But when you want to calculate the expected volatility, you must include the covariance or correlation of each asset. Disclaimer Copyright, Share Your Knowledge The Company with a higher return of 11.5% has a higher risk than the other company. The different types of portfolio investment are as follows: Risk-Free Portfolios â Risk-free portfolios are the ones that have investment securities regarding treasury bonds and such where the risk is almost nil but low returns. These theories can be classified into different categories as depicted in figure 6.1. This pattern of investment in different asset categories, security categories, types of instruments, etc., would all be described under the caption of diversification, which aims at the reduction or even elimination of non- systematic or company related risks and achieve the specific objectives of investors. It is the percentage change in the price of the stock regressed (or related) to the percentage changes in the market Index. Traditional Approach: 1. Arithmetic returns tend to be biased upwards unless the holding period returns are all equal. In other words, a portfolio is a group of assets. An arithmetic mean is a simple process of finding the average of the holding period returns. Image Credit Onemint 2 most basic types of risk Investment is related to saving but saving does not mean investment. PORTFOLIO MANAGEMENT-TRIAL QUESTIONS 1) Explain the following terms as used in Portfolio management and give examples and/or furmulas. In general, returns are presented pre-tax and with no adjustment for the effects of inflation. Content Guidelines 2. A portfolio that consists of 70% equities which return 10%, 20% bonds which return 4%, and 10% cash which returns 1% would have a portfolio return as follows: Portfolio return = (70%×10%)+(20%×4%)+(10%×1%) = 7.9% Portfolio return = ( 70 % × 10 %) + ( â¦ On the other hand alpha and Epsilon (α + ∑) measures the unsystematic risk, which can be reduced by efficient diversification. (Alternatively, this term may refer to a portfolio that has the minimum amount of risk for the return that it seeks, although itâs a less common usage.) Aggressive Portfolio: An aggressive portfolio comprises of high-risk investments like commodities, futures, options and other securities expecting high returns in the short run. The previous year’s returns are compounded to the beginning value of the investment at the start of the new period in order to earn returns on your returns. Covariance (or correlation) denotes the directional relationship of the returns from any two stocks. A portfolio that consists of 70% equities which return 10%, 20% bonds which return 4%, and 10% cash which returns 1% would have a portfolio return as follows: $$ \text{Portfolio return} = (70\% × 10\%) + (20\% × 4\%) + (10\% × 1\%) = 7.9\% $$. A net return is the return post-deduction of fees. Average investors are risk averse. This means itâs generating the highest possible return at your established risk tolerance . An Example for Covariance and Correlation: Given the standard deviation of X and Y as 13.23 and 9.75 in the portfolio of two securities the covariance between them has to be estimated. Tax considerations like capital gains tax and tax on interest or dividend income will need to be deducted from the investment to determine post-tax returns. Share Your PDF File Thus (.04)2 = .0016 and this multiplied by the probability of it 0.25 gives .0004 and so on. A portfolioâs historical standard deviation can be calculated as the square root of the variance of returns. Portfolio management is the art of selecting the right investment tools in the right proportion to generate optimum returns with a balance of risk from the investment made. If Beta is 1, a one percentage change in Market index will lead to one percentage change in price of stock. Defensive Portfolio : Defensive portfolio comprises of stocks with low risk and stable earnings â e.g. Risk avoidance and risk minimization are the important objectives of portfolio management. The expected return of the portfolio can be computed as: Covariances and correlation of returns Before moving on to the variance of the portfolio, we will have a quick look at the definitions of covariance and correlation. Dow â¦ Assuming that investor puts his funds in four securities, the holding period return of the portfolio is described in the table below: The above describes the simple calculation of the weighted average return of a portfolio for the holding period. These are briefly discussed below. If an investor makes use of derivative instruments within a portfolio or borrows money to invest, then leverage is introduced into the portfolio. If the correlation coefficient is one (+ 1), an upward movement of one security return is followed by a direct upward movement of the second security. Thus, the portfolio expected return is the weighted average of the expected returns, from each of the securities, with weights representing the proportionate share of the security in the total investment. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. If we have a large enough portfolio it is possible to eliminate the unsystematic risk A holding period return is a return earned from holding an asset for a specified period of time. Faced with the problem of choosing from among alarge number of securities column 6 to but! It is the absolute deviation and the other standard deviation ( sd ) provides portfolio! 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