Using the data provided, create an investment portfolio for a risk-averse investor, and another portfolio for an investor with relatively high risk tolerance.
Portfolio Management: An Art and Science
Portfolio management is an art and science which is used to make decision about the investment into few securities to manage the risk and return. This portfolio management process is used to match the investment objective, asset allocation etc for institutions and individuals and maintain the risk against performance. The overall aim of the portfolio management is to determine strength, opportunities, threats and weakness of the debts, equity, domestic shares, international shares, safety, growth etc to attempt to minimize the risk and maximize the return (Zimmerman and Yahya-Zadeh, 2011).
In the report, the optimal portfolios have been prepared on the basis of the risk and return. On the basis of the given data, 2 portfolios have been prepared. One portfolio focuses on the risk-averse investors and other focuses on the high risk tolerance. In the given report, the performance of both the portfolios has been measured to identify the position of the firms and the overall returns from the portfolios. For evaluating the risk position and the return of the assets, equity and debt, FTSE 250 index price has been taken into the concern.
Portfolio is a collection of investment which is all owned by the same investor, individual or an organization. Normally, these portfolios include stocks, bonds, investment in individual businesses, government securities, mutual funds, debt etc to reduce the risk level and manage the return from the overall investment of the individual (William et al, 2015). A portfolio is prepared in such a way that if one stock is offering the negative result than other stock, bond or other securities overcome that risk and loss of the individual.
The portfolio explains that all the amount must be invested into different securities so that the risk could be diversified and a portfolio manger must assures that the investment is done in the different venture. In the given case, the 3 different firms of UK market have been taken for the purpose of portfolio. The risk and return of all the firms have been calculated firstly to make an optimal capital structure for the risk-averse investors and other focuses on the high risk tolerance.
The risk-averse investors are those individuals or the organization that prefer to take lower return for the portfolio with known risk rather than taking the higher return from the unknown risk. These kinds of investors play safe in the security market and invest in those securities which are associated with lower risk (Nobes and Parker, 2008). On the other hand, high risk tolerance investors are those individuals which mainly focus on the higher return. No matter, how much risk is associated with the portfolio, they only focuses on the higher returns from the portfolio. The risk-averse investors and the high risk tolerance explain that the choices of an individual are always different while preparing a portfolio. Some only focuses on the risk whereas some focuses on the return of the company.
Preparing Investment Portfolio for Different Risk Tolerance Levels
Along with the investment in each security or stock, the risk and return is essential. A few reasons due to which portfolio is prepared by the investors are:
- Risk of losing the money
- With the volatility in the price, the worth of the total investment could be lower at the time of need (Weygandt et al, 2009).
- The changes into the growth or the competition level could affect the stock price of an organization.
- Or the changes into a particular industry could also affect the investment of an individual.
Thus, an investor has to be sure that the investment has to be done in different organization from different industry and in government bonds and the debts so that the level of the risk could be minimized (Phillips and Stawarski, 2016). A portfolio could be diversified in many ways to manage the risk and return of an organization. An investor could follow the different methods to manage and prepare a portfolio such as:
- Diversification of investment through investing into the stocks, currencies, real estate investment, convertible securities etc.
- Investment into the different countries so that the economic fluctuation could not impact on the return.
- Investment into the different market to save from currency fluctuations and other factors (Niu, 2006).
- Investment into the different industry to reduce the industry risk.
- Different market optimization
- Investment companies with different market share
- Rate of return
- Investment style
- Holding period of the portfolio
- Holding period of cash (Moles, Parrino and Kidwekk, 2011).
Above all are few methods which could be applied by the portfolio manager or the individuals on the basis of the choice and the demands to make a better portfolio. The main benefits of the portfolio management are as follows:
- Better decision making
- Risk management
- Faster project turn times
- Increase project delivery success
- Streamline data and increment in the collaboration (Needles, Powers and Crosson, 2013)
On the basis of it, it has been found that the portfolio is one of the best choices for the purpose of investment as it helps an organization or the individual to manage the overall performance of the investment amount.
An efficient portfolio is the portfolio in which the return and risk are combined in a way that it maximizes the return in anticipated and the current circumstances. Optimal portfolio could be prepared on the basis of the efficient portfolio and the modern portfolio theory (Bromwich and Bhimani, 2005). Modern portfolio theory is an optimal portfolio strategy which constructs an optimal portfolio through considering various figures such as beta, alpha and R-squared. The theory explains that the risk of a stock could be evaluated on the basis of the fluctuations in the total stock price of an individual security on the basis of the index stock price.
According to the given data in the case, two portfolios have been prepared on the basis of the overall risk and return of the security. Firstly, a portfolio has been made for the risk-averse investors and it has been found that the total risk of the firm 1, firm 2 and firm 3 are 0.10, 0.11 and 0.03. At the same time, the market risk premium and risk free rate of UK is 6.60% and 1.39% (Bloomberg, 2018). The portfolio has been prepared for the risk-averse investors. The risk-averse investors are those individuals or the organization that prefer to take lower return for the portfolio with known risk rather than taking the higher return from the unknown risk. These kinds of investors play safe in the security market and invest in those securities which are associated with lower risk. And thus, the portfolio beta has been prepared on the basis of the risk (Bromwich and Bhimani, 2005).
Methods of Managing and Preparing Investment Portfolios
The portfolio weight has been decided on the basis of the individual stock so that the beta (risk) of the portfolio could be minimized. No matter how much, it impacts on the overall return of the portfolio. The weight has been given 10%, 10% and 80% to firm 1, firm 2 and firm 3 respectively, due to the fact that the beta of firm 1 and firm 2 is 0.10 and 0.11 which is quite higher than the beta of firm 3. The beta of firm 3 is 0.03 which is lowest and thus the rest fraction which is 80% has been given to the Firm 3.
On the basis of this study, it has been found that the overall risk of the portfolio with 10%, 10% and 80% weight would be 0.04 which explains about lower volatility and lesser risk. It indicates the change into the index price would only impact 0.04 to the portfolio stock and it explains about lower risk of the portfolio (Travlos et al, 2015).
Further, on the collected information, it has been found that the overall portfolio beta of the portfolio is 0.04 and on the other hand, the market risk premium and risk free rate of UK is 6.60% and 1.39% (Market premia, 2018). It explains that the overall return of the portfolio could be calculated through capital asset pricing model. The capital asset pricing model explains that the overall return from the portfolio would be 1.67%.
On the basis of the below given table, it has been recognized that the overall risk of the portfolio is 0.04 and the return from the portfolio is 1.67%. It explains that the associated risk with the portfolio is lower and thus it is better option for the risk-adverse investors. However, it has also been found through this portfolio that overall return of the portfolio is also lower (Thanatawee, 2013). But the risk-averse investor only focuses on the lower risk; return does not matter that much to them.
Thus, this portfolio is one of the better option for the risk averse investor and if an investor wants to face lowest risk than he should invest into the portfolio for sure.
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Particulars
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Firm 1
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Firm 2
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Firm 3
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Weight
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A
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10%
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10%
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80%
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w1
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w2
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w3
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Beta
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B
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0.10
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0.11
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0.03
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Portfolio Beta
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β1
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β2
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β3
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Portfolio Beta
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βp=(w1xβ1)+(w2xβ2)+(w3xβ3)
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0.04
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Market Risk Premium
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B
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6.60%
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Risk Free Rate
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C
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1.39%
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Portfolio Expected Return
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D=C + (βpxB)
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1.67%
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(Horngren, 2009)
Further, a portfolio has been made for the high risk tolerance and it has been found that the total return of the firm 1, firm 2 and firm 3 are 0.05%, 0.05% and 0.06%. At the same time, the market risk premium and risk free rate of UK is 6.60% and 1.39%. The portfolio has been prepared for the high risk tolerance investors. The high risk tolerance investors are those individuals and organizations which mainly focus on the higher return. No matter, how much risk is associated with the portfolio, they only focuses on the higher returns from the portfolio (Damodaran, 2011). These kinds of investors like to invest in those securities which are offering the highest return to the shareholders, associated risk are ignored by the investors. And thus, the portfolio beta has been prepared on the basis of the total return.
Benefits of Portfolio Management
The portfolio weight has been decided on the basis of the individual stock so that the return of the portfolio could be maximized. No matter how much, it impacts on the overall risk of the portfolio. The weight has been given 45, 45% and 10% to firm 1, firm 2 and firm 3 respectively, due to the fact that the return of the portfolio would be higher in that case.
On the basis of this study, it has been found that the overall risk of the portfolio with 45%, 45% and 10% weight would be 0.10 which explains about higher volatility and huge risk. It indicates the change into the index price would only impact 0.10 to the portfolio stock and it explains about higher risk of the portfolio (Davies and Crawford, 2011).
Further, on the collected information, it has been found that the overall portfolio beta of the portfolio is 0.10 and on the other hand, the market risk premium and risk free rate of UK is 6.60% and 1.39%. It explains that the overall return of the portfolio could be calculated through capital asset pricing model. The capital asset pricing model explains that the overall return from the portfolio would be 2.03%.
On the basis of the below given table, it has been recognized that the overall risk of the portfolio is 0.10 and the return from the portfolio is 2.03%. It explains that the associated return with the portfolio is higher and thus it is better option for the high risk tolerance investors. However, it has also been found through this portfolio that overall risk of the portfolio is also higher. But the high tolerance investor only focuses on the higher return. It does not matter that how much risk is associated with it (Brealey, Myers and Marcus, 2007).
Thus, this portfolio is one of the better options for the high risk tolerance investor and if an investor wants to gain higher return than he should invest into the portfolio for sure.
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Particulars
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Firm 1
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Firm 2
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Firm 3
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Weight
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A
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45%
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45%
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10%
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w1
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w2
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Beta
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B
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0.10
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0.11
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0.03
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Portfolio Beta
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β1
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β2
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β3
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Portfolio Beta
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βp=(w1xβ1)+(w2xβ2)+(w3xβ3)
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0.10
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Market Risk Premium
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B
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6.60%
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Risk Free Rate
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C
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1.39%
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Portfolio Expected Return
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D=C + (βpxB)
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2.03%
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On the basis of the study, it has been recognized that the risk and return of a portfolio has positive relationship with each other. If the risk of a portfolio is higher than the overall return of the portfolio would also be higher. On the other hand, it has been recognized that a portfolio is always evaluated and measure by the investors on the basis of their choice (Besley and Brigham, 2008). Some of the investors want minimum return from the portfolio while some investors want huge return from the portfolio.
Optimal Portfolio and Modern Portfolio Theory
Thus a portfolio should be prepared on that basis only. The risk return trade off explains that the risk and return of the company would be lower and it would be a better option for the risk adverse investors who do not want to face huge risk in their investment whereas the risk and return of the company would be higher and it would be a better option for the high risk tolerance investors who wants to earn higher return from their investment (Bierman, 2010). It explains that an investor is required to evaluate all the related topics while making a decision about the overall performance of the company.
On the basis of the study on the portfolio management, benefits of portfolio management etc. it has been found that the portfolio is among the better choices of an organization or an individual to make investments. If an investor is focusing on the risk only and he wants to invest into those portfolio from where the risk is minimum than the portfolio one is the better option for the investor and if an investor wants to face lowest risk than he should invest into the portfolio for sure. On the other hand, it has been found that if an investor is focusing on the return only and he wants to invest into those portfolio from where the highest revenue could be earn than the portfolio two is the better option for the investor. And if an investor wants to generate higher profit then he should invest into the portfolio for sure.
To conclude, the portfolio management process is quite crucial for an organization and the individual to manage the overall position and the performance of an organization. The overall aim of the portfolio management is to determine strength, opportunities, threats and weakness of the debts, equity, domestic shares, international shares, safety, growth etc to attempt to minimize the risk and maximize the return.
References:
Besley, S. and Brigham, E.F., 2008. Essentials of managerial finance. Thomson South-Western.
Bierman, H., 2010. An introduction to accounting and managerial finance: a merger of equals. World Scientific.
Bloomberg. 2018. Rates and bonds. (online). Available at: https://www.bloomberg.com/markets/rates-bonds/government-bonds/uk (accessed 11/6/18).
Borio, C., 2014. The financial cycle and macroeconomics: What have we learnt?. Journal of Banking & Finance, 45, pp.182-198.
Brealey, R., Myers, S.C. and Marcus, A.J., 2007. FundamentalsofCorporate Finance. Mc Graw Hill, New York.
Bromwich, M. and Bhimani, A., 2005. Management accounting: Pathways to progress. Cima publishing.
Damodaran, A, 2011, Applied corporate finance,3rd edition, John Wiley & sons, USA.
Davies, T. and Crawford, I., 2011. Business accounting and finance. Pearson.
Horngren, C.T., 2009. Cost accounting: A managerial emphasis, 13/e. Pearson Education India.
Market risk premia. 2018. Market return. (online). Available at https://www.market-risk-premia.com/gb.html (accessed 11/6/18).
Moles, P. Parrino, R & Kidwekk, D,.2011, Corporate finance, European edition, John Wiley &sons, United Kingdom
Needles, B., Powers, M. and Crosson, S., 2013. Financial and managerial accounting. Nelson Education.
Niu, F.F., 2006. Corporate governance and the quality of accounting earnings: a Canadian perspective. International Journal of Managerial Finance, 2(4), pp.302-327.
Nobes, C. and Parker, R.H., 2008. Comparative international accounting. Pearson Education.
Phillips, P.P. and Stawarski, C.A. 2016. Data Collection: Planning for and Collecting All Types of Data. John Wiley & Sons.
Thanatawee, Y., 2013. Ownership structure and dividend policy: Evidence from Thailand.
Travlos, N.G., Trigeorgis, L. and Vafeas, N., 2015. Shareholder wealth effects of dividend policy changes in an emerging stock market: The case of Cyprus.
Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2009. Managerial accounting: tools for business decision making. John Wiley & Sons.
Williams, J.R., Haka, S.F., Bettner, M.S. and Carcello, J.V., 2005. Financial and managerial accounting. China Machine Press.
Zimmerman, J.L. and Yahya-Zadeh, M., 2011. Accounting for decision making and control. Issues in Accounting Education, 26(1), pp.258-259
