Portfolio Diversification and the Reduction of Risk (Research Paper Sample)

Portfolio Diversification and the Reduction of Risk
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Theories of Portfolio Diversification and the Reduction of Risk
This paper seeks to explain the various theories of portfolio diversification as well as reduction of risk. An investment is made with the intention of earning periodic and terminal returns. However, it is not always the case due to uncertainties in various industries. Portfolios theory comprise of modern and traditional theories. Cowles.econ.yale.edu, (2015). says that the aim of investors and investment banks in having a portfolio of investment is to diversify risk. Portfolio management seeks to have an optimal combination of assets. It involves securities selection, feasible security construction and determination of the appropriate weight of the different classes of asset making up the combination. The objectives of portfolio management include facilitation of planning of the investor’s income, achievement of capital growth through reinvestment, securing the investments and maintaining liquidity of the investor. It also includes diversification purposes that is reducing risks and obtaining a favourable tax status. Phases of portfolio management comprises of five phases. They comprise of security analysis, portfolio analysis, portfolio selection, portfolio revision and portfolio evaluation. Security analysis involves examination of each type and security class in a portfolio such risk and returns, Cowles.econ.yale.edu, (2015).
The pricing of an asset is important aspect of this analysis to determine those that are underpriced or overpriced. Technical and fundamental analysis is critical in this phase. Technical analysis evaluates the share movement while the fundamental analysis evaluates the company factors such as market share and earnings per share. Portfolio analysis involves combining the identified desirable securities into a portfolio. Cowles.econ.yale.edu, (2015). says that the portfolio selection phase involves seeking the most efficient portfolio by selecting the portfolio with the highest return. Portfolio revision involves changing the portfolio as a result in the changes in the financial market due to their dynamic nature. These changes include sale of some securities which are not performing as per the expectation and buying new securities which have been analyzed and found to be performing well. Care must be taken while carrying out portfolio revision. Portfolio evaluation is done through quantitative measurement of return and return of the chosen portfolio, (Alphatheory.com, (2015).
A portfolio describes the various forms of assets in which an individual or an entity invests. There exists in the market in which one makes an investment. Risk is the chances that an investment will not give the expected output. The causes of these deviations from the actual or expected returns are the risks. Some risks are controllable are controllable while others are not. Risks may be systematic or unsystematic. Some risks affect certain industry or certain assets of investment. Alphatheory.com, (2015). says that Diversification seeks to control unsystematic through investing in a variety or combination of assets. Diversification and hedging are used to manage risks that investment face. The portfolio may comprise of assets such as bonds, futures, forwards, shares and swaps among others.
Alphatheory.com, (2015). indicates that the role of portfolio theory seeks to maximize returns by minimizing risks. It was developed as a guideline to investor on the various methods of selecting the right mix of portfolio by making the right analysis of risks. Diversifiable risks can be mitigated through diversification of assets. It is also referred to as unsystematic risks. Systematic risks cannot be reduced since they affect the entire economy in which all industries operate. Traditional portfolio theory seeks to encourage diversification by investment in variety of assets. There is a certain level of investment in which the risks cannot decrease any more. The traditional approach uses a non-quantitative approach. It is meant to minimize risks through investment in different classes of asset of different companies operating in different industries. This ensures that there is little correlation between the classes of asset an investor chooses to invest in. Under the traditional portfolio theory they emphasize on characteristic of the investor, objectives of the portfolio, strategy of the investment and individual investment selection. The investor characteristics comprise of age, purpose of the income, liquidity and risk altitude as well as status of the taxation system. The objectives of the portfolio include investors’ wealth maximization. The investments with higher risks are considered to have higher returns. The strategy of investment includes achieving and maintaining liquidity, finding a balance between transaction costs and capital gains and determining balance between equities and fixed interest securities. Diversification is meant to minimize risks. Individual investment selection involves seeking expert advice on the right portfolio mix to invest in. technical analysis uses share price to estimate the value of return in a portfolio, Aase, K. K. (January 01, 1984).
The modern portfolio theory was developed in 1950 by harry Markowitz. It s also referred to as Markowitz model and optimization of risk and return. Markowitz described as father of the modern portfolio theory indicates that diversification can be used for risk reduction and returns are a function of expected risk. He explained that investors can only concern themselves with risk and returns when analyzing assets to invest in. the investor are more concerned with the overall risk of the portfolio rather than the risk of an individual asset. Risk is the variability of expected returns. Low risks portfolio are those that the actual returns are fairly stable. Those with high rate of fluctuations are considered to be highly risky. The modern portfolio theory uses statistical techniques in selection and balancing of assets to be invested in. coefficient calculation are used to determine the riskiness of the portfolio. (Matuszak, 2015) says that the difference between modern portfolio theory and the traditional theory since the modern theory achieves risk reduction through quantitative methods. The modern theory main objective is to ensure the right and efficient portfolio is achieved. An efficient portfolio is one which gives back the highest returns. An efficient and optimal portfolio enables profit maximization. An optimal portfolio is based on an investor’s tolerance to risk and which gives him the highest yields. An efficient frontier is a portfolio that balances risks with return. Markowitz work on portfolio theory was build up by James Tobin who added the risk free assets in 1958.he led to the development of the market security line and super efficient portfolios. The capital pricing model was coined by Sharpe in 1964 as well as brought about the asset beta. The CAPM states that market portfolios should be held at the risk free asset.
The major assumption of the modern portfolio theory is that investors are risk averse. They are not risk takers and will prefer a portfolio with the lowest risk unless he accepts higher returns from the portfolio. Risk is determined through the use of standard deviation. The two mutual fund theorem is used in the portfolio analysis. It applies the efficient frontier concept in a mutual fund investment, Aase, K. K. (January 01, 1984). A risk free asset is one which whose payment rate are risk free based. Government securities are considered as risk free since the probability of government default in payment is very low and is usually fixed. However due to this low risk nature they usually pay with a low rate of return. Government securities comprise of treasury bills, and bonds.
The modern portfolio theory makes certain assumptions regarding the investors and the market. They comprise of the following. The interest of the investors is on optimizing the mean-variance. There is normal distribution of asset returns is also assumed. Other assumptions include the correlations will remain constant and forever, the main aim of investors is to maximize their economic utility through the efficient market hypothesis, there is risk averseness and rationality among investors, there is information asymmetry in the market, there exist no transactions costs and taxes, investors tend to be price takers, securities are divisible into parcels and risk and returns are constant and are known in advance. An extension has been made to the modern portfolio theory giving rise to the post modern portfolio. It makes use of mean variance analysis. All these theories assist investors in diversification of their portfolios, Aase, K. K. (January 01, 1984).
Variations in returns are caused by some factors known as elements of risks. Risks may be systematic or unsystematic. Combined they form the total risk to a portfolio. Systematic risk arises from economic changes. During depression the stock prices decline as the company’s profits decrease. The company’s stock price rises during the boom as a result of increased profit and better performance.thr system risk comprise of the interest rate, market and purchasing power risks, Aase, K. K. (January 01, 1984).
The interest rate risks arise from changes in the interest rates of debt securities. Most securities have a fixed interest rate. There is an inverse relationship between price and the rate of interest prevailing in the market. The purchasing power risk occurs due to the rate of inflation prevailing in the economy. The higher the inflation rate in a given economy the lower the purchasing power. During high inflation period bonds and fixed income securities are not desirable...