IntroductionWhen people invest in stocks, it is usually in a number of different stocks. People typically invest their wealth in a portfolio of assets. The portfolio approach to investment is linked to an investment and risk strategy. By owning multiple assets, certain types of risk can be reduced. Constructing a portfolio requires a thorough selection process involving deciding which types of assets and the quantity these assets to purchase, and more importantly at what time to purchase. This selection process is based on performance measurement techniques analyzing an asset or portfolio’s financial variables and statistics (i. e.
return, std-dev, beta etc). The optimum portfolio chosen will ultimately depend on individual investor choice. Nevertheless it is assumed that most investors are rational and risk-averse to differing degrees. Background TheoryRiskRisk it the probability of earning less than expected return which can be identified by the variability of return to the asset which can measured by the standard deviation. Research has shown that most of the benefits of diversification, in term of risk reduction, can be gained by forming portfolio containing 15 to 20 randomly added assets. Types or riskUnsystematic risk or diversifiable risk: this risk is firm specific risk and can be eliminated by adding more securities in a portfolio to diversify away the risk in the portfolio. Systematic risk or non-diversifiable risk: the associated risk relate to those factors influence the whole market such as war, inflation, exchange rate.
The fact that it is non-diversifiable it is considered the only relevant risk for an investor. Std. Deviation (Total Risk) Unsystematic Risk (Unique Systematic Risk (Market) No. of SecuritiesThe risk in a portfolio consisting of one asset can be measured by variance which measures how much is the dispersion of return from the mean.
However, correlation is what is important in a portfolio which is made up of multiple assets. The optimum portfolio is in the end based on the risk tolerance of that investor. Covariance and CorrelationCovariance describes the relationship between two variables statistically. A positive covariance means that asset returns move together. Negative covariance suggests that the returns move inversely. The correlation coefficient is a measure that determines the degree to which two variable's movements are associated.
The correlation is equal to the covariance divided by the product of the asset’s standard deviations. All of Our ten stocks have positive covariance. This means when market index (all ordinaries) increase by 1, those share will also increase by the ‘covariance amount’. BetaBeta measures the volatility of the security, relative to the asset class. The CAPM equation Er = Rf + b(Rm – Rf) is implies that investors require higher levels of expected return to compensate them for higher levels of expected risk. Beta indicates the linear regression of the return of portfolio and the return of the market.
The Beta of the market is 1 which is the slope in the regression line indicating the sensitivity of a security to the market. It takes both negative and positive values and zero meaning no correlation between the return on the market compared to the return of the portfolio. A positive value of beta means the increase in the return on the market will reflect an increase on the return of the portfolio, the return of the portfolio of negative value will perform better in recession like state.