Portfolio Theory

INTRODUCTION

A portfolio is a collection of different investments which comprise an investor’s total investments.  For example, a property investor’s portfolio may consist of many investment properties in different locations and which are used for varied purposes.  Other examples of a portfolio are an investor’s holding of shares, or a company’s investment in many different capital projects.  Portfolio Theory is concerned with setting guidelines for selecting suitable shares, investments, projects etc. for a portfolio.

PORTFOLIO RISK AND RETURN

By investing all of one’s funds in a single venture the whole investment may be lost if the venture fails.  However, by spreading the investment over a number of ventures the risk of losing everything will be reduced.  If one of the ventures fails only a proportion of the investment will be lost and hopefully, the remainder will provide a satisfactory return.

Investors are generally risk-averse and will seek to minimise risk where possible.  The objectives of portfolio diversification are to achieve a satisfactory rate of return at minimum risk for that return.

A portfolio is preferable to holding individual securities because it reduces risk whilst still offering a satisfactory rate of return – i.e. it avoids the dangers of “putting all your eggs in one basket”

When investments are combined, the levels of risk of the individual investments are not important.  It is the risk of the portfolio which should considered by the investor.  This requires some measure of joint risk and one such measure is the coefficient of correlation.  The relationship between investments can be classified as one of three main types:

 

  • Positive Correlation – when there is positive correlation between investments if one performs well (or badly) it is likely that the other will perform similarly. For example, if you buy shares in one company making umbrellas and another which sells raincoats you would expect fine weather to mean that both companies suffer.  Likewise, bad weather should bring additional sales for both

 

  • Negative Correlation – if one investment performs well, the other will do badly and vice versa. Thus, if you hold shares in one company making umbrellas and another which sells ice-cream, the weather will affect the companies differently.

 

  • No Correlation – the performance of one investment will be independent of how another performs. If you hold shares in a mining company and a leisure company it is likely that there would be no obvious relationship between the profits and returns from each.

The Coefficient of Correlation can only take values between –1 and +1.  A figure close to +1 indicates high positive correlation and a figure close to –1 indicates high negative correlation.  A figure of 0 indicates no correlation.

It is argued that if investments show high negative correlation then by combining them in a portfolio overall risk would be reduced.  Risk will also be reduced by combining in a portfolio securities which have no significant correlation at all.  If perfect negative correlation occurs, portfolio risk can be completely eliminated but this is unlikely in practice.

Usually returns on securities are positively correlated, but not necessarily perfectly positively correlated.  In this case investors can reduce portfolio risk by diversification.

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