CASE STUDY 13-6 Page

no.-544
Spreading Risks in the Choice of a Portfolio
Submitted By:- Sumita Kapoor (FMG19 B-191117)
The basics of investing are 'Think long with your equity portfolio' and 'spread risk according to
your risk appetite’. The portfolio can be divided into short-term and long-term and the right mix of
products for both periods can be chosen.

A series of model portfolios have been created as follows:

These portfolios vary from one with 90% in bonds (P90) to a portfolio with 20% in bonds (P20),
and a range of allocations in between. There are two portfolios with 40% in bonds (P40-1 and P40-
2) that have different allocations to the various equity classes. The average annual return and risk
define the range of risk and return that are available from well-diversified portfolios of these asset

classes:
When these risk/return pairs are plotted on a graph, we get the curved shape that is characteristic
of what is called the efficient frontier. Each point on the graph represents one of the return model
portfolios.

—Risk indifference curve

—Frontier
P70-risk return indifference
curve is tangent to frontier

From the graph, Portfolio P70 generates more return with less risk than P90. This shows the basic
power of diversification: you get more return for a given level of risk by mixing asset classes with
low correlation to one another. P70 is expected to generate 1.3% per year in additional return,
with less risk, than P90.

Every investor wants to get the most return for the risk that he/she takes on. The theory of asset
allocation suggests that investors will want to include allocations to domestic equities, foreign
equities, bonds, commodities, and real estate (at a minimum) to get a well-diversified portfolio
that delivers the most return for a given level of risk. While diversification is a prerequisite, divide
your portfolio according to your risk appetite and investment horizon for the portfolio.
Sources: Eugene F. Brigham, Michael C. Ehrhardt, Financial management: theory and practice;
“Diversified portfolio cuts risk” Economic Times (25 Oct 2009); “Risk appetite dictates portfolio
mix” Economic Times (7 Dec 200); “It pays to spread your bets on commodities” Economic Times
(3 Mar 2010); http://seekingalpha.com/article/78116-choosing-your-portfolio-risk-tolerance