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