Portfolio Management | Investment Management
Every investor expects to have a higher level of return for the level of risk they take while investing. And to have a higher level of return, the investors need to carefully allocate their funds in risky and risk-free assets. Because of the power of diversification, forming a portfolio does reduce risk to some extent but it does not eliminate the level of risk completely.
The assets having a lower correlation in the portfolio will expose to a low level of risk to the investors and the investors can be benefited from this combination. Depending upon the nature of the investors also the combination of the risky and risk-free assets varies in the portfolio.
Allocation of Risky and Risk-free Assets
Every investor expects to have a higher level of return for the level of risk they take while investing. And to have a higher level of return, the investors need to carefully allocate their funds in risky and risk-free assets (Frone, 2017). Generally, it is assumed and believed that the risky assets yield a higher level of returns whereas the risk-free assets have no risk for the low return.
The risk regarding investment is calculated by using the standard deviation on the returns of investment. If the standard deviation seems to be higher, it indicates that there is a high level of risk for investing in these stocks.
Systematic/Non-Diversifiable Risk and Unsystematic/Diversifiable Risk
The rate of return on any assets is influenced by various macroeconomic forces in the economy like inflation, interest rates, money supply, economic growth, business cycle, etc. These factors cannot be predicted with a full level of certainty directly affecting the returns with the firms and assets in the economy. Systematic or Non-diversifiable risk arises due to the macroeconomic forces of the environment and is related to the market as a whole (Lubatkin, 2011). Even, having a good portfolio diversification cannot diversify this risk.
Unsystematic Risk arises basically because of the firm-specific factors which directly affect the individual firm but not related to the market as a whole. Inside the firms, there are various factors like relation to labor, R&D, positioning of the product, quality of management which exposes certain kinds of risk to the firm (Beja, 2012).
One of the good points of unsystematic risk is that with a proper formation of the portfolio, this type of risk can be diversified as the name itself suggests it’s a diversifiable risk. Forming a portfolio does reduces risk to some extent but it does not eliminate the level of risk completely.
As mentioned above with a proper diversification of assets, there are maximum chances that the risk can be reduced. Generally, the risk of the portfolio is influenced by the correlation between the different assets listed in the portfolio. Harry Markowitz‘s concept of Markowitz Diversification supports the concept of correlation and portfolio risk (West, 2006).
He suggests that the assets having a lower correlation in the portfolio will expose to a low level of risk to the investors and the investors can be benefited from this combination. The essence of the Markowitz model is that for a given level of risk, investors will be interested in that type of portfolio which yields higher returns and minimum variance.
Investment Opportunity Set/ Feasible Set
Investment Opportunity Set is the set of all those portfolios that are possible for the formulation of two risky assets that can be formed with an investing fund available to the investor (Tim Adam, 2008). If the portfolio of two assets is formed, one having lower and another having a higher standard deviation then at the initial phase the risk with the portfolio starts falling to a certain point and then increases if we do invest in the assets having higher standard deviation. This concept does apply to all the assets that have the value of the correlation between -1 and +1.
Capital Asset Pricing Model (CAPM)
CAPM model is an asset pricing theory that explains that the equilibrium returns on all of the risky assets are the function of their covariance with the market portfolio (Tim Bollerslev, 2011). There are some of the assumptions behind the concept of the CAPM model which are as follows:
- By looking at the expected returns and standard deviation over the single period horizon, investors do evaluate the portfolios.
- Most of the investors are risk aversive in nature which leads them to choose the portfolio with low standard deviation and higher expected return.
- It is assumed that all of the investors get market information in a perfect manner as the capital market is of efficient in nature.
- It is not possible for any of the investors to affect the stock’s market price.
Portfolio Management | Numerical Illustration and Solution
Chapter 7; Question 16; Page Number 237
- Rate of Expected Return on Risk-Free Assets E( RF ) = 12%
- Rate of Expected Return on Risky Assets E( RM )= 30%
- Risky Assets’ Standard Deviation ( σM ) = 40%
- Overall Portfolio’s Standard derivation ( σp ) = 30%
- Rate of Expected Return on Portfolio E ( RP ) =?
We know that;
Overall Portfolio’s Standard derivation (σp) = Weight of Risky Asset (wM) + Risky Assets’ Standard Deviation ( σM )
Or, 30% = wM + 40%
Therefore, Weight of Risky Asset ( wM ) = 75%
Rate of Expected Return on Portfolio E ( RP ) = RF + wM ( RM-RF)
= 12% + 75% (30-12%)
Therefore, the expected rate of return on Portfolio is 25.5% for a standard deviation of 30%.
Beja, A. (2012, March 16). On Systematic and Unsystematic Components of Financial Risk. The Journal of Finance, 27(1), 37-45.
Frone, L. (2017, June 14). Capital Allocation Between a Risk-Free Asset and a Risky Asset. Retrieved from Investment Fundamentals: https://thismatter.com/money/investments/capital-allocation.htm
Lubatkin, S. C. (2011, May 23). Corporate mergers, stockholder diversification, and changes in systematic risk. Strategic Management Journal, 7(2), 12-18.
Tim Adam, V. K. (2008, February 13). THE INVESTMENT OPPORTUNITY SET AND ITS PROXY VARIABLES. The Journal of Financial Research, 13(2), 42-28.
Tim Bollerslev, R. F. (2011, April 13). A Capital Asset Pricing Model with Time-Varying Covariances. The Journal of Political Economy, 96(1).
West, G. (2006). An introduction to Modern Portfolio Theory. Financial Modeling Agency.