Risk And Return Part II

Topics: Capital asset pricing model, Modern portfolio theory, Financial markets Pages: 28 (1270 words) Published: March 22, 2015
Risk and Return -II



 What is an Investment Portfolio
 A group of Assets that is owned by an
 Single Security is riskier than Investing in a

 Portfolio may contain- Equity Capital, Bonds ,
Real Estate, Savings Accounts, Bullion,
Collectibles etc.
 In other words the Investor does not put all
his eggs in to one Basket.


Diversification –Risk Reduction
 Let us assume you put your money equally into the

stocks of two companies Banlight Limited, a
manufacturer of sunglasses and Varsha Limited, a
manufacturer of rain coats.
 If the monsoons are above average in a particular
year, the earnings of Varsha Limited would be up
leading to an increase in its share price and
returns to shareholders.
 On the other hand, the earnings of Banlight would
be on the decline, leading to a corresponding decline
in the share prices and investor's returns.
 If there is a prolonged summer the situation would
be just the opposite.

Diversification –Risk Reduction
 While the return on each individual stock might

vary quite a bit depending on the weather but the
return on your portfolio (50% Banlight and 50%
Varsha stocks) could be quite stable because the
decline in one will be offset by the increase in the
other. In fact, at least in theory, the offsetting could
eliminate your risk entirely.
 The table below gives the returns on the two stocks
on the assumption that rainy, normal and sunny
weather are equally likely events (l/3 probability
each). Let us calculate the expected return and
standard deviation of the two stocks individually and
of the portfolio of 50% Banlight and 50% Varsha

Diversification –Risk Reduction


Standard Deviation - Computation


Standard Deviation - Computation


Diversification –Risk Reduction

 Where

VAR(k) is Variance of returns.
 Pi is Probability associated with ith possible item.

Ki is rate of return from ith possible outcome.

K is expected rate of return.
 N is the number of years.


Diversification –Risk Reduction

 The portfolio earns 10% no matter what the

weather is. Hence through diversification, two
risky stocks have been combined to make a
riskless portfolio as is evidenced by the
standard deviation of the portfolio.


PORTFOLIOS -Relationship
 Perfectly Positively correlated

When two stocks go up or down together
exactly in the same manner they are said to
be perfectly positively correlated

 Perfectly Negatively correlated
 When two stocks go up or down together
exactly in the opposite manner they are
said to be perfectly negatively correlated

PORTFOLIOS -Relationship
 In reality the above relationship

between stocks does not exist
 In general all stocks have some
degree of positive correlation due to
variables like
Economic factors
 Political climate
 Changes in tax rates
 Industrial recession etc.


PORTFOLIOS -Relationship
 The Finance Manager’s attempt is to

maximize the Market value of portfolio with
minimum risk.

 The relationship of assets in a portfolio helps

the investor to achieve reduction of Risk
through Diversification

 As long as the assets of a portfolio are not

perfectly positively correlated Diversification
does result in reduction of risk.

Diversifiable & Non Diversifiable Risk
 The amount of risk reduction depends on

the degree of Negative Correlation
between stocks in the portfolio
 The higher the degree of Negative
Correlation the greater is the amount of risk
reduction is possible
 In practice Risk can never be reduced to
zero as there is limit of reduction through

Diversifiable & Non Diversifiable Risk
 Diversifiable Risk

That part of the Total Risk that is specific to the
company or Industry...
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