Investing in Stocks & Mutual Funds: Components of Risk, Diversification, CAPM, and Investing Styles

Investment in Stocks: Components of Risk and Effects of Diversification

You Have Been Asked To Prepare a Briefing Note For The Prospective Client. You Have To Support Your Discussion And Arguments By Adequate Academic Literature. It Is Up To You To Decide On The Content Of The Note, But It Should Include An Appropriate Mixture Of Information On:

The Components Of Risk When Investing In Stocks And The Effects Of Diversification

How The Relationship Between Risk And Return Is Maintained Using Capm

Mutual Funds (Structure, Types, Benefits And Performance)

Types Of Share Analysis To Value Stock

Investing Styles

Advantages And Disadvantages Of Investing In International Markets

One of the key business as well as the individual decisions is regarding the investments. This is because the investments determine the financial as well as overall risk. Therefore, the managers for the business as well as the individuals must decide the components and the proportion in the investments as per the risk capacity as well as the other factors. The following report is aimed at studying the varied aspects of investments, particularly in equity, mutual funds, relationship between risk and return, cost of capital and others. The report would end with an overall conclusion highlighting the key aspects studied (Emm, and Trevino, 2014).

One of the significant features of the equity investment is that the stock investments are risky as the prices fluctuate due to the internal factors of the entity as well as the external factors owing to the business as well as the industry and area of operations. Majorly there are four types of risks that surround the stock investments (Cronqvist, Siegel, and Yu, 2015). These are economic risk, inflationary risk, market value risk, and risk of being too conservative. The economic risk refers to the risk of economy going bad like that of the 2008 financial crisis. The inflation risk could lead to the destruction in the value of the holdings, and creation of the recession if the inflation rates are too high. Market value risk is dependent on the choice of the investments in stock, as the market can turn against the said stocks. As the stock market is risky, the risk of being too conservative can also be harmful for the investors (Kelly, Pruitt, and Su, 2019). In addition to this, there is reinvestment risk wherein the investors may face the risk of getting lesser cash flows when shifting between the products. The liquidity risk may also be faced due to the lock in period of the investments. In addition there is a possibility of the foreign investment risk, when the investments are made in the offshore markets. Further there are other types of risks such as shortfall risk, longevity risk and others.

Explanation of The Risk and Return Relationship Using the CAPM Model

One of the effective means to reduce the risk in the investment in the stocks is by diversification. It refers to a technique wherein the risk is reduced by allocating investments across different industries, financial instruments, and other categories. The aim of the diversification is to maximize returns by investing in different areas. In relation to the stocks, the investors must diversify in the different industry stocks so as to ensure that in the event of one particular industry getting affected, the overall holdings of the stocks are maintained for the investors. The investors are recommended to diversify among different asset classes as well apart from the industry diversification. This is because, the different assets such as bonds and stocks move in different manner in the case of adverse events. Thus, a portfolio comprised of different asset classes such as the stocks and bonds will lead to reduction in the sensitivity of the portfolio towards the market swings because the same tend to move in opposite directions (Mansor, Bhatti, and Ariff, 2015). Therefore, the result of the unpleasant movements in one stock or the asset class will be offset by the positive results in another. The impact of diversification in quantitative terms has been explained hereunder.

As evident from the example above, the diversification has led to the reduction in the overall portfolio beta as well as increased the overall portfolio return as compared to the individual investment in the company B stock (Guidi, and Ugur, 2014).

The Capital Asset Pricing Model (CAPM) describes the relationship between expected return of the assets, particularly the stocks and the systematic risk. The goal of the CAPM is to examine whether the stock’s current market price is representative of the fair valuation (Contractor, Lahiri, Elango, and Kundu, 2014). The said evaluation is done by the comparison of the expected return to the time value of money and the risk involved therein. Higher the risk in a security, owing to the industry factors as well as the overall market factors; the higher is the expectations of the shareholders to be compensated in the form of the higher returns. The formula for the cost of equity determination with the help of the CAPM, has been elaborated as follows (Camp, Tubbs, Fleisig, Dines, Dines, Altchek, and Dowling, 2017).

In determination of the cost of equity through CAPM, the start is done from the risk free rate. This is the rate of a treasury bond as issued by the regulators and do not have risks. There is done an addition of the premium as per the market risk. The said premium is adjusted as per the stock specific risk, as determined from the Beta. It is to be noted that when comparing the risk and returns of the stock, the Beta must be determined as per the historical returns of the market as well as the stock. A higher beta is evident of the fact that the stock has proportionately more risk as compared to the market returns. A lower beta signifies of the lower risk in the stock (Patel, Fernhaber, Covin, and Have, 2014).

Investing Styles

The investing styles depends on the investor`s focus that highlights passive investing, growth, indexing, diversification, buy and hold, market capitalisation, active investing, and value. An investor must first consider degree to which the company believes that financial experts that may create greater returns than the normal returns. Active investing style look if there is higher tolerance for the risks so that they can keep eye on market movements. Passive investing consider more risks averse and who do not wish to stare the market screens. Passive investors invest money with long term horizon rather than short term perspective (Kroencke, Schindler, and Schrimpf, 2014).

Growth investing style focus on company`s stock whose earnings are growing faster as compared to most of the stocks and they are expected to grow. Unlike the growth investors who have been seeking for overvalued securities, investors often look up to those shares, which are out of favour or undervalued. A buy and hold investing style is under passive investing where investor is engaged in hold and buy investing with trade in the portfolio less frequently. It is mainly concerned with overall long term growth. Popular form of passive investing is indexing where investor creates portfolio that reflect companies of stock index. This type of investing is good for people, which are risk averse due to diversification of index. The next type of investing style is that of the value investing. The said technique follows the hard rule of buying low and selling high. The term low here describes the lower value of stock as deemed by the investor in comparison to its rationale worth. The next style is income investing. In the said style, the investors look for steady dividend incomes in opposition to negative surprises, and hence such stocks are relatively more stable.

Diversification consider two types of risks, which each investor concerns such as systematic as well as unsystematic risks (Savrul, Incekara, and Sener, 2014). Systematic risks is the market risks, which cannot be diversified away and on the other hand, unsystematic risks come from the investing in any specific company. By diversifying the portfolio and then adding or replacing technological companies with the consumer goods where the overall risk level can be reduced. Market capitalisation considers those investors who select stocks regarding the size of company, which uses market capitalisation style showing as number of outstanding shares multiplied by EPS (earning per share). Broad market capitalisation categories incorporate the investing style as small cap, mid-cap, and large cap. Smaller cap stocks are considered as risky investments as compared to the large cap stocks which tend to remain stable.

A mutual fund is a type of investment security wherein the funds are pooled by the investors and invested into different securities such as shares, bonds and others. Such collective investments are segregated into small units, and each units is composed of all the features of the pool as a whole. The type of mutual fund has been classified based on several characteristics such as basis on asset class, based on structure, based on investment goals, based on risks, and specialised mutual funds.

On basis of asset class, it is seen that equity fund invest in stocks as they invest pooled money from several investors from different backgrounds in stocks and shares of varied company. Gains and losses has been associated with funds depending on how invested shares do perform. Debt fund invest mainly in fixed income securities especially treasury bills, fixed maturity plans, liquid fund, long term bonds, short term plans and also the monthly income plans. Money market funds consider investment in market securities such as bonds, certificate of deposits, dated securities, and T–bills. In this procedure, a fund manager invests money and then disburse regular dividends in return opting for short term plans. Hybrid funds is an optimum mix of funds thereby bridging gap between debt funds and equity funds (Arouri, Lahiani, and Nguyen, 2015).

Based on the structure, mutual funds are differentiated based on risks profile and also asset class. It include open ended funds, internal funds, and close ended funds that is quite broad depending on flexibility to purchase and sell individual mutual fund units. Interval funds traits are open for the redemption and purchase only during the particular intervals.  

Based on the interment goals, growth funds, income funds, tax saving funds, and liquid funds. Growth funds generally allocate considerable portion in growth sectors and shares that is suitable for the shareholders. The mutual funds are categorised on the basis of risk level, aggressive growth funds, capital protection funds, asset allocation funds, leverage funds, specialized mutual funds, commodity focused stock funds, and fixed maturity funds (Alessandri, and Seth, 2014). Following is presented an example of different funds.

Major advantage of investing in international market is diversification because international investing is vital for stock portfolio while adding it to the international stocks that may provide higher returns. Diversified portfolio will give investor options to finance alternatives source of stability.  International investing in quite popular where investment option available in current market. Three most famous international investment include mutual fund, American depositary receipts, and exchange traded funds (ETFs). Benefit of global investing leads to protection in against to fraud and the liquidations. Developed market organisation generally have stronger rules, which might ensure sound corporate governance. It protects investors from the potential scams and also insider trading. Within the UK economy, it is seen that UK politically uncertainties is weighted on the valuations, which may contribute to relatively higher possibility of avail attractive yield. Like international investing, it gives a portfolio safety in numbers in opposition to have assets being invested in a nation`s economy so as the currency differences from nation to nation. Several nations across world do have stronger currencies.

Disadvantages of international investing would include three prominent risks such as huge transaction costs, currency volatility, and political risks (Wang, and Tsai, 2014). One of the barrier in global market while investing is added transaction costs that may differ depending on foreign market where investor wish to invest in. For US market, Winvesta application offer zero commission brokerage that is cheaper as compared to domestic investment. Additional costs such as FX conversion charges, and annual maintenance, which one must know on the top of any brokerage commissions. Market volatility directly decreases diversification benefits by showing increased correlation in market volatility. While investing in foreign market, one will have to convert from US dollar to rupee at existing current exchange rate. It might hurt return that depends on ways the domestic currency has been moving.

Overall, international investments has become an integral need of hour in order to achieve stronger portfolio diversification. There is much data available online that is to measure risks and finally ensure the portfolio mix (Abdelsalam, Fethi, Matallín, and Ausina, 2014).

Conclusions

It has been concluded from the discussions conducted in the previous parts that it is imperative to define the investment goals before opting to invest in the securities market due to the different products available. Therefore, the risk and return capacity must be examined before opting for an investment.

References and Bibliography

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Alessandri, T.M. and Seth, A., 2014. The effects of managerial ownership on international and business diversification: Balancing incentives and risks. Strategic Management Journal, 35(13), pp.2064-2075.

Arouri, M.E.H., Lahiani, A. and Nguyen, D.K., 2015. World gold prices and stock returns in China: Insights for hedging and diversification strategies. Economic Modelling, 44, pp.273-282.

Camp, C.L., Tubbs, T.G., Fleisig, G.S., Dines, J.S., Dines, D.M., Altchek, D.W. and Dowling, B., 2017. The relationship of throwing arm mechanics and elbow varus torque: within-subject variation for professional baseball pitchers across 82,000 throws. The American journal of sports medicine, 45(13), pp.3030-3035.

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Cronqvist, H., Siegel, S. and Yu, F., 2015. Value versus growth investing: Why do different investors have different styles?. Journal of Financial Economics, 117(2), pp.333-349.

Emm, E.E. and Trevino, R.C., 2014. The changing risk-return characteristics of value and growth investing. Journal of Financial Planning, 27(11), pp.55-60.

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Kroencke, T.A., Schindler, F. and Schrimpf, A., 2014. International diversification benefits with foreign exchange investment styles. Review of Finance, 18(5), pp.1847-1883.

Mansor, F., Bhatti, M.I. and Ariff, M., 2015. New evidence on the impact of fees on mutual fund performance of two types of funds. Journal of International Financial Markets, Institutions and Money, 35, pp.102-115.

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