Highly Risk Investment Portfolio vs More Tolerant to Risk One - Essay Example

Using between three and seven shares which are part of the Dow Jones Industrial Average, create an investment portfolio for two individual investors;one is highly risk averse, the other is more tolerant to risk Contents Introduction 3 Discussion 4 Types of risk 4 Types of investors 5 Portfolio A 9 Portfolio B 10 Sharp Ratio 10 Conclusion 11 References 13 Introduction Security Analysis & Portfolio Management theory is an important segment in financial management. Portfolio theory may be defined as the study on how an investor can construct his portfolio depending on his risk taking capacity & return expectations, based on a certain level of existing market risk. The theory also establishes risk return relationship emphasizing on the fact that higher return is always associated with high risk. A salient part of Portfolio Management constitutes analysis of securities. Security analysis helps to understand the pattern of movement of various securities & derive changing values of various tradable financial assets as a result of market volatility. The concept of portfolio management is very relevant of today’s global scenario. As a result of privatization, Governments of maximum countries are withdrawing support such that providing retirement benefits & medical securities to individual which leads to reduction in welfare system. Besides, high standard of living & need for financial security for the aging population tends the individuals to manage their portfolio sensitively which has given significant rise to financial awareness among investors. Considering the volatility of the market, investors plan to design their portfolio in such a way that they can meet their short term, medium & long term financial requirements. With the expansion of technology, market information being readily available to the portfolio managers & investors, their aim is to bring all the assets & securities into one roof and optimise the risk of the total portfolio in order to achieve expected return. Discussion Portfolio management theory is based on the inherent relationship of risk & return. Each & every security in a portfolio contains a certain level of risk. Therefore, it solely depends on the investors & their risk appetite that how they will construct their total portfolio. Types of risk Systematic Risk Systematic Risk is an unpredictable risk that affects the market as a whole, not a particular security or industry. Hence, this type of risk is undiversifiable i.e. it is impossible for an investor to shift or ignore the risk completely. However, systematic risk can be partially controlled through hedging & by implementing proper asset allocation strategy. Systematic Risks can be attributed as- A) Market Risk. B) Interest Rate Risk. C) Purchasing Power Risk. Unsystematic Risk Unsystematic is a type of risk that can be reduced or eliminated through diversification. This is a company specific or more prominently, an industry specific risk. Hence, in order to avoid such risk, investors are advised to owe stocks from different industries rather that owing large no. of stocks from same industry. Unsystematic Risks can be attributed as- A) Business Risk, B) Financial Risk. C) Insolvency Risk & D) Liquidity Risk (Graham, 2004). Types of investors Considering the risk existence & various investment opportunities available to the investors, they can be categorised into three segments such that Risk Taker Investors are willing to take additional risk for achieving extra unit of return. Risk taking capacity of such investors is very high, hence there is a probability that the investors may end up with a low return because of existence of such high risk factors. Risk Averse Risk Averse are those investors who prefer a low return than taking high risk. Risk Neutral Those investors who can manage risk effectively are called Risk Neutral. Risk neutral investors are only interested in a moderate expected return. They are not willing to take risk beyond that level to get an extra return. In order to quantify the expected return & risk, standard deviation is used as a measure of expected return & variance is used to measure the level of risk. Hence, in different market condition, a portfolio is expected to yield different returns depending on different level of market fluctuations. Hence, to construct portfolios using six shares viz. BA, AXP, GE, INTC, I & VZ, which are selected from Dow Jones Industrial Average between the time period of 02.01.2013 and 31.12.2013, following assumption should be made: 1. Investors are from United States. So, they are following US market. Hence, investment decision of such investors is largely based on the economic, political & business environments of US. Any fluctuation US inflation rate, price index ration or any other macro economic variables, change in business cycle will directly affect the investment pattern of the investors. 2. All investors are rational in nature & are risk averse. 3. Investors can lend & borrow unlimited amount at a risk free rate of interest. 4. The risk fee rate is assumed to be 1.92%, using the USA 10 years treasury. 5. All investors having homogeneous expectation. 6. The higher the risk is, return tend to be on high side. This factor gives an incentive to the investors to invest an additional amount. 7. Investors are having well diversified investment avenues to choose from, for the purpose of constructing a standard portfolio. 8. No transaction cost & taxation is involved n the market. Figure 1: Risk Return Indifference Curve & Efficient Frontier According to Eminent Economist, Harry Markowitz, risk- returns indifference curve shows an investor’s preference to for risk and return, keeping other things constant. Hence, such curve enhances the technique of selecting the most efficient portfolio among all other portfolios present there. The theorem is based on the following rationale such that 1. All portfolios line on the indifference curve are equally desirable for the investor even though they are having different level of risk & expected return. 2. Portfolio lying on the northwest corner of the indifference curve is likely to be most desirable for an investor than any other portfolio. Hence, in order to determine efficient portfolio, criteria from investors’ perspective are, 1. Investors tend to choose the portfolio that constitutes lower risk for same level of return. 2. Similarly, for portfolios with same level of risk, investors will always strive to select the portfolio that which will yield a high rate of return. However, the risk of a portfolio considers the risk & return of each & every investments as well the correlation among various securities in the portfolio. Hence, a portfolio to be considered as an efficient portfolio, expected return must be higher as compared to the level of risk that should be lower or at least same and efficient frontier is constructed by joining the locus of all such efficient portfolios (Kevin, 2008). Figure 2: Efficient Frontier Investors being rational will tend to have a higher return at the cost of low risk as being risk averse. In the above figure, the area PVWU shows the possible region for the investors to invest. But PQVW indicates the line from where investors can achieve comparatively high return at a low or same level of cost. For example, risk level X2 constitutes of three portfolios, S, T & U. But an investor will definitely choose portfolio S because for the same level of risk, portfolio S is giving maximum expected return (Y2) as compared to T & U. So, S can be said to be an efficient portfolio. Similarly, portfolios lie on the boundary PQSVW are called efficient portfolios, calculating their risk & expected return level. Hence, this boundary (PQSVW) is known as Efficient Frontier. All portfolios lying on that boundary may not the best portfolios as it may show lower return for a given level of risk or higher risk for a given level of return. But from investors’ perspective, these are most efficient. For that reason, the portfolios lie on the boundary is called Efficient Portfolios. Efficient frontier is same for all investors, taking the assumption that the investors are risk averse & all of them want to ensure maximum expected return with a lowest possible risk (Rad & Levin, 2004). Now, to evaluate comparative analysis of two portfolios to be constructed by using six shares say BA, AXP, GE, INTC, T & VZ, selected from Dow Jones Industrial average, one for an risk averse investor & another for an investor who is risk taker. The two portfolios are as follows: Portfolio A designed for Risk Taker investor: This portfolio should consist of shares BA, AXP & VZ as these shares inherit high risk & high return. Portfolio B designed for Risk Averse investor: This portfolio should consist of shares INTC, GE & T as these shares inherit comparatively low risk & low return. For simplification of calculation, we are assuming that both the investors will invest proportionately into the three shares. Portfolio A Share Expected Return Probability (Weighted Average) BA 59.13% .33 AXP 44.37% .33 VZ 15.22% .33 Hence, the Expected return of Portfolio A = (0.5913 x .33) + (0.4437 x .33) + (0.1522 x .33) = 0.195 + 0.146 + 0.050 = 0.391. Hence, the Expected Return of Portfolio A is 39.1%. And, the risk associated with the portfolio = 0.75. Portfolio B Hence, the Expected return of Portfolio B = (.2333 x .33) + (.0551x .33) + (.3048 x .33) = 0.077 + 0.018 + 0.101 = 0.195. Hence, the Expected Return of Portfolio A is 19.5% And, the risk associated with the portfolio = 0.75. Sharp Ratio Sharp Ratio may be defined as the extent of excess return the investor is receiving as a result of additional market volatility, considering the additional amount of risk. This ratio was introduced by Mr. William F Sharpe to calculate the risk adjusted performance of a portfolio. The ratio is calculated by subtracting risk free rate of return from the return of the portfolio & then dividing the value by standard deviation (risk) associated to the portfolio. Sharp Ratio of Portfolio A = (Expected Return of Portfolio A – Risk free rate of return) / Risk of Portfolio A = (0.391- 0. 019) / 0.75 = 0.372/ 0.75 = 0.49. Sharp Ration for Portfolio B = (Expected Return of Portfolio B – Risk free rate of return) / Risk of Portfolio B = (0.195 – 0.019) / 0.75 = 0.176/ 0.75 = 0.23. From the above calculation of Sharp Ratio of Portfolio A & Portfolio B, the former shows a better investment feasibility than Portfolio B. Conclusion Portfolio A & Portfolio B clearly shows that in spite of having similar level of risk association, the return of Portfolio A is much higher than that of portfolio B. Tendency of the investors of Portfolio A holder to take more risk results in a high return of the portfolio in a similar market condition. Hence, if the two portfolios can be imposed into a risk return indifference curve or efficient frontier, Portfolio A would have indicated as an efficient portfolio as it gives a higher return for a same level of risk. Hence, those investor who have chosen Portfolio A, have been able to make a wise decision. As investors’ tendency is to choose efficient portfolio from the all other portfolios available on that risk return region, investors in Portfolio B should also change their portfolio pattern & construct a portfolio similar to Portfolio A (Zapatero, 2004). Sharp Ration that shows a risk adjusted measure of return to evaluate portfolio performance & compare the performance of one portfolio to another, also shows a higher ratio for Portfolio A, indicating a sound portfolio structure. Though a Sharp Ratio more than 1 is considered to be a very good measure, in respect to these two portfolios, though the ratio is less than one, Portfolio A still shows a high ratio indicating the portfolio to be better than that of Portfolio B. Hence, investment portfolios created from analysing 30 stocks from Dow Jones Industrial Average & selecting six stocks among them between the time period of 02.01.2013 and 31.12.2013 resulted in construction & evaluation of two portfolios that shows all these aspects of security analysis & portfolio management.   References Graham, B., 2004. Security analysis: The classic 1951 edition. New York: McGraw-Hill Education. KEVIN, S., 2008. Security analysis and portfolio management. New Delhi: PHI Learning Pvt. Ltd. Rad, P & Levin, G., 2004. Project portfolio management tools and techniques. New York: IIL Publishing. Swensen, D., 2009. Pioneering portfolio management: an unconventional approach to institutional investment. New York: Simon and Schuster. Zapatero, F., 2004. Introduction to the economics and mathematics of financial markets. Massachusetts: Library of Congress Publication. Read More