PORTFOLIO INVESTMENT.

Uncertainty vs Risk - a distinction is usually made between the two terms;Uncertainty is defined as the situation where various cash flow patterns are possible but probabilistic information is absent or at least incomplete. Risk, however is defined as a situation where the parameters of the probability distribution of outcomes are known, ie normally distributed about a mean average return. RETURN - The return from holding an investment (share) over some period of time (more than a year), is simply any cash payments received due to ownership (dividends), plus the change in the market price (capital gains), divided by the original purchase price (to give a %);Return = ie;(dividends paid) + (ending price - begining price) begining price

100 1

R = Dt + ( Pt - Pt-1 ) Pt-1

100
1

Research shows that investors in financial securities demand higher returns from risky investments in equities than from comparatively riskfree government securities. Investors rarely place their entire wealth into a single asset or investment. Rather, they construct a portfolio, (a combination of two or more securities or assets), of investments. When we begin with a single stock, the risk of the portfolio is the standard deviation of that one investment. As the number of randomly selected stocks held in the portfolio is increased, the total risk of the portfolio is reduced. Such a reduction is at a decreasing rate however. Thus, a substantial proportion of the portfolio risk can be eliminated with a relatively moderate amount of diversification, usually with 15 to 20 randomly selected stocks.

standard deviation of portfolio return

Unsystematic risk Total risk Systematic risk 15/20 Number of Securities in Portfolio. Systematic (Market) Risk - Risk due to factors that affect the overall market, such as changes in the nations economy, tax changes by the government, changes in the worlds energy situation, etc. These are risks that affect securities overall, consequently, they cannot be diversified away. Unsystematic (Unique) Risk - Risk unique to a particular company or industry, (ie. it is independent of economic, political, etc. factors which affect all securities in a systematic manner), typically involving - strikes at one company, increased competition in the market, etc. This type of risk can be reduced and even eliminated if diversification is efficient. TOTAL RISK = SYSTEMATIC RISK + UNSYSTEMATIC RISK (non-diversifiable) (diversifiable) If the unsystematic (unique) risk can be diversified away through increasing the portfolio assets, then the only risk left is the systematic (market) risk. In this situation, individual risky assets will be priced by reference to their relationship to the market generally, ie. on the basis of their market risk alone. Therefore, it is the covariance of the individual securities with the market which is now the appropriate measure of risk. This measure of risk is called BETA and is represented by the Greek symbol .

BETA ( ) - An index of systematic risk. It measures the sensitivity of a stocks returns to changes in the returns on the market portfolio. The beta of a portfolio is simply a weighted average of the individual stock betas in the portfolio.

Excess return On stock +ve

>1

(aggressive)
=1

<1

(defensive)

-ve

+ve excess return on market portfolio

-ve

Capital Asset Pricing Model (CAPM) - In market equilibrium, a security is supposed to provide an expected return commensurate with its systematic risk. The greater the systematic risk of a security, the greater the return that investors will expect from that security. The relationship between the expected return and the systematic risk, (and the valuation of the securities that follows), is the essence of the CAPM. This model states that the required return on an asset (j) is;Rj = Rf + Where;j j

( Rm Rf ).

= the beta coefficient for the risky (j) asset. Rf = the return on risk free (Government Stocks) investments. Rm= the expected return on the market portfolio.

The Security Market Line - Describes the relationship between an individual securitys required return and its systematic risk, as measured by beta;Security market line Expected Return Risk premium Rm Rf

Risk-free return 0 1.0 Systematic Risk (BETA) Returns and Stock Prices - The Capital Asset Pricing Model provides a means by which to estimate the expected rate of return on a security. This return can then be used as the discount rate in a dividend-valuation model. The intrinsic value of a stock can be expressed as the present value of the stream of expected future dividends;t= t= 1

V =

Dt
t

(1+ Ke)

Where;-

Dt Ke

= the expected dividend in period t. = the expected rate of return for the stock.

If however, it is believed that there will be a perpetual increase (growth) in the future dividends, the above model can be modified to a more common (and simpler) form;-

V =

D1 Ke - g

Where;-

V = value of the stock. D 1 = the expected rate of return in period 1. Ke = the expected rate of return for the stock. g = the expected future growth in dividends per share.

SUMMARY;1) Rj = 2) V = Rf +
D1 Ke - g

(Rm Rf).

(NOTE:- For all practical purposes the Required Rate of Return is the same as the Expected Rate of Return, ie.- Rj = Ke.)