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Lecturer notes on Financial Mana calculations, concepts and theories.
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UNIT 6INTRODUCTION
The theory of portfolio management describes the resulting risk and return of a
combination of individual assets. Harry Markowitz pioneered this theory in his paper
"Portfolio Selection," which was published in the Journal of Finance in 1952.
The theory states that, given a desired level of risk, an investor can optimise the
expected returns of a portfolio through diversification. A primary objective of
the theory is to identify asset combinations that are efficient. Here, efficiency means
the highest expected rate of return on an investment for a specific level of risk.
INVESTORS’ ATTITUDES TO RISK - THE RATIONALITY OF PORTFOLIO
MANAGEMENT
Investors that require low risk investments are said to be ‘risk-averse’ and will
receive low returns. While investors that require higher risk and are said to be ‘risk-
pro’ and will receive higher returns. Risk tolerance depends on the investor’s goals,
income, personal situation, even their egos.
DIVERSIFICATION
• Diversification is a strategy designed to reduce exposure to risk by combining,
in a portfolio, a variety of investments, such as stocks, bonds, and real estate,
which are unlikely to all move in the same direction.
• The goal of diversification is to reduce unsystematic risk in a portfolio.
Volatility is limited by the fact that not all asset classes or industries or
individual companies move up and down in value at the same time or at the
same rate.
• Diversification reduces both the upside and downside potential and allows for
more consistent performance under a wide range of economic conditions.
Mathematically, the purpose of diversification is to reduce the standard
deviation of the total portfolio.
Page 1 of 7
, PORTFOLIO RISK AND RETURN
• Most investors invest in a collection of two or more assets. Such a collection
of assets held by an investor is known as a portfolio.
• It is often assumed that a rational investor will build a portfolio that will give
him or her maximum possible returns for a given risk profile remembering that
the greater the returns the greater the risk.
• The components of the total risk of a portfolio is the systematic (market) and
unsystematic (asset specific) risk.
SYSTEMATIC VERSUS UNSYSTEMATIC RISK
• Total risk = Market risk (systematic) + firm-specific (unsystematic) risk
• Market risk (systematic): Risk that affects all players in the market place is
called ‘market risk’ or ‘systematic risk’. Changes in economic fundamentals
(interest rates, exchange rates, inflation, consumer demand, the price of key
commodities such as oil, etc.). Market risk is measured by the beta co-
efficient.
• Firm-specific risk (unsystematic): Risk associated with the basic functions
of the organization (information technology, production processes, product-
markets, innovation, financing, leadership, human skills, etc.). This
is operational/business risk. It is often assumed that management can
eliminate this risk by diversification or simply managing better.
TWO-ASSET PORTFOLIO RISK AND RETURN
Holding more than one investment in financial assets is generally referred to as
holding a portfolio of investments (although there may be a one-asset portfolio).
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