Offer investors the highest expected rate of return - Free Essay Example

INTRODUCTION The main aim of this case is to find the portfolio that will offer investors the highest expected rate of return for any degree of risk they are willing to tolerate. Extra returns are needed by the investors for taken a higher level of risk and covariance measures the process in which the returns of two securities vary with each other. Sandra is a new investor; she needs the basic idea on risk-return tradeoff and on portfolio management from Bolton in order to make the right investment. When investors are considering investing in a security market, the problem they face is deciding how much to invest or hold and choosing the best security which depends on the characteristic of risk-return of different individual securities. RELATIONSHIP BETWEEN RISK AND RETURN People invest their money in order to have good income which will help them in the future; this investment involves risk and return. The risk and return are the process through which investors makes decision. The inv estment return is the compensation given to investors for the time spends waiting and the worries based on the risk of an asset invested. (Brealey,Myers Marcus, 2009,p.317). Investors uses the historical record to measure the current opportunity cost of capital which is the return that shareholders gives up for investing in a project and probability is used to estimate the possible situation which will occur within the period of investment. (Roses,Westerfield Jordan,1998,p.367). In appendix A, the risk premium serves as the compensation to investors for investing on that particular asset. When comparing individually, the utility-company is the best decision based on their coefficient-variation since it has the lowest value in units i.e. having 2.65% of risk, 9.7% of return and 0.27 of coefficient-variation. Then High-tech-company has 21.91% of risk, 10% of return and 2.19 of coefficient-variation. Counter-cyclical-company has 12.07% of risk, 5% of return and 2.41 of coeffici ent-variation. Therefore expected return depend on the risk involved and Investors uses the past record to estimates the future using the method of arithmetic average, variance, standard deviation since he assume that the future will be like the past. A good investor needs to choose a project which has higher return and lower risk but when its difficult to decide between two asset, then coefficient-variation may help. HOW BETA RELATES TO REQUIRED RETURN Pls draw another chart of beta in your tutorial paper at the back. figure1 Any potential investor that wants to get good return with better risk when investing on a market portfolio should able to understand the meaning of beta because it measures systematic asset or non-diversifiable risk in order to get a high return. Beta is the sensitivity of the return of stock over the variety in market portfolio return. (Brealey, Myers Marcus 2009,p.340). It is the measure of risk on the portfolio of an individual stock a nd it account for both stocks for standard deviation and correlation among other securities available in the market.(levy Alderson,1998,p.307). The market risk premium depends completely on the beta in order to get assets risk premium. Therefore beta is an important determinant of an asset expected return in order to eliminate a systematic risk which cannot be diversified. An average beta is 1.0, risk free rate is 0. Aggressive-stock shows that its riskier than the market portfolio but provides larger gain while Defensive-stock shows that stock will fluctuate less than the market which is relatively safer but provides lesser gain. Also based on the calculation in appendix C, the beta for the individual asset are Utility-company is 0.529, High-Tech-company is 0.207 and counter-cyclical-company is -0.356 showing that all the individual asset are on defensive-stock. The formula is Beta j = Covariance mj / rm. The company with the highest risk is Utility-company and the lowest ri sk is Counter-cyclical-company. Composite index is preferred more than index fund because is a standardized combined indexes which provides useful measures statistically in overall market performance. Also the expected return is more than the index fund and the chances of risk is very low compared with index fund as shown in appendix B, i.e. having return of 18.70% and risk of 4.96% while index fund has only 8.40% of return and 10.72% of risk. WHY WE HAVE TO DIVERSIFY OUR INVESTMENT Since investors cannot be able to reduce their risk and return of two assets based on each scenario performance then it is better to diversify in-order to balance the risk and return of any two assets. Diversification is a principle designed which reduces the variability of risk by spreading the market portfolio across many investment.( Brealey,Myers Marcus 2009,p.323). Its the distribution of investors saving among different securities and it reduces investors overall risk of their holding either as losses in one investment or partial profit attained in another investment. (Lee, Finnerty Norton,1997,p.39). Therefore diversification is the spread of risk and return of two or more assets with different characteristics. In the calculation shown in appendix D, the right choice is Utility-company which its risk is 2.65% and return is 9.70% while the risk for Counter-cyclical-company is 12.07 and its return is 5% but needs to be diversified in order to balance the scenario performance of both companies. Diversification is applied by Investing 75% in utility-company and 25% in Counter-cyclical-company which gives a portfolio return of 8.53% and 1.41% of risk. The portfolio risk of a stock depends on whether the return tends to vary or against the return of other portfolio asset. Not to put all eggs in one basket. Sandra diversify primary to reduce unnecessary risk in order to maximize the present-value of her lifetime consumption and diversification reduces risk by de creasing the amount of uncertainty of return without reducing expected return. The Possible situation which can affect the stock price may be as a result of macroeconomic factors. DETERMINING UNDERVALUE AND OVERVALUE FROM SECURITY MARKET LINE Figure2 Any investors who those not want to lose his or her investment in the market suppose to understand what SML means in order to make the right decision. Security market line shows the standard for investing different fractions of market fund based on the risk and expected return.(Brealey,Myers and Marcus,2009,p.349). SML signify or establish a linear relationship between beta and the expected return for all the assets.(Levy and Alderson,1998,p.319). In figure2 above calculated in appendix C, the individual stock at Beta 0.529 offers 12.24% expected rate of return, risk free rate of 5% and market risk premium of 13.7%. No investor will buy when the stock offered a lower rate of return. The price will drop if nobody decides t o hold the stock which is a better buy for investors. This will lead to a higher rate of return and the expected return will move to 12.24%, therefore at this point the capital assets pricing model holds at the expected return and the price. The Utility-company is overvalue because is below the SML line while High-tech-company and Counter-cyclical-company is undervalue because is above the SML. The Capital Asset Pricing Model helps to show that the expected rate of return of all securities and portfolio lie on security market line and also expected rate of returns depend completely on the beta. The CAPM is graphically represented by SML. EFFECTS OF INTEREST RATE IN A DIVERFISIFIED PORTFOLIO Investors needs to know what it means when the rate is high or low and focusing very well in the interest rate movement in order to make reasonable decision. Capital Asset Pricing Model is described as the relationship between return and risk which states that the expected risk premiu m on security is equals to its beta times the market risk premium.(Brealey, Myers Marcus,2009,p.348). It explains the exact linear equilibrium relationship between the beta and the expected rate of return of individual assets and portfolios. (Levy Alderson,1998, p.322) Based on the definition of diversification explained previously, if Sandra choose a well diversified portfolio, these will be as a result of when the stock more than 12.24%, then diversified investors will like to buy more of that stock which will automatically increase the price and the expected return will decrease until it is at the level of CAPM. CAPM is a recognized instrument or techniques which help to adjust risk discount rate through the analysis of portfolio i.e. risk are measured in beta factors and these measures the sensitivity of its return on a quoted shares based on the market movement as a whole. INVESTING ON FIXED-INCOME SECURITY Any Potential investor like Sandra who those not know whe n the investment is defensive or aggressive should better put her money bank on a fixed income security. A project NPV or cost of capital is the amount which is expected to multiply the wealth of current shareholders of a firm and the rules is that if the proposed projects NPV is positive, then invest but if not dont invest. (BodieMerton,2000,p.168). The project cost of capital is the acceptable minimum expected rate of return on a project with its risk given. (Brealey, Myers Marcus,2009,p.357). If Sandra prefers to put all her money in fixed income securities, then the cash-flow of the project needs to be calculated. If for example the future interest rate of return is 18%, risk free offers a return of 5% and expected market risk premium is 13.7% with zero beta: r=rf+B(rm-rf), = 5+(0x13.7)= 5%, then since the expected return is 18% while the cost of capital is 5%, Sandra should go ahead but if compared with the exact project return of 18.7% company cost of capital, then th e project is not worthwhile. Furthermore, in the cost of capital, if the market portfolio has the same risk with the project and the beta is 1.0, it means that its still worth investing on even though the project appearance is less attractive. GROWTH RATE A HOT TIPS FOR UNDERVALUE STOCK A hot tip is an important idea given to new investors like sandra in order to monitor its investment knowing whether it is in the right track or not. Growth stock: when firm stock are repurchased, the stock are considered to be undervalued, which means that the market is less than the present value of future stock expected cash-flow and this decision is concluded when management uses Present Value evaluation models. (Levy Alderson,1998,p.478). When the future investment opportunities which are expected to yield a rate of return is greater than the required risk adjusted rate of the market.( Bodie Merton,2000,p.242). Investors buy growth stock and income stock expecting to have capital gain s and cash dividends in the future.(Brealey, Myers Marcus,2009,p.201) Therefore hot tips regarding undervalue stock is an identified movement of stock growth knowing up-to-date and valuable information on when to buy stock which guarantees successful trading on the stock market. This superior knowledge and strategy makes investors like Sandra to have confidence, secure and buy right stock at the right time with excellent return not minding what the market will be in the future. DIVERSIFYING EQUALLY IN THE STOCK OF TWO COMPANIES Diversifying equally in the companies is a good choice for Sandra so as to balance her risk and return between the companies which can sometimes eliminate risk completely. the calculation shown in Appendix E, it explains that High-tech-company has higher return of 10%, higher risk of 21.91% and beta of 0.207 while counter-cyclical-company has lower return of 5%, lower risk of 12.07% and beta of -0.356, this is difficult to choose without beta but using the beta method will now help Sandra to make the right decision. When Sandra invests her money equally on the two companies through diversification then the expected return will be 7.50% and the risk will be 6.63%, these shows that when two companies are joined together, the volatility will decrease as a result of the performance in each scenario. Finally, the inverse relationship between the two companys return mean that adding Counter-cyclical-company in all the High-tech-company stabilizes the portfolio returns. The Counter-cyclical-company reduced the return performance of the High-tech-company but improving the worst-case return. Therefore every investor cares about its risk and expected return of their portfolio assets. INVESTING 70%:30% IN A DIVERSIFIED PORTFOLIO An investor that invested with index-fund with 70:30 is also a good choice except that the risk is very high compared with 50:50 above. Index fund is an investment collective scheme or rules set which is held constant not minding the movement of the market. it is usually an exchange trade-fund or mutual fund constructed with a portfolio to track the market index components. The calculation shown in appendix F, explains that High-tech-company has return of 10% and risk of 21.91% while index fund has return of 8.4% and risk of 10.72%. To stabilize the risk, the two components will be combined through diversification using 70:30 respectively for High-tech-company and index fund and the result shows a return of 9.52% and risk of 18.54%. This combination of 70%:30% is good but using 30%:70% is much better as shown in appendix G. The returns will be 8.88% and risk is 14.06. The reason is because the different between 70%:30% and 30%:70% for High-tech-company and index fund is that, the return difference is only 0.64 but the risk is reduced more with 4.48. also investing more on index fund is much better based on the definition explained above and also when measuring the amount of risk per unit of return, 70%:30% gives 1.95 but 30%:70% gives 1.58. BEST SUGGESTION ON DIVERSIFIED PORTFOLIO The possible portfolio combination for Sandra that is more better than 30%70% in High-tech-company and index fund is investing 10%:90% as shown in Appendix H, because when measured per unit of risk over the return it will be 1.38 even though the return is still reduced to 8.56% but the risk is also reduced more by 11.83%. If Sandra choose this diversified portfolio its a good choice since it is the principal key relies mainly on statistical approximations in order to stabilize any chances of risk and return in her investment, no matter the fluctuation in the market or economic crisis around the globe. CONCLUSION Any comprehensive collection of risk measures should capture the following characteristic of the entire financial system which includes leverage, liquidity, correlation, concentration, sensitivity and connectedness. Therefore weather a particula r stock moves up or down is not that important to investors but what is important is the return and risk of that portfolio stock. Also using beta to estimate a systematic risk which cannot be diversified or better still invest fully in a fixed market income. Risk aversion explains that high security risk result to low price and high required return.