Empirical Investment Portfolios - Essay Example

?Topic: Empirical Finance work Affiliation: Investment is an essential activity in the economy. It is one of the key drivers of economic welfare. On the same note, it contributes to investor welfare from the expected returns on investment. Instruments of investment are diverse and dynamic in nature, and so are the trends of investment of investment from time to time. Economic performance is a critical investment determinant due to the underlying risks that are associated with investment activities. These risks emerge due to the uncertainties associated with the future. Therefore, investment basically is a risk-inclusive undertaking, and individuals’ levels of risk taking vary depending on investment instruments and the expected returns. Successful investments must take into account relevant strategies that should aid the realization of the investment objectives. A number of investment strategies in the UK investable universe are evaluated and assessed for their performance: Small Cap vs. Large Cap Portfolios Volatility of returns is the principle determinant of whether a portfolio is a small cap or a large cap. The size of a company is determined by its market capitalization, a situation that further defines that company’s market cap. A small cap portfolio is defined by a market capitalization that is between 300 million and 2 billion. An amount less than this will enter the portfolio into a lesser marker cap, normally referred to as the micro-cap. Small cap portfolio is characterized by high volatility in the market, and the price of the stock keeps fluctuations due to the underlying market uncertainties. Large cap portfolios on the other hand are the direct opposite of small cap portfolios. Large cap portfolios are less volatile in the market, and the prices of these stocks are therefore relatively constant over time (Fama and French, 2011, p.46). Investors that prefer less volatile portfolio often opt for the large cap portfolios. However, this does not rule out risk prevalence in investment. Large cap portfolios are characterized by market capitalization of about 10 billion and above. This kind of portfolio experiences hardships in in and out trade activities. As a result, price swings are minimized, leading to the realization of consistency in its price. Value vs. Growth Portfolios Investors have different motives for investment. While some opt to invest in value stocks, others prefer growth stocks. These stocks share some common characteristics, but their distinguishing features outline the outstanding difference between the two stocks. The valuing of stocks is done with regard to market trends, incorporating risks and benefits to the value of the stocks. Investors prefer undervalued stocks, so that once the prices of the stocks changes, they are in a position to reap huge investment returns. Value stocks are depict the flowing features: less than 10 % price earnings ratio, less than 1 price to earnings growth, current assets that are twice the current liabilities, matching debt and equity and share prices that are at par with the tangible book value or even less (Fama and French, 2011, p.53). Growth stocks are defined by their outstanding feature of expansion and ability to generate more and more returns with time. They are referred to as growth stocks because they have the ability to diversify the underlying portfolio. Growth stocks are characterized by a growth rate that is strong and reliable. This is to say that the portfolio remains vibrant and beneficial over a long period of time. It is important to account for the fact that different companies grow at different speeds and rates, and it essential that an investor be accommodative in regard to growth portfolios. Equity returns are also strong with growth stocks. Company-industry comparison is used to determine the strength of the stock returns. Growth stocks are characterized by per share earnings that surpass the industry’s averages. As a result, stock price projections in most case favour the expectations of the investor. Assessing Portfolio Risk Characteristics The fact that investment is a risky undertaking cannot be refuted. The above discussed portfolios are characterized by risk characteristics that are either shared or unique to each of the portfolios. The most common risk characteristic shared by all the aforementioned stocks is the underlying uncertainty. Risks emerge from the fact that the future is untold, and the projections made are subject to realization or failure altogether. Small cap portfolios are face small market risks. Small market capitalization presents a limited returns phenomenon in the underlying stocks. Diversity and dynamism in stock returns is not guaranteed as high volatility risks increase. Large cap portfolios encompass the diversity and dynamism in investment that is likely to enhance investment returns in the stock market. While uncertainty risks are common across stocks, hardships in internal and external trades are experienced. This hinders market continuity, and investors are likely to shun investments after high returns reaping. On the same note, investors that observe the market over a long period of time are likely to conclude stagnation of the stock markets. The stocks are also subject to pricing risks. This means that the stock may not be sensitive to inflationary pressures in the economy, a scenario that is likely to negatively influence investment. Value and growth stocks are faced by a number of risk characteristics. The first risk characteristic is market uncertainties. The expected value and growth of the portfolios is hard to ascertain. Values of stocks are in most cases undervalued or overvalued (Fama and French, 2011, p.79). It is hard to establish a strict stock value at one point in time. The swings experienced in stock values impact on investors differently. The undervaluing of stocks is often preferred, but the opposite is avoided altogether. This trend influences trends of returns. The growth stocks further an extra risk characteristic, in that it is hard to define measures of growth and specify the units of measurement of that growth. 2004-2010 Data in a Nutshell This data is an eye opener to the sense that investment is an on-going activity. 2010 data depicts an investment scenario that by great margin surpasses the 2004 data. Across this period, investment instruments have also embraced diversity to encompass numerous elements of investment for each instrument of investment. Many risks that were prevalent in the year 2004 have been accounted for over the years, to present investor welfare by the year 2010. Stock markets have also significantly increased, and investment returns have generally increased over the same period. Reference Fama, E, and French, K, (2011), The Cross-section of Expected Stock Returns, Journal of Finance, June 2011. Read More