High-risk High Return versus Low-risk Low-return Investment - Assignment Example

ASSUMPTION MADE IN MEAN-VARIANCE ANALYSIS AND THE CAPITAL ASSET PRICING MODEL (CAPM) By Foundation Department of High-risk high return versus low-risk low-return investment Introduction Asset pricing model (CAPM) is a model used in the determination of return rate on assets. The asset sensitivity, diversifiable and non –diversifiable factors are looked into. In this chapter, the risk associated with investment, most preferred investment and factors that contribute to the saving the investor will prefer will be focused on. To start with, we will understand the concept of an efficient portfolio as described below. Efficient portfolio concept Most investors, according to mean-variance analysis and asset pricing model, tend to invest in a more efficient portfolio available to them at the different level of risk. An efficient portfolio is a collection of investments that provide the highest expected return at the given level of risk or portfolio that yield the lowest risk at given expected a return. Expected return is the minimum return expected by investors investing in any given asset. The risk occurs due to deviation from the expected return in either case as explained by Markowitz. According to Markowitz Portfolio Theory, individuals who accept to take high return with high-risk cannon diversify further without acceptance of greater risk. On the other hand, individuals will not agree to reduce their return without reduction of risk. This fact explains why low-risk, low-return and high-risk, high-return portfolios are equivalent when it comes to investing. Markowitz (1952: 77) believes that portfolio choice is dependent on maximum discounted risk venture which will give a high return since the future is uncertain and assurance of money back on investment should be assured. The low-risk, low-return investors motivated by low risk in an asset they are investing in will invest more getting quantifiable income. On the other hand, high risk – high return individuals will tend to invest in minimal assets with high risk, but getting a quantifiable return due to their nature of the high return. As argued by Markowitz (1952, p, 77) investors should not just go for high return high-risk investment rather they should focus on the expected return. An investor may go for high-risk, high return bonds, but in case of failure, the return will be greatly reduced. On the other hand, an investor may go for several low-risk, low-return, but the cumulative expected return will be high (hypothesis of the maxim by Markowitz 1952: 78.). According to maxim hypothesis, both diversified and under-diversified assert will have the same cumulative expected return. In the United States, the under-diversified portfolio is greater among young people, low income earning individual, less educated and less sophisticated investors. On the other hand, according to research, investors will be less diversified on high volatile and higher skewed asset. This is can be explained by the risk notion which is high for people who have great wealth and need to add more wealth where else people with low income will tend to concentrate on low-risk ventures which with low return as argued by Goetzmannnkumar (2008:433) in his journal. Comparison of diversified portfolios and individual stock Goetzmannnkumar (2008:435) further states that an investor chooses their diversification based on their attraction to stock pattern consistent with their behaviour. An investor who values some industries will tend to invest in their greater volatile and skewed assets, whereas investors who earn a low return and have invested successfully will tend to hold greater under diversification due to past experience. According Markowitz (1952, p, 87), holding one stock increases the risk which reduces with promptly with an increase in the number of stock being held. Focusing on thumb rule, holding 45 stocks reduces the risk by 80%, holding 100stocks reduces the risk variance by 90% and holding 400 stocks reduces risk by 95%. It is clear then that a single individual stock is very risky than holding diversified stock. In individual stock, the risk of holding one stock come with no available alternative to turning into in case one the sacrificial assert fail to give the return. In the diversified portfolio, the investor net expected return may be positive in case if any assert failing. Markowitz 1952 noted that the investor in diversified portfolios will be motivated to invest as long as the average marginal cost of investment is lower than the marginal revenue. On the other hand, for individual stock, marginal cost and marginal revenue are dependent on one stock and investors will be motivated to invest again in the occurrence of return otherwise, they will be demotivated to invest again. In conclusion, well-diversified portfolios are better to invest than a single stock because they reduce the risk of investment and also they act as motivating factor though some ventures might have lost in the process. It is then advisable to any able investor to invest in many schemes so as to reduce the aspect of risk in investment. The impact of Preference for efficient portfolios. According to Fama (2004:28), to the efficient market hypothesis, all investors are risk averse and rational on contrary choice of asset investors want to invest in does not merely depend on return it gives to them. Several other factors like human behaviour, level of education, future perception, and financial status may as well affect the choice of investment an individual wants to invest in. According to the graph above, risk – assert are represented by the straight line, whereas the hyperbola represents the efficient frontier which covers the asset with risk either low or high. The efficient combination of an asset will be from the point of tangent upwards where with high risk, there is high return. As presented by the two mutual fund theorem, the efficient frontier will be generated by holding any two given portfolio on the frontier. This means that investors will still invest in risky assets provided that they give a positive return. The curve also assumes that investors are capable of lending and borrowing infinite asset which is a misconception because any given state will have control over the asset (mostly cash revolving in the economy) (Bhalla, 2010:588) When one asset is held on efficient and the other one is held in a risky frontier, the investor will wait the net marginal return to be positive and sell the nonperforming asset. Simply, as evident in the curve, one assert on the efficient portfolio may be taken to compensate the other in the risky position. On the graph, the risk-free rate is assert that pays an exact amount which was expected. Some example of this risk-free assets includes preference share, fixed account interest venture and government bill which has a specific rate of compensation in their entire lifetime. When an investor holds a risk-free asset, they are represented by the first half of the capital allocation line as given by the curve to the tangent. The tangent of the capital allocation line and the hyperbola represent assert with 100% risk free rate. Risk-return relationship As per the trade-off principle, the graph shows that investors are willing to lose much as they gain. The curve above shows the correlation of high-risk, high-return and low-risk low-return investment. Notable in the curve to the curve, the individual may choose to invest in any asset given the expected return. Risk averse investors will prefer high-risk investment where else risk diverse investor prefer the low-risk ventures which carry low return. The type of the asset is not much of the consideration when it comes to investment rather return and risk involved in assert are the major determinant of investment. The curve assume in a free market, there is no such thing as perfectly risk-free assets and therefore investors will go for risky asset provided that they have a return. The curve assumes that all investors are exposed to asset information at the same time, hence will purchase this asset at the identical time. The curve also assumes that investors have a similar take on the expectation of assert return and will behave the same when it come to the purchase of an asset. To wide up, it is so clear from the two graphs that an investor will not only go for free risk asset, but will go for any assert basing their argument on the ultimate return. References Bhalla, V. K. 2010. Investment Management. New Delhi: S. Chand & Co. Ltd. pp. 587–93 Chandra, S. & Shadel, W. G. (2007). "Crossing disciplinary boundaries: Applying financial portfolio theory to model the organization of the self-concept". Journal of Research in Personality 41 (2): 346–373. Fama, E., French. 2004 “The Capital Asset Pricing Model: Theory and Evidence”, Journal of Economic Perspectives, Vol. 18, No. 3, pp. 25-46 Goetzmann, W., Kumar, A. 2008 “Equity Portfolio Diversification”, Review of Finance, Vol. 12, No. 3, pp. 433-463 Hubbard, Douglas 2007. How to Measure Anything: Finding the Value of Intangibles in Business. Hoboken, NJ: John Wiley & Sons. Markowitz, H. 1952 “Portfolio Selection”, Journal of Finance, Vol. 7, No. 1, pp. 77-91 Sharpe, W. (1964) “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk”, Journal of Finance, Vol. 19, No. 3, pp. 425-442 Statman, M. 1987 “How Many Stocks Make a Diversified Portfolio?” Journal of Financial and Quantitative Analysis, Vol. 22, No. 3, pp. 353-363 Read More