk Manager Handbook. John Wiley and Sons. Edition 4, illustrated. pp209, 210. Management-hub.com. (2009). How Do You Go About Investing In Equity Funds? Retrieved October 26, 2009 http://www.management-hub.com/asset-equity-fund.html Moneyterms.co.uk. (2009). CAPM. Retrieved October 26, 2009 http://moneyterms.co.uk/capm/ Siegel, Jeremy J. (2007). Stocks For The Long Run: The Definitive Guide To Financial Market Returns And Long-Term Investment Strategies. McGraw-Hill Professional. Edition 4, illustrated. p 140. Read More