Portfolio management How a financial manager can exploit interrelationships between projects to adjust the risk-return characteristics of the whole enterprise Diversification theory; dont put all your eggs in one basket. Eliminate/reduce risk by selecting perfect negative correlation between two investments. The extent to which portfolio combination can achieve a reduction in risk depends on the degree of correlation between returns.
Attitudes to risk Risk-averse prefer less risk to more risk for a given return Moderately risk-averse Risk indifferent Investors would expect more return for increased risk
Two asset portfolio risk Step 1 Expected return The use of probability distribution on projected cash outcomes Given by the formula; n = piXi i=1 or ERp= ERA + (1-)ERB
Step 2 Standard deviation Risk of a portfolio expresses the extent to which the actual return may deviate from the expected return. Expressed by standard deviation or variance p= [ 2 2 +(1-)^2 ^2 + 2(1 )] Where; =the proportion of the portfolio invested in A (1-) =proportion invested in B 2 = the variance of the return on asset A 2 = the variance of the return on asset B cov AB=the covariance of the returns on A and B
Step 3 Covariance A statistical measure of the extent to which the fluctuations exhibited by two ore more variables are related Correlation coefficient is a measure of the interrelationship between random variables n rAB= cov AB covAB= [pi(RA ERA)(RB-ERB)] A X Bi=1
Example Information is available for two shares; B Ltd and G Ltd. The returns of shareholders have been calculated for the last five years. Calculate the mean (expected return), standard deviation and covariance. Year B Ltd G Ltd 1 26% 24% 2 20% 35% 3 22% 22% 4 23% 37% 5 29% 32%
Line ABC represents a feasible set of portfolios of asset P and Q As expected investment return increases, the additional subjective satisfaction of an investor declines at an increasing rate Rate of decline is dependent upon the attitude toward risk of the individual investor
Benefits of diversification Reduces variability of portfolio returns Reduction in risk which comes with the increase in number of different shares in the portfolio Specific risk- unsystematic risk or diversifiable risk that is unique to a company Market risk-systematic risk or non-diversifiable risk e.g. changes in economic climate determined by inflation, interest rates and foreign exchange rates