Handout – 03

Programme : Bachelor of Commerce (Special) Degree

Fourth Examination in Commerce – 2008/2009
2nd Semester
Course Title : Investment and Portfolio Management
Course Code : BCOM 42542
Course Status : Elective
Handout Title : Investment Diversification and Portfolio Analysis
Prepared By : B.Prahalathan, Dept.of Commerce & Financial Management
Issue Date : 12th June 2010

Learning Objectives:
• define portfolio theory and portfolio
• calculate portfolio expected rate of return and portfolio risk
• understand the impact of covariance or correlation on portfolio risk
• find optimum portfolio

Introduction
Individual securities have risk return characteristics of their own. The future return expected from a
security is variable and this variability of returns is termed risk. It is rare to find investors investing
their entire wealth in a single security. This is because most investors have an aversion to risk. It is
hoped that if money is invested in several securities simultaneously, the loss in one will be
compensated by the gain in others. Thus, holding more than one security at a time is an attempt to
spread and minimise risk by not putting all our eggs in one basket.

Portfolio Theory
The portfolio theory provides an normative approach to the investors’ decision to invest in an asset
or securities under risk. It is based on the assumption that investors are risk – averse.

Portfolio
A portfolio is a combination of individual assets or securities. The process of creating such a
portfolio is called diversification. If the investor holds a well diversified portfolio, then his concern
should be the expected return and risk of the portfolio rather than individual asset or securities.

Portfolio Return/Expected Return of a Portfolio

(Two Asset Case)
The return of portfolio is equal to the weighted average of returns of individual assets (securities) in
the portfolio with weight being equal to the proportion of investment of investment in each asset.
Expected return on portfolio will depend on the percentage of wealth invested in each asset.
Formula:

Portfolio Risk
Risk of a portfolio could be measured in terms of its variance or standard deviation. However, the
variances or standard deviation of a portfolio is not simply the weighted average of variances or
standard deviation of individual securities.
The risk for a two security portfolio is measured by the standard deviation of the portfolio returns.
Formula:
The amount of risk reduction achieved through diversification. It depends on the degree of
correlation between the returns of the individual securities in the portfolio.

Reduction of Portfolio Risk through Diversification

The process of combining securities in a portfolio is known as diversification. The aim of
diversification is to reduce total risk without sacrificing portfolio return. To understand the
mechanism and power of diversification, it is necessary to consider the impact of covariance or
correlation on portfolio risk more closely.

Covariance
Covariance of the two securities measures their co-movement of their returns.

Coefficient Correlation
Correlation coefficient measures the degree of relationship between two variables. The
correlation coefficient will always lie between + 1.0 and – 1.0.

Security Returns Perfectly Positively Correlated

When security returns are perfectly positively correlated, the correlation coefficient between
the two securities will be +1. The returns of the two securities then move up or down
together. Here diversification is not a productive activity when security returns are perfectly
positively correlated.

Security Returns Perfectly Negatively Correlated

When security returns are perfectly negatively correlated, the correlation coefficient between
them becomes -1. The two returns always move in exactly opposite direction. The portfolio
may become entirely risk free when security returns are perfectly negatively correlated.
Hence, diversification becomes a highly productive activity when perfectly negatively
correlated.

Security Returns Uncorrelated

When security returns are entirely uncorrelated, the correlation coefficient would be zero.
When security returns are uncorrelated, diversification reduces risk and is productive activity.
Formula:

Optimum Portfolio OR Minimum Variance Portfolio

A portfolio that has the lowest level of variance (risk) is referred to as optimal portfolio. A risk -
averse investor will have a trade – off between risk and return. The following formula can be used to
estimate optimal weights of securities. (Two asset case)

References

1. JAE.K.Shim,JOEL G.Siegel, Financial Management, 2nd Ed, Tata McGraw – Hill

Publishing Company Ltd,2006.

2. I.M.Pandey, Financial Management, 9th Ed, Vikas Publishing House PvtLtd, 2008