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Portfolio Analysis - Essay Example

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1. Risk and Return a. Indifference curves in the context of risk and return The selection of the best portfolio for an investor can be done in a number of ways, but perhaps the commonest way is the use of preference curves. In this context, Damodaran (2010) states that a preference curve is a representation of an investor’s selection for risk and return, meaning the attitudes that the investor has towards risk and the associated return on an investment…
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Portfolio Analysis
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Portfolio Analysis

The indifference curve can be used to reflect investor attitude or risk by refloating an investor’s preference. The plot of many indifference curves shows the different options that an investor would take. However, from the indifference map, the best option is to take the option that is highest that any other indifference curve. b. Selection of a suitable portfolio Indifference curves are not just used to display the risk aversion factors of an investor; in fact, the indifference curve can be used to select a suitable portfolio in terms of risk and return (Yin and Zhou, 2004). As already stated, the indifference curve is a plot of the risk and return preferences of an investor, therefore, to select the most suitable portfolio, an investor can utilize the mean-variance theory. The mean-variance theory of portfolio selection is derived from the indifference curve, where the map of the different indifference curves for an investor is plotted together (Maharakkhaka, 2011). From the plot of the indifference curves, the transitive preferences of an investor can be determined, which refers to the selection of the best preference curve as chosen by an investor. From an analysis of the transitive preferences, it is evident that the highest preference curve is the one that should be selected by the investor. From the indifference curve, the investor can determine the highest possible indifference curve, which, combined with the other indifference curves, gives the mean-variance portfolio or the most efficient portfolio in an investment. 2. Correlation and Co-variance a. Correlation and Co-variance The relationship between two variables can be measured or determined in different ways, but the commonest way is the determination of the correlation and covariance of the two variables. A number of variables are sometimes related in some way or another, either the occurrence of one variable affects the occurrence of the other variable, or the does not affect the working of the other variable. The covariance refers to the type of relationship that two variables have, meaning that it shows whether two variables have a positive or negative relationship. In this case, a positive relationship refers to the fact that one variable moves in the same direction as the other variable. Conversely, the correlation between two variables incorporates another dimension, the extent to which two variables are related. In addition to the covariance angle of determining whether variables are positively or inversely related, the correlation also shows the extent to which the variables are inversely or positively related. b. Covariance, Correlation, and Portfolio risk As already stated, the correlation between two variables is determined by the movement of one variable in relation to the movement of the other variable. In the investment market, diversification is a good practice, since it ensures that an investor does not lose an investment in case of a catastrophe or loss in market value. A positive correlation between assets means that one asset will move in the exact same way as another asset. In investment, stocks with low or negative correlation are used to reduce portfolio risk since when one asset falls; the other asset ... Read More
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