RISK AND RETURN OF THE PORTFOLIO - Accounts and Finance for Managers

  • Portfolio is the Combination of two or more assets or investments.
  • Portfolio Expected Return is the weighted average of the expected returns of the securities or assets in the portfolio.
  • Weights are the Proportion of total funds in each security which form the portfolio
  • Wj Kj.
  • Wj = funds proportion invested in the security.
  • Kj = expected return for security J.
  • The risk of the portfolio could be determined what it was in the process of individual assets?
  • Benefits of portfolio holdings are bearing certain benefits to single assets.
  • Including the various type of industry securities - Diversification of assets.
  • The portfolio construction leads to bring down the risk of the portfolio than the risk of single assets.
  • It is not the simple weighted average of individual security.
  • Risk is studied through the correlation/co-variance of the constituting assets of the portfolio. The Correlation among the securities should be relatively considered to maximize the return at the given level of risk or to minimize the risk. Correlation of the expected returns of the constituent securities in the portfolio.
  • It is a Statistical expression which reveals the securities earning pattern in the portfolio as together.
  • Positive correlation means that Return of the securities in the portfolio are moving together in same direction.
  • Negative correlation which illustrates that the Return of the securities are moving in opposite direction.
  • Zero correlation reveals that there is - No relationship in between the earnings pattern among the securities of the portfolio.
  • The Co-efficient of correlation normally ranges in between –1 and +1.

Diversification of the Risk of Portfolio

Diversification of the portfolio can be done through the selection of the securities which have negative correlation among them which formed the portfolio. The return of the risky and riskless assets are only having the possibilities to bring down the risk of the portfolio.

The following example will certainly facilitate to understand the diversification process of the securities in the portfolio through the correlation co efficient of the returns of the securities which formed the portfolio:

Diversification of the Risk of Portfolio

The above table reveals that Portfolio AB is the better one to diversify the risk as minimum as possible, the reason is that the returns of the respective securities are having negative correlation among A&B unlike A &C. The negative correlation of the returns between the A&B only facilitated to reduce the risk to the levels of minimum.

The risk of the portfolio cannot be simply reduced by way adopting the principle of correlation of returns among the securities in the portfolio. To reduce the risk of the portfolio, the another classification of the risk has to be studied, which are as follows:
The risk can be further classified into two categories viz Systematic and Unsystematic risk of the securities

Systematic Risk - which cannot be controlled due to market influences which is known as Uncontrollable risk, cannot be avoided
Unsystematic Risk-Which can be minimized or reduced this type of risk through diversification of the securities in the portfolio

  • Systematic Risk- Unavoidable, Uncontrollable risk - finally Market risk War, inflation, political developments
  • Unsystematic Risk- Avoidable, Controllable risk. Strike, Lock out, Regulation

Systematic Risk: Which only requires the investors to expect additional return / compensation to bear the

Unsystematic Risk: The investors are not given any such additional compensation to bear unlike the earlier.

The relationship could be obviously understood through the study of Capital Asset Pricing Model (CAPM).

  • Developed by William F. Sharpe
  • Explains the relationship in between the risk and expected / required return
  • Behaviour of the security prices
  • Extends the mechanism to assess the dominance of a security on the total risk and return of a portfolio
  • Highlights the importance of bearing risk through some premium
  • Efficiency of the markets
    • Investors are well informed
    • No transaction costs - No intermediation cost during the transaction
    • No single investor is to influence the market Risk and Return
  • Investor preferences
    • Highest return for given level of risk Or
    • Lowest risk for a given level of return
    • Risk - Expected value, standard deviation

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