Introduction Portfolio Management refers managing a pool of investments for the given period of time. Pool of investments refers collection of different types of investments, which ultimately represents the holding/ownership of the investor. Factors such as globalization and liberalization of capital market activities creates many investment opportunities (sources of investments) locally and globally. Investors can be categorized as individuals/group of people and institutions.
Factors affecting choice of investments;
- Risks (Spreading Risks)
- Growth Prospects
- Attitude of the investor
- Portfolio Risk
Portfolio Risk and Return
In general, risk can be identified as a variability (of expectations) due to uncertainty. Hence, portfolio risk is also a variation of expected return on investment (portfolio) as opposed to actual return. Actual return will not same as expected due to many reasons. However, rational investor attempts to minimize such gap of variations. Gap represents the risk. Return on portfolio is the weighted average return received from respective investments in the portfolio. This usually will be calculated by weighting the different returns as opposed total investment in each category. Even though, it is quite qualitative in nature, portfolio risk and return will be calculated based on mathematical approach. Return will be average of total returns while risk will be denoted/measured through standard deviation.
Calculating return and risk;
Return from the known investment will be as follows;
- Return is the weighted average expected value
- Risk is the standard deviation
Based on portfolio theory, a rational investor might attempt to reduce overall risk of investment by spreading the risks between each other. This usually called diversification. Diversification theory leads following three types of relationships between investments;
- Positive Correlation: positive correlation effects when invest in shares of the companies having similar pattern of business. Both investments take similar direction. Umbrella and Raincoats business.
- Negative Correlation: invest in shares of the companies having complete different pattern of business leads to negative correlation. Two types of investments take opposite direction. Umbrella and Ice-cream business
- No Correlation: when different investments do not denote pattern of relationship, it can be treated as no correlation situation. Telecommunication and Plantation.
Portfolio Theory and Financial Management
In most aspects of financial management, focus is to enhance the shareholders’ wealth. Portfolio theory attempts to minimize the risks of investments through diversifications. Remember, minimizing risks does not count maximize the return. Hence, reasonable question arise whether company should more work towards diversification or refrain from diversification.
Why company should refrain from diversification strategy;
- Company can get maximum from its employees when deployed them with the work for which they have enormous level of skills and experience rather than deployed with the work new to them. You still can argue that staff can get training and/or recruit new staff with skills. However, all those claim costs and take time.
- Company can post growth momentum of revenue in the business that they are in for many years rather than in new business. With minimum effort, company can seek avenues for increase revenue and profit since it clearly demarcate the dimensions of business activities.
- Since shareholders themselves can minimize risk being invest in different sources, it is not expected from company to diversify the business and minimize the risks accordingly. Shareholders might willing to see company undertake (even) high-risk projects which gives high level of return.
- There is a high tendency of being takeover the individual businesses because when businesses are valued independently, those carry low level of EPS/PER. Above factors do not necessarily alarm companies refrain from diversifications. But care is must when company planning to diversify into completely different types businesses