...Assignment # 3. Diversification in Stock Portfolios. Strayer University Tim Creel, CPA,CMA,CIA, Professor Finical Management-FIN 534 5/28/11 You are a risk averse investor who is considering investing in one of two economies. The expected return and volatility of all stocks in both economies is the same. In the first economy, all stocks move together - in good times all prices rise together and in bad times they all fall together. In the second economy, stock returns are independent-one stock increasing in price has no effect on the prices of other stocks. Which economy would you choose to invest in? Please explain. A risk averse investor is a person who is reluctant to accept a bargain with an uncertain payoff rather than another bargain with more certain, but possibly lower, expected payoff. Thus, it can be said that risk averse person would be more inclined towards investment in bank’s fixed deposit than in uncertain returns of a stock market. But, if I being a risk averse investor and given a choice to invest in one of the 2 economies then I would select the second economy where stock returns are independent- one stock increasing in price has no effect on the prices of the other stocks. The first economy would result in uncertain returns as the prices would rise with the market and would fall with the market and to predict the market would be a risky task for a risk averse person. Relatively, investment in second economy would be less risky as the movement...
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...Theory Investment/Portfolio M3: Assignment 1 Discussion B6201-P Roger Thornhill What makes for good diversification in a portfolio investment? How do you achieve diversification? Portfolio diversification is a necessity for risk minimized investing. Things that can happen to an undiversified investor were seen through the 401k vested employees of Enron before and after their scandal. During the 1990’s and early 2000’s before it was discovered that Enron’s accounting practices where fraudulent, they encouraged their employees to invest in their 401k program that consisted of 100% Enron stock. At that time, Enron’s stock was growing at an astronomical rate. There were no apparent devaluation signs and Enron investors thought they had found their future nest egg. Thousands of employees saw the opportunity and dumped frequent payments and, at times, their full retirement savings into Enron stock and Enron’s 100% stock 401k plan. They should have diversified. By solely investing in Enron stock, 100% of the unsystematic risk remained with Enron’s success or failure. Although, at the time, the risk associated with Enron’s failure was at a minimum, the fundamental idea that no stock is risk free, even the best of them, was a prevailing factor. When Enron’s scandal went public in 2001, the stock plummeted from as high as $90 to $0.12 per share and never recovered. Both 100% stock portfolios and 401k investment plans became worthless – investors and employees lost billions...
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...International portfolio investment and international diversification- benefits and limits Project submitted for assessment of the Curricular Unit: Fundamentals of Finance and International Financial Management of the 2nd Year of the Joint Degree International Business Management 2014.01.10 Contents Introduction 3 1.1 International Portfolio Investment definition 4 1.2 Principles of International Portfolio Investment 4 1.3 The Benefits from International Portfolio Investment 5 1.4 Participation.in.Growth.of.Foreign.Markets 6 1.5 Risks of International Portfolio Investments 6 2.1 International Diversification definition 7 2.2. History of research about international diversification 9 2.3 Benefits of International Diversification 10 2.4 Costs of International Diversification 12 Conclusion 15 References 16 Introduction At first sight, the idea of investing internationally seems exciting and full of promise because of the many benefits of international portfolio investment. By investing in foreign securities, investors can participate in the growth of other countries, hedge their consumption basket against exchange rate risk, realize diversification effects and take advantage of market segmentation on a global scale. Even though these advantages might appear attractive, the risks of and constraints for international portfolio investment...
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...A study on the quarterly sector-wise returns from the Indian Capital Markets over the last 10 years and its implication on sector selection and portfolio diversification EGMP24109 EGMP Batch 24 EGMP – 24 | EGMP24109 Objective: The study attempts to analyze sector-wise returns over the last ten years (2001-2011) from various sectors that form a part of the Indian Capital Markets. It attempts to calculate summary estimates of rates of return from each sector and identify implicit relationships that exist among sectors to aid portfolio selection and diversification decisions. Summarized Quarterly Returns: Month | Quarter | Auto | Banks | IT | Oil | Metals | Health Care | FMCG | Power | Capital Goods | Sensex | BSE 100 | June-01 | 2001-02: Q1 | -7.29% | -10.3% | -7.32% | 3.28% | 1.64% | -5.31% | -5.78% | 12.62% | 5.22% | -4.10% | -3.65% | Sept-01 | 2001-02: Q2 | -3.15% | -8.36% | -35.7% | -20.0% | -29.0% | 0.97% | -7.53% | -20.35% | -15.6% | -18.6% | -19.4% | Dec-01 | 2001-02: Q3 | 38.98% | -0.82% | 69.11% | 1.87% | 20.59% | 8.50% | 8.69% | 11.15% | 12.89% | 16.03% | 18.65% | Mar-02 | 2001-02: Q4 | 25.78% | 1.40% | 2.10% | 54.01% | 32.52% | 11.04% | 1.37% | 14.83% | 23.97% | 6.35% | 10.21% | June-02 | 2002-03Q1 | 12.16% | 3.87% | -10.5% | 2.75% | 37.45% | -3.74% | -8.62% | 7.57% | 24.37% | -6.48% | -3.84% | Sept-02 | 2002-03Q2 | -18.4% | -1.38% | -8.59% | -5.57% | -26.3% | -5.16% | -6.96% | -10.54% | -12.9% | -7.81% | -10.69% | Dec-02...
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...Introduction Diversification / Risk Internationalizing Portfolio National Markets / Performance Mini Case Summary International Portfolio Theory and Diversification Group 5 Kristin Hanselmann, Anna Ivaniuk, Lalita Pongpitakwises, Christian Seemann Fachhochschule Mainz - MA.IB International Finance March 2013 K. Hanselmann, A. Ivaniuk, L. Pongpitakwises, C. Seemann International Portfolio Theory and Diversification 1/35 Introduction Diversification / Risk Internationalizing Portfolio National Markets / Performance Mini Case Summary Introduction Christian Seemann International Portfolio Theory and Diversification 2/35 Introduction Diversification / Risk Internationalizing Portfolio National Markets / Performance Mini Case Summary Agenda Introduction International Diversification and Risk Internationalizing the Domestic Portfolio National Markets and Asset Performance Mini Case Summary 1 2 3 4 5 6 Christian Seemann International Portfolio Theory and Diversification 3/35 Introduction Diversification / Risk Internationalizing Portfolio National Markets / Performance Mini Case Summary Introduction Multinational Business Finance Part 5 - Foreign Investment Decisions Chapter 17 Pages 432 – 451 Christian Seemann International Portfolio Theory and Diversification 4/35 Introduction Diversification / Risk Internationalizing Portfolio National Markets / Performance ...
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...Portfolio Analysis A portfolio is a combination of securities. Portfolio analysis provides a framework by which the investors can identify optimal portfolios from a universe of infinite portfolios. Investors need to estimate the expected return and variance of each security under consideration for inclusion in the portfolio along with all the covariances between securities. With these measures the investors proceed to calculate the expected return and risk of alternative portfolios to evaluate their desirability and derive a set of efficient portfolios. Notations wi = percentage of investor’s funds invested in security i wj = percentage of investor’s funds invested in security j [pic] = expected return on security i [pic] = expected return on security j (2i = variance of return on security i (2j = variance of return on security j (ij = covariance of return on security i and j (ij = correlation of return on security i and j [pic] = expected return on the portfolio (2p = variance of return on the portfolio 2-Security Case The expected return of a portfolio is an weighted average of the expected return of the securities, where the weights are percentage of investor’s funds invested in the securities: [pic] = wi [pic] + wj [pic] The variance of a portfolio is a weighted average of the variance of the individual securities plus the covariance between the two securities in the portfolio: (2p = w2i (2i + w2j (2j + 2wi...
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...Diversification A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out/reduces unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated. Advantages and disadvantages of diversification Diversifying your investment portfolio can protect you from localized fall in the market, but it can also prevent you from making big money. The question of what breadth of diversification is appropriate is an ongoing conversation among financial professionals. Finding the right diversification level for yourself involves an analysis of your assets and your tolerance of risk. Advantages Risk reduction When your assets are widely diversified, your portfolio tends to perform in a similar way to the market as a whole. If you own stocks in 20 different areas and one of them takes a dive, it's unlikely that your portfolio will suffer terribly. Diversification is the best way to increase the stability of your investments and decrease your risk of losing money in the event that a single area decreases in value...
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...Introduction The averaging out of independent risks in a large portfolio is called diversification. The principle of diversification is used routinely in the insurance industry. In this paper I will talk about two different types of home insurance and talk about the different risks associated with each. Discussion A portfolio is used to describe a collection of securities. In finance, the risk of an individual security differs from the risk of a portfolio composed of similar securities. In order to help us understand why, Chapter 10 in the book gave a great example on insurance companies. Let’s consider two types of home insurance: theft insurance and earthquake insurance. Lets also suppose that the risk of these two hazards is similar for a given home in a given area. Based on this information we would know that the risks of the individual policies are similar, however, the risks of the portfolios might be drastically different. For example, if the chance of theft in a given home is 1%, the insurance company would expect about 1% of the 100,000 homes in the area to experience a robbery. Thus the number of claims would be around 1,000 per year. If the insurance company holds reserves sufficient to cover roughly 1,000 claims, it will have enough to meet its obligations on its theft insurance policies. The portfolio for the earthquake insurance is a little riskier. For example, if in a given area, the risk of an earthquake is 1%, the risk of having an earthquake so low...
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...Investment Portfolio should be managed in a manner which is consistent with the philosophy of the Investor and reflects the unique purpose for the Investment Portfolio. This IPS is the governance instrument for the investment of those funds entrusted to the Investor. The basic tenets under which the portfolios will be managed include the following: (1) Modern Portfolio Theory, as recognized by the 1990 Nobel Prize, Harry Markowitz, will be the primary influence on the portfolio structure and subsequent decisions. The underlying concepts of Modern Portfolio Theory include: Investors are risk averse. The only acceptable risk is that which is adequately compensated for by potential portfolio returns. The portfolio as a whole is more important than an individual security. The appropriate allocation of capital among asset classes (stocks, bonds, cash, etc.) will have more influence on long-term portfolio results than the selection of individual securities. Investing for the long-term becomes critical to investment success because it allows the long-term characteristics of the asset classes to surface. For every risk level, there exists an optimal combination of asset classes that will maximize returns. A diverse set of asset classes will be selected to help minimize risk. The proportionality of the mix of asset classes will determine the long-term risk and return characteristics of the portfolio as a whole. Portfolio risk can be decreased by increasing diversification of the portfolio...
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...Efficient Diversification 1. So long as the correlation coefficient is below 1.0, the portfolio will benefit from diversification because returns on component securities will not move in perfect lockstep. The portfolio standard deviation will be less than a weighted average of the standard deviations of the component securities. 2. The covariance with the other assets is more important. Diversification is accomplished via correlation with other assets. Covariance helps determine that number. 3. a and b will have the same impact of increasing the Sharpe ratio from .40 to .45. 4. The expected return of the portfolio will be impacted if the asset allocation is changed. Since the expected return of the portfolio is the first item in the numerator of the Sharpe ratio, the ratio will be changed. 5. Total variance = Systematic variance + Residual variance = β2 Var(rM) + Var(e) When β = 1.5 and σ(e) = .3, variance = 1.52 × .22 + .32 = .18. In the other scenarios: a. Both will have the same impact. Total variance will increase from .18 to .1989. b. Even though the increase in the total variability of the stock is the same in either scenario, the increase in residual risk will have less impact on portfolio volatility. This is because residual risk is diversifiable. In contrast, the increase in beta increases systematic risk, which is perfectly correlated with the market-index portfolio and therefore has a greater impact on portfolio risk. ...
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...1 Causality and the Diversification Discount 1 Introduction Does corporate diversification, i.e. the expansion of a firm’s business operations into unrelated areas, destroy shareholder value? The wealth effects associated with conglomerates have been controversially discussed in scholarly journals ever since the seminal papers of Lang and Stulz (1994) and Berger and Ofek (1995) suggested that diversification reduces shareholder value. Both find that conglomerates are attributed with a lower market value than a portfolio of comparable focussed firms operating in the same businesses as the conglomerate. This finding seemed to suggest the hypothesis of a “diversification discount”. In line with this Scharfstein and Stein (2000) postulate "it has become almost axiomatic among researchers in finance and strategy that a policy of corporate diversification is typically value reducing.” Yet, subsequently financial scholars have challenged this dogma of a diversification discount. They did so with respect to the method used (Mansi and Reeb (2002); Glaser and Müller (2010)) and the causal interference (Graham et al. (2002); Campa and Kedia (2002); Villalonga (2004)). Taking these latest developments into account, the empirical evidence on the value effects of corporate diversification is mixed. The controversy that has evolved around these wealth effects provides a suitable setting to investigate the pitfalls associated with causal analysis and interference in empirical...
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...Robert L. Cole FIN/402 Investment Fundamentals and Portfolio Management November 11, 2013 Richard E. Smith Composition of investment portfolios is a complicated process involving rigorous methods ensuring successful financial transactions aimed at financial stability and profitability. Selection of appropriate asset classes are only half the task, revision is the other crucial element needed to complete the process of excellent portfolio performance. Portfolio diversification assists investors’ exposure to risk in both domestic and international markets, and is a notably significant component regarding the composition of a portfolio. An investor must comprehend all investment vehicles because alternatives might become necessary after mediocre portfolio performance evaluations. In addition, derivative securities can further enhance portfolio performance; therefore, careful consideration of these assets must be taken seriously with regards to the composition and revision of an investment portfolio. Diversification of any portfolio, whether it is domestic or international, is extremely important because having assets with different characteristics allows investors the potential of a differentiated level of risk. Risk reduction through international diversification pertains to international market correlations increased after unexpected shocks. The implication of diversification benefits are reduced after unexpected travesties;...
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...Lecture 1 -‐ Arithmetic Average 1. Ignores compounding; 2. Does not represent an equivalent, single quarterly rate for the year; 3. Is the best forecast of performance for the next quarter without information beyond the historical sample. -‐ Geometric Average 1. Also called a time-‐weighted average return-‐ignoring the quarter-‐to-‐quarter variation in funds under management; 2. Mutual funds are required to publish this as a measure of past performance. -‐ Dollar-‐weight Return 1. Similar to a capital budget problem 2. Accounting for varying amounts of capital under management form quarter to quarter 3. Less than time-‐weighted return of 7.19% -‐ Risk free assets: an asset with a certain rate of return (often taken to be short term T-‐bills) -‐ Scenario analysis: l Determine a set of relevant scenarios and associated investment outcomes and assigns probability to each l l -‐ Compute mean return and variance However, ...
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...To create a portfolio, investors must invest in different assets, possibly in different countries. As learned from a team project, a well diversified investment must have different types of securities and possibly have investments located in different countries. It can help to reduce the risk as compared to the asset investment, also known as taking stand alone risk, in their domestic country. The risk minimizes because there is a difference that exists in the economic growth. Because of this diversification, a fall in one country gets rewarded with the rise in the other country. There are two main effects of international portfolio diversification on the investment portfolio on is the risk and the return. The international portfolio diversification is the best and effective way to achieve higher risk-adjusted returns than domestic investment alone here the investor gets the best return at the lowest level of risk he or she can afford. This is done through investment in various markets of different countries. The international portfolio diversification facilitates the risk sharing among different global investors and du to this a country even gets diversified of its own risk. So one can say that not only the investors but also due to the international portfolio diversification strategy even the country gets diversified investors and due to this the risk level within the country gets minimized. Here the idiosyncratic shocks of the country may be diversified away due to different...
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...Abstract Like any other form of business or enterprise, investing internationally is a risk that can be turned into opportunity once well managed. There is a veritable sea of benefits in international portfolio investment. These include participation in the growth of other countries, hedging against exchange rate exposure to risk, diversification benefits and advantages (abnormal returns) of market segmentation on a global scale. However, we cannot be so overwhelmed by the payoff of international portfolio investment as to overlook the bitter side of it. In an international environment, financial investments are not only subject to currency risk and political risk, but also to many institutional constraints and barriers. What are crucial in international portfolio investment are optimal portfolio allocation and the associated market and currency risks. Diversification into multiple securities can practically eliminate potential severe losses from any individual security. However, domestic diversification cannot remove systematic market risk due to high correlations among most domestic securities. Since market risk differs from country to country, international diversification can reduce substantially the overall risk exposure of investment portfolios. Introduction and Overview Increased global competition and opportunity have attracted many national economies and individual domestic businesses to the international markets. In recent...
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