# Risk And Return Part II

**Topics:**Capital asset pricing model, Modern portfolio theory, Financial markets

**Pages:**28 (1270 words)

**Published:**March 22, 2015

PGDM/MMS- SEM-II

PROF. V. RAMACHANDRAN

FACULTY- SIESCOMS , NERUL

1

PORTFOLIOS & RISK

What is an Investment Portfolio

A group of Assets that is owned by an

Investor

Single Security is riskier than Investing in a

Portfolio.

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.

2

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

3

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

stocks.

4

Diversification –Risk Reduction

5

Standard Deviation - Computation

6

Standard Deviation - Computation

7

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.

8

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.

9

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

10

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.

11

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.

12

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

Diversification

13

Diversifiable & Non Diversifiable Risk

Diversifiable Risk

That part of the Total Risk that is specific to the

company or Industry...

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