Discuss about the Combining Portfolios for Optimising Efficiency.
The current report aims to evaluate the reasons behind choosing a list of securities and funds in the portfolio, which would provide the investors with an insight to ascertain the asset allocation for conforming to the investment strategies. The portfolio efficient frontier has been formed by combining the various stocks chosen in the study, which would depict the highest return with minimum level of risk for the investors. In addition, the minimum variance portfolio and optimal risky portfolio have been identified and critically demonstrated. Finally, the report sheds light on the “optimal complete portfolio” of the investors along with the strengths and weaknesses of the same.
The diversified group of securities has been chosen to form the portfolio in order to minimise the market risk. In this context, Aouni, Colapinto and La Torre (2014) remarked that diversification of securities is of prime importance for the investors to maximise returns on investments, since each security would have different reaction towards the same event. It has been evaluated that the investors have experienced a fall in average return from the shares of BHP Billiton, which is $ (0.00148).
This depicts that the share price of the organisation has fallen in accordance with the decline in “All Ordinaries Index”. However, this could be compensated with the positive return earned from the shares of Cochlear Limited, which is a biotechnological organisation. Therefore, the risk aroused from the negative returns on investment has been minimised with the positive return from other securities. However, Guerard, Markowitz and Xu (2015) argued that diversification of portfolio might result in significant losses for the investors during global financial crises, as the different classes of assets move in tandem with each other.
From the average return of the securities and the index, it has been found that AMP Limited, BHP Billiton, Japara Healthcare Limited and Bank of Queensland Limited has strong and positive correlation with the “All Ordinaries Index” , as the returns fetched are negative. On the other hand, AGL Energy Limited and Australian Agricultural Corporation Limited have fetched positive returns despite the negative trend in the index. Therefore, the loss incurred on the part of the investor could be offset by the positive returns of the two above-mentioned securities. Thus, the diversification of these specific securities has been made in order to minimise the risk and potential loss of the investors.
In the words of Brown (2012), the “portfolio efficient frontier” is the combination of different securities, which fetches the maximum return for a provided risk level. With the help of this frontier, the investors are able to decide the course of investment by developing a portfolio with those stocks that are highly beneficial. The expected return obtained from the first level of securities is 0.3157, while the expected return from the second set of securities is obtained as 0.2229. Therefore, the portfolio efficient frontier has been drawn by apportioning weights to each of the securities chosen.
Figure 1: Portfolio efficient frontier of the chosen stocks
(Source: Yahoo7 Finance Australia 2016)
The portfolio efficient frontier has been drawn by apportioning different weights to the two groups of portfolio into a single portfolio. In this context, Francis and Kim (2013) stated that the merger of two portfolios often minimise the risk of investments for the investors, which couldlead to increased yield on investment. However, as argued by Haslem (2015), the merger of two portfolios might decrease the return on investment due to fixed rate of return aroused through risk minimisation.
The highest return is expected when the total weight is apportioned on the first group of securities, which is estimated at 0.3157. However, the risk associated with this apportionment of weight is slightly higher, as the standard deviation obtained is 0.0170. In addition, the investors are also expected to earn excess return of 17.7229% in addition of the risk-free rate. As commented by Gandhi (2015), the Sharpe ratio is a useful tool for arriving at the risk-adjusted return, which could be obtained in excess of the “risk-free rate” and volatility unit or risk. Therefore, it could be inferred that the higher the weight on the first group of securities, the greater is the return for the investors with minimal risk.
The portfolio of the member one consists of the share analysis of SGP, COH, AGL, STO, BHP, CSR and AORD. The member two portfolios consist of securities of the AMP, BHP, JHC, BOQ, AGL, AAC, AORD. The variance analysis of the portfolio states the risk, level of the aforementioned securities. The various types of the investment risk can be analysed based on the variance of the portfolios. The mean variance analysis consists of the process of the evaluating the weighing risk of the portfolio based on the expected return. The analysis shows the expected return from the variance of the assets and shows the choices of the investors. The lowest variance depicts lower risk and hence is considered as a better choice (Teerikangas and Morris 2015).
In the given case, enlisted under the member one consists of more number of positive returns such as SGP, COH, AGL and CSR. The comparison of the two portfolios shows that the variance of member 1 is 0.0379 while the variance of member 2 is observed to be 0.0339. It can be observed that there is a little difference between the two portfolios and hence even if the variance of the securities invested by the member 2 is observed to lower but it is having lower returns. Hence, the investment in the portfolio member 1 is observed to be a better proposal for the investment decision (Teller and Kock 2013).
The concept of the optimal portfolio concept lies under the modern portfolio theory. The theory aims to reduce the risk level of the investors in order to minimize the overall risk, which can offer the highest possible return. The optimal risk portfolio shows the determination of the highest return with lowest degree of possible risk. This concept shows the lowering of the risk level by investment in the government securities. This types of the investment is shown in form of the various types of the investment in the risk free assets (Stettina and Hörz 2015). The volatility of then risk level can been seen in form of the choosing the portfolio which falls under the category of the efficient frontier.
The optimal complete portfolio has been depicted by the Y value. The optimal complete portfolio from the computed results has been observed to be 9.42. The calculation of this is based on expected return of both the members. It is calculated by dividing the expected return with the standard deviation. The expected return is further observed to be 0.2693 and the standard deviation of the given results based on the both the members is observed to be 0.0169 (Pandya 2013).
The following are the strengths of the selected portfolios:
Elimination of Risk:
Since, the selected portfolio consists of a large number of different Australian securities, the investors would be able to minimise the amount of risk. This is because although the return from the second group of securities is lower, the amount of return for the first group is higher. Therefore, the loss incurred could be reduced through diversification of the portfolio (Kevin 2015).
Increased Returns:
According to the returns of “All Ordinaries Index” for the first group of securities, the investors could incur loss; however, the returns from the securities of AGL and COH are positive. Despite the falling market index, the investors could still expect to earn positive returns in the long-run with the help of portfolio diversification (Kolm, Tütüncü and Fabozzi 2014).
Choice of Assets:
The different securities have been chosen for spreading out the investment in diversified securities like bonds and stocks. The securities include the stocks and bonds of real estate, energy, misnaming, biotechnology and many others. Each of the security has its own strength and quality irrespective of the market conditions. In this context, Ouenniche et al. (2016) cited that the profitability from each stock relies on the market demand and supply. Therefore, an efficient mix of these securities has resulted in a strong and stable portfolio.
However, there are certain drawbacks associated with the constructed portfolio, which is briefly summed up as follows:
Slow Income:
Since, the portfolio comprises of only the Australian securities, the investors might experience complexities in making profits from one industry to another. Although portfolio diversification could prevent the investors from fluctuations, however, it limits the growth of the stock. In the words of Pandya (2013), the motive behind investment in stock is to increase gain by undertaking higher risk. Therefore, a balance is needed in diversification of the chosen portfolio.
Spreading Thinly:
Since, the securities have wide diversification; the investors might incur significant losses. Therefore, if the market experiences a massive decline, the holdings might be complex, since it is spread thinly. This is because the investors would have to prevent from the financial exposure and therefore, there is high probability that the investors could experience decline in profit.
Increased Cost for the Investors:
In order to invest in different types of securities, the investors avail the option of hiring a broker before making investment decisions. However, the brokers operating in the Australian stock market (ASX) have different structure of commission or transaction fees. Therefore, incurring money in a diversified group of s3ecurities like the constructed portfolio might result in increased cost for the investors, which could be avoided through investment in a single fund.
Conclusion:
From the above discussion, it has been found that despite the fall in the “All Ordinaries Index”, the investors could be able to minimise the loss incurred through positive earnings from some of the stocks of the two groups of portfolio. This is because the securities are widely diversified from one industry to another and therefore, the market price fluctuations would not affect the return of the investors largely. From the portfolio efficient frontier, it has been deduced that apportioning the maximum weight to the first group of securities is highly desirable to the investors for maximising the returns on investments, although the risk associated is slightly higher.
In addition, the “minimum variance portfolio”, “optimal risky and complete portfolio” for the investors have been identified and critically evaluated. The major strength of the combined portfolio is that it ensures fixed rate of return to the investors irrespective of th3e market conditions. However, this portfolio could result in increased cost and fixed return for the investors.
References:
Aouni, B., Colapinto, C. and La Torre, D., 2014. Financial portfolio management through the goal programming model: Current state-of-the-art. European Journal of Operational Research, 234(2), pp.536-545.
Brown, R., 2012. Analysis of investments & management of portfolios.
Francis, J.C. and Kim, D., 2013. Modern Portfolio Theory: foundations, analysis, and new developments (Vol. 795). John Wiley & Sons.
Gandhi, D.J., 2015. Portfolio management by an investor and suggesting the optimal portfolio using sharpe model. IJAR, 1(13), pp.167-175.
Guerard, J.B., Markowitz, H. and Xu, G., 2015. Earnings forecasting in a global stock selection model and efficient portfolio construction and management. International Journal of Forecasting, 31(2), pp.550-560.
Haslem, J.A., 2015. Book: Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship. Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship.
Kevin, S., 2015. Security analysis and portfolio management. PHI Learning Pvt. Ltd.
Kolm, P.N., Tütüncü, R. and Fabozzi, F.J., 2014. 60 Years of portfolio optimization: Practical challenges and current trends. European Journal of Operational Research, 234(2), pp.356-371.
Ouenniche, A., Ouenniche, J., M’zali, B. and Pérez-Gladish, B., 2016. A portfolio analysis approach to assist socially responsible investors in making decisions. International Journal of Operational Research, 27(3), pp.469-501.
Pandya, F.H., 2013. Security Analysis and Portfolio Management. Jaico Publishing House.
Stettina, C.J. and Hörz, J., 2015. Agile portfolio management: An empirical perspective on the practice in use. International Journal of Project Management, 33(1), pp.140-152.
Teerikangas, S. and Morris, P., 2015. Toward a Project Portfolio Management Approach to Addressing the Challenge of Climate Change?.
Teller, J. and Kock, A., 2013. An empirical investigation on how portfolio risk management influences project portfolio success. International Journal of Project Management, 31(6), pp.817-829.
Yahoo7 Finance Australia. (2016). Yahoo7 Finance Australia. [online] Available at: https://au.finance.yahoo.com/ [Accessed 30 Sep. 2016].
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