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Paper Topic:

Portfolio Analysis

Portfolio Analysis

PART 1

The high volatility of contemporary markets has alerted investors to the need to address risks inherent in the financial system . One can suppose that investors after suffering serious problems with their investments have grown to be more risk-averse than in the past and want to take fewer risks with their investment . However , the old notion of risk-return tradeoff embodied in the portfolio theory remains as ever important and will affect investment outcomes and decisions

The basic idea is that investors , being rational , will seek maximum return

with the lowest possible risk . In practice , this may be illustrated with someone choosing mutual funds based on the correlation between their standard deviation (showing risk ) and annualised returns It may be tempting to put money in new industry just developing , for instance , but someone willing to make such an investment should always remember that such markets are volatile and can exhibit sharp swings . It makes sense in this respect to remember the tech bubble that appeared when everybody put funds in companies that seemed to bring sizzling returns - only to see the value of their stocks plunge later on

Today , investors have become more cautious and want to guard their investments with more prudence . In this light , the theory of investment known as modern portfolio theory comes to the forefront . Under this theory , if one plots all possible asset portfolios in risk-return space there will be in this space a line known as the efficient frontier , and combinations along this line represent portfolios for which there is lowest risk for a given level of return (Wikipedia . Thus , an investor who has defined his or her degree of risk will have an opportunity to find the best possible combination of assets on the frontier for this level of risk

Rational investors , therefore , will hold only portfolios that are located on the frontier , given the fact that their level of risk is offset by the best return . Every other portfolio composed of risky assets is inferior to the one on the frontier in terms of risk-return trade-off . Adding leverage to the portfolio is possible only with the addition of a risk-free asset . As a result , by combining a risk-free asset with risky assets , it is possible to construct portfolios whose risk-return pros are superior to those on the efficient frontier (Wikipedia . Changing optimal weightings of risk-free asset and risky portfolio , the investors can manipulate risk and return

Selecting their investments wisely , investors can strive to diversify away the specific risk associated with a given asset . This is possible through diversification into different asset classes and assets . In contrast , there exists systematic risk , or market risk , [that] refers to the risk common to all securities . systematic risk cannot be diversified away (within one market (Wikipedia . The need to reduce or eliminate specific risk explains the advantages of diversification that addresses this issue . In any case , a rational investor will choose an optimal portfolio that reduces risks and maximizes returns

PART 2

According to investopedia .com , holding period return /yield is calculated as income plus price appreciation during a specified time period , divided by the cost of the investment . Thus

Holding period return income appreciation / cost of the investment

In this case income is equal to dividend payments on the stock or interest , in the case of the bond . Appreciation is taken to be the difference between the purchase price and the sales price

Therefore , for the bond

Holding period return 19 ,500- 20 ,000 2 ,100 20 ,000 0 .08 , or 8

However , this return was earned in only two days , in the period between May 10 , 2005 , and May 2005 . To calculate the annualized return , we need to divide the given return by 2 and multiply by 365 , assuming that there are on average 365 days in a year

(0 .08 /2 365 14 .6 , or 1460

For common stock

Holding period return 86 ,456- 106 ,000 456 .00 106 ,000 -0 .18 , or -18

The annualized return on the common stock will be

(-0 .18 /367 365 -0 .179 , or -17 .9

For the mutual fund

Holding period return 8 ,100- 8 ,000 1 ,000 654 .00 8 ,000 0 .22 or 22

This return is already annualised because the investment is said to have been held for one year

PART 3

While there are perhaps investors willing to gamble their whole fortune on a single stock , there are many more who gamble on a smaller size investing about 50 or more in single asset . For instance , Cosgrove (2006 ) reports that according to David Wray , president of the Profit Sharing /401 (k ) Council of America in Chicago , in 2004 , the combined defined contribution holdings of workers at 1 in 8 companies was more than 50 percent in company stock . This shows that many investors have ignored Enron lessons and continue to hold their investments in the company stocks , endangering their portfolio

The high concentration of the portfolio in one asset class or asset is especially dangerous to those approaching retirement and making investments out of their pension accounts . By the time of their retirement , they have perhaps accumulated significant amount of funds that they will be willing to have available at retirement . On the contrary , younger workers for whom the retirement age is still far ahead will be less affected by the sharp drop in the value of their investments and might want to take more risks with less diversification . References

Cosgrove , S (2006 , March 26 . 401 (k ) investors ignore Enron 's painful lesson : Many have invested more than 50 of portfolio in employer 's stock , putting nest egg at risk . Baltimore Sun . Retrieved March 31 2006 , from http /www .baltimoresun .com /business /investing /bal-bz .stock26mar26 ,0 ,700 6912 .story ?coll bal-business-headlines

Investopedia (n .d . Holding Period Return /Yield . Retrieved March 31 2006 , from http /www .investopedia .com /terms /h /holdingperiodreturn-yield .asp

Wikipedia (2006 , March 28 . Modern Portfolio Theory . Retrieved March 31 , 2006 , from http /en .wikipedia .org /wiki /Portfolio_theory

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PORTFOLIO ANALYSIS

31 March 2006 ...

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