What Investment Entails Concerning Future Share Period Returns Finance Essay - Free Essay Example

Investment entails some degree of uncertainty concerning future share period returns. In financial perspective risk is a synonym for uncertainty while return signify the totality of gain or loss on an investment. Risk in investment cannot be eliminated but can be managed through number of strategies such as diversification, asset allocation etc. This study was conducted to help Sandra (widow) manage her inherited portfolio by explaining to her on how reduce the risk level of her portfolio and risk-return tradeoffs. RELATIONSHIP BETWEEN RISK AND RETURN Risk is the possibility of suffering a financial loss due to vagueness in terms of Macroeconomic fluctuations, asset-specific unexpected developments, and changing fortunes of various industries (Bodie et.al 2007). While return is the overall gain or loss on an asset. Risk and return cannot be separated from one another in an investment as the required return depends on the risk of the investment (Stephen A. Ross et.al 2008). Companies Utility Company High-Tech Company Counter Cyclical Company Return 9.70% 10.0% 5.0% Risk 2.65% 21.91% 12.07% In the table above, it is clearly illustrated that High-Tech Company has higher risk and return compared to Utility Company and Counter Cyclical Company while Counter Cyclical Company has higher risk and return compared to Utility Company. That is, the greater the risk, the greater the return and vice versa as clearly depicted in appendix A. BETA AND ITS RELEVANCE TO REQUIRED RETURN ON STOCKS In view of the fact that risk are related to return in an investment and that some risk (Unsystematic) can be eliminated by diversification, therefore such risk cannot be rewarded since it s borne unnecessarily. The expected return on an investment depends only on that stock systematic risk. Beta assesses how volatile an asset is in relation to the general market (Elton and Gruber, 1991) i.e. it assess a risk that arises from the relationship between th e return on an asset and the return on the market. It also measures the systematic risk and doesn t change no matter the economic situation. In appendix B the composite index was chosen to calculate for beta instead of index fund because it is associated with a higher expected return of 18.7% and less risk of 4.96% compared to Index fund which has an expected return of 8.40% and risk of 10.72% as illustrated in appendix A. The higher the required return and expected return the Higher the beta (risk). Stock Beta Required Return Expected Return Utility Company 0.529 12.24% 9.70% High T Company 4.043 60.39% 10.00% C.C Company -2.109 -23.89% 5.09% Diversification and Its Importance to Investment The simple fact that an asset is associated with diverse degrees of expected risk leads most investors to the notion of holding more than one security at a time. According to Fischer and Jordan ((1999)), endeavour to reduce and spread risk take the form of diversification. Dive rsifying investment means spreading risk across variety of asset classes i.e. investment. Investors invest their money in firms of dissimilar industries to avoid the risk of losing their portfolio because no matter the situation of the economy, some investment will do well. Diversification of one s investment is anticipated to lessen risk in an economy wherein each asset s returns lies on some degree of uncertainty. In appendix B we can see the difference between the risks of holding a single asset compared to holding of diversified portfolio. Company Utility Company High-Tech Company 50-50 Portfolio Expected Return 9.70% 10.00% 9.85% Standard Deviation 2.65% 21.91% 12.19% From the scenario sited above, Investment in 50-50 portfolio shows higher returns compared Utility Company and reduces risk compared to High-Tech Company. Therefore investment in portfolio asset generates higher return in asset and reduces risk compared to individual stocks. VALUATION OoF STOCK Investors in the financial market use to calculate intrinsic or intrinsic value of stocks and companies due to uncertainty in order to predict potential market prices. Stocks are either judged overvalued or undervalued. Undervalued stocks are considered good as there is expectation for return while there is no expectation for return on overvalued stocks. Security Market Line is a line on graph that illustrates the relationship between risk as measured by Beta and the required rate of return for individual securities (Brigham and Houston, 1998). The line changes over time due to changes in investor s aversion to risk, interest rates and individual company Betas. Results in the SML are graphed using the Capital Asset Pricing Model formula. Stocks plotted below the security Market line are overvalued while the ones plotted above the security market line are undervalued. The graph below shows the relationship between the risk and return using the SML line. The X-axis represents the risk (Beta) while the Y-axis represents the expected return. The slope of the SML reflects degree of the aversion in the economy. Stocks in Counter Cyclical Company are undervalued while stocks in High-tech Company are overvalued. Therefore, the greater the average investor s aversion to risk the steeper the slope of the line and the higher the required rate of return on all stocks. RELATIONSHIP BETWEEN INTEREST RATE AND VALUE OF STOCK Interest rate and stock exchange are two key factors of economic development of a country. Interest rate is one of the vital economic variables which are related directly to economic growth. It is regarded as cost of capital i.e. the cost paid for the use of money over a period of time. Good investors always search for investment in a proficient market in order to be able to make extra ordinary profit .If interest rate paid to depositors increased by banks people switch from stock market to fixed deposit. In the other hand if interest rate paid to depositors decreased by banks, people switch from fixed deposit to share markets. That is, demand for stock increases when interest rate is low and vice versa. STOCK AND FIXED INCOME SECURITIES Despite the fact that the risk associated with fixed income security are low compared to stock investment, the aim of every investor is to acquire the highest possible return in an investment. Market risk and interest rate greatly affects fixed income as it is coupled with continual change (Brealey et. al, 2009). Also the opportunity cost investing fully in stock may be high as in most cases does not make high returns compared to stock market. An investor should diversify its investment in order to eliminate the unsystematic risk and also try to invest some of its funds in fixed income when there is a rise in interest rate so as to be able to get the maximum return obtainable. HOT TIPS REGARDING UNDERVALUED STOCKS Undervalued stock as mentioned above is the type of security wh ich has the possibility of getting high returns in the future. The real money is in finding a truly undervalued stock. Investors when trying to buy undervalued stock should check on the stock s price earnings ratio, cheaper securities really have lower price earnings ratio (Levi, 1996). The lesser the price earnings ratio the more attractive the security. Secondly, assessment of debt to equity ratio should be carried out. Companies with higher equities compared to their debt stand the chance of excelling in terms of any hardship arousal. Thirdly, search for companies which have unfailing growth quarter after quarter in order to identify any reason for bad performance. Fourthly, build your stock screener on any financial website to be able to plug in ranges of variables such as price parameters, sector parameters etc so as to get a list of stock in which you will identify the hottest undervalued stock. Lastly and most importantly, look for undervalued stock with decent dividends in o rder to be paid while waiting for rise of undervalued stock. EXPECTED RETURN AND RISK ON 50-50 PORTFOLIO Portfolio of asset compared to single asset is subject to low level of risk. Therefore if combination of 50-50 portfolio asset in high-tech Company and counter-cyclical company was undertaken there will be lower rate of risk compared to fully investing in one of them. Company High-Tech Counter-Cyclical 50-50 portfolio Return 10.00% 4.09% 7.55% Risk 4.0431 -2.1089 0.9670866 The table above clearly illustrate the relationship between risk and return in the three companies. Investment in 50-50 portfolio will generate higher returns compared to Counter-Cyclical Company and lower risk compared to High-Tech Company. Since the investor do not need to bear more risk and its aim is to get the most obtainable return, investment in 50-50 will stand more feasible. Refer to appendix C for calculation. EXPECTED RETURN AND RISK ON 70-30 PORTFOLIO Although portfolio of as set reduces risk on an investor s asset, an investor should try to choose among the best possible combination in order to get the most obtainable return with less rate of risk (Bodie and Merton, 2000) Company High-Tech Index-Fund 70-30 Portfolio Return 10.00% 8.40% 9.52% Risk 21.91% 10.72% 18.54% The table above illustrate the level of risk and return of 70-30 portfolio of High-Tech Company and index-fund. The risk in the portfolio is too high compared to index fund and doesn t have high expected return compared to High-Tech. Since the potential investor s status in life does not need to bear much risk, this portfolio combination does not seem to be feasible. Refer to appendix D for calculations. POSSIBLE PORTFOLIO COMBINATION Based on the calculations undertaken in the appendix C and D, the most favourable combination which will generate the most possible achievable return alongside with less rate of risk is 50-50 portfolio of High-tech and Counter-Cyclical Com pany. This combination has less expected return compared to 70-30 portfolio but is coupled with low rate of risk which suites the investors status in life. CONCLUSION Investment requires the commitment of a sum of money in order for profit to be received in the future. Since risk cannot be eliminated from investment and that risk can only be reduced, the best possible way for reducing risk in an investment is through diversification. The hot tips regarding undervalued stock were clearly stated so as to help Sandra in making investment. Calculations of possible portfolio combination were calculated and the researcher came to a conclusion of choosing 50-50 portfolio of High-tech and Counter cyclical Company because it has low rate of risk and a good rate of return which suites the investors status in life.