Risk-free assets are typically those issued by a government and considered to have zero risk. When we combine a risk-free asset with a portfolio of risky assets, we create a capital allocation line that we can represent on a graph on the efficient frontier curve. The capital allocation line connects the optimal risky portfolio to the risk-free asset.
The two-fund separation theorem states that all investors, regardless of taste, risk preference and initial wealth, will hold a combination of two portfolios or funds: a risk-free asset and an optimal portfolio of risky assets. This allows us to break the portfolio construction problem into two distinct steps: an investment decision and a financing decision. To start with, the optimal risky asset portfolio using the risk, return and correlation characteristics of the underlying assets dictate the investment decision. Besides, considering an investor’s risk preference, a determination is made on the allocation to the risk-free asset. Plotting the risk-free asset with the risky portfolio on a graph creates the capital allocation line (CAL).
A highly risk-averse investor may choose to invest only in the risk-free asset. A less risk-averse investor may, on the contrary, have a small portion of their wealth invested in the risk-free asset and a large portion invested in the risky portfolio. An investors with a high-risk tolerance may, in fact, choose to borrow from the risk-free asset and invest in a risky portfolio. This enables the investor to invest more than 100% of their assets and create a leveraged portfolio.
Utility is a measure of relative satisfaction that an investor derives from different portfolios. We can generate a mathematical function to represent this utility that is a function of the portfolio expected return, the portfolio variance and a measure of risk aversion.
To determine the risk aversion (A), we measure the marginal reward an investor needs in order to take more risk. A risk-averse investor will need a high margin reward for taking more risk. The utility equation shows the following:
The risk aversion coefficient, A, is positive for risk-averse investors (any increase in risk reduces utility). It is 0 for risk-neutral investors (changes in risk do not affect utility) and negative for risk-seeking investors (additional risk increases utility).
An indifference curve plots the combination of risk and return that an investor would accept for a given level of utility. For risk-averse investors, indifference curves run “northeast” since an investor must be compensated with higher returns for increasing risk. It has the steepest slope. An investor that is more risk-seeking has an indifference curve that is much flatter as their demand for increased returns as risk increases is much less acute.
We can overlay an investor’s indifference curve with the capital allocation line to determine their optimal portfolio.
Question
Using the utility function U = E (r) – ½Aσ2 and assuming A = -4, which of the following statements best describes the investor’s attitude to risk?
A. The investor is risk-neutral.
B. The investor is risk-averse.
C. The investor is risk-seeking.
Solution
The correct answer is C.
A negative risk aversion coefficient (A = -4) means the investor receives a higher utility (more satisfaction) for taking more portfolio risk. A risk-averse investor would have a risk aversion coefficient greater than 0 while a risk neutral investor would have a risk aversion coefficient equal to 0.
Building an investment portfolio can seem intimidating to those who are just beginning their investment journey. It can be challenging to set aside sufficient funds each month, while also budgeting for various expenses such as rent, equated monthly instalments (EMIs) for vehicles, and other obligations. However, the earlier you begin investing, the more time there is for your portfolio to mature and grow.
Smart investing takes into account your current expenses while ensuring that you can plan for your short-term and long-term goals. The most important aspect of building a portfolio is to balance growth opportunities with risks. The trick lies in understanding your own risk appetite while building a diversified portfolio.
Here are some ways to build a robust investment portfolio.
Asset Allocation
The first rule of building a portfolio is to allocate your investment between different assets, including: Stocks, bonds, government securities, real estate, commodities, and cash. Prudent asset allocation can be critical in insulating your portfolio from a downturn in a particular asset or market. There are three key aspects that you must consider for asset allocation – your financial goals, investment horizon and risk tolerance.
Financial goals
Before you commence building your portfolio, take stock of your short, mid and long-term financial goals. Short-term goals are meant to be achieved in less than three years, such as vacations or renovating your house. Mid-term goals can range from three-ten years and can include goals like paying for children’s college education. Long-term goals, such as retirement planning or buying a house, can take more than 10 years to accomplish. Our asset allocation should, therefore, reflect these goals.
Investment horizon
This refers to the time period for which you expect to hold an investment. The investment horizon of the various assets in your portfolio should be decided according to your financial goals. Your portfolio should include assets that mature in time for short-term, mid-term, and long-term goals.
Risk tolerance
Risk tolerance is the level of risk you can withstand, and depends on your income, expenditure, and willingness to take risks. It can differ from person to person and may also change over time. For instance, your risk tolerance may increase as your salary appreciates, and lessen with more dependents and expenses. Risk tolerance can also be impacted by age as people who are closer to retirement may be less willing to tolerate high risk.
Risk diversification
Risk diversification is one of the cornerstones of smart investing. It is based on the principle that different assets are associated with different levels of risk and involves investing across a variety of assets to minimize the impact of risks associated with any single asset class. Low-risk investments are typically associated with low returns, while high-risk investments often generate higher returns.
By investing across different asset classes, we can strike a balance between our risk and security. Diversification must also extend within each asset class. Investing across different industries and markets insulates your portfolio from a sudden downturn in these areas by limiting the damage. Risk diversification dictates that the risks of investing in high growth stocks for optimum returns must be counterbalanced by low-risk, low-return assets such as market securities or bonds.
Plan for Emergency and Health Insurance
Two essential components of every portfolio are emergency fund and health insurance. Planning for these components is essential to protect your portfolio from unplanned threats. An emergency fund is meant to aid you in withstanding an unexpected crisis, such as the loss of employment or a breakdown of a personal vehicle. Depending on the expected expenditure, an emergency fund could range from three to six months’ salary.
To ensure quick availability of cash, it is best to park part of your investments in liquid funds, such as money market securities like treasury bills (T-bills) and commercial papers. As government securities, these instruments offer a low-risk balance to higher-risk, but high-return investments like stocks. More importantly, they ensure that you can liquidate a part of your portfolio in times of urgent need.
Similarly, adequate health insurance is necessary to protect household savings from medical emergencies. It ensures that you and your family can avail healthcare without jeopardizing your portfolio in case of hospitalization or long-term care. You may also want to get a top-up health insurance plan if your existing medical coverage is inadequate. When planning for medical coverage, make sure dependents, such as parents and children, also have sufficient medical cover.
Invest in Mutual Funds with Systemic Cash Flows
Many investors view mutual funds as stable investments where their money is tied up for the long term. While it is a safe avenue for investment, mutual funds with a Systematic Withdrawal Plan (SWP) also facilitate a regular cash flow. Under an SWP, investors can withdraw a fixed amount at regular intervals that can be monthly, quarterly or yearly. Other than ensuring a regular income from investments, SWP funds also offer investors the flexibility of deciding the amount and frequency of withdrawals.
Buy-hold your portfolio, but back it up with a stop-loss order
An investment portfolio is essentially meant for the long term. By allowing your investments to mature over a period of time, you can also let the associated risks play out. For long-term investors, a buy-hold strategy can be more beneficial than day trading which requires constant vigilance and a comprehensive knowledge of the market.
At the same time, it is important to limit your losses through strategies like a stop-loss order. It is an order placed with a broker to buy or sell a security when it reaches a certain price. For instance, if your stop-loss is set at 12%, the broker will sell the stock when it falls 12% below the price you paid for the stock, protecting you from any further losses.
Study the market, assess the qualitative risks of a stocks
To be a long-term investor, you must also invest some time in studying the markets and understanding the factors that influence their movements. The main markets include the money market, capital market, credit market, foreign exchange market, and debt market. RBI policies, inflation, demand and supply are just some of the factors that impact market fluctuations.
In addition, you must also assess the risks associated with any stock before you invest in it. For qualitative risk analysis, you must take into account the background of the company, including its corporate governance and compliance, competitive advantage, brand value, and the presence of risk management practices.
Risks Involved In Investment Portfolio Building
No investment is without any risk. Even the most dependable asset can see an unexpected setback. Portfolio risks can be divided into three broad categories, sovereign risk, loss of principal, and inflation risk.
Sovereign risks occur when a government or country cannot or does not want to honor its debts or loan agreements. This can jeopardize assured investments like government securities.
Loss of principal is the risk of losing the original, or at least, part of the original investment made by the investor. Many conservative investors choose to invest in low-risk assets to minimize the risk of loss of principle. However, it is important to understand that every asset carries this kind of risk.
Inflation risk is the chance that the returns from an investment portfolio will be less than its expected worth due to inflation. It impacts the rate of real returns on one’s investments, and is most commonly associated with fixed income securities and bonds.
Minimizing portfolio risks
Risks are unavoidable in a portfolio. Hence, prudent investment stresses on risk management, to minimize an investor’s exposure to uncertainties through risk diversification. It is considered the most effective strategy for addressing all three risk categories.
Sovereign risks can be minimized by ensuring that your portfolio does not depend solely on government securities for stability. Diversifying into stocks also minimizes the chances of inflation risks while bonds and mutual funds are meant to offset the chances of loss of principal. At the same time, investors must also stay vigilant for market movements. Strategies like stop-loss orders are meant to limit one’s losses when they are unavoidable.
Another key aspect of portfolio risk management is its periodic review and rebalancing. Our risk tolerance can change with time and as per our income, circumstances, or age. For instance, you will be less willing to take risks with children or near retirement age. It’s important to assess your portfolio to determine the distribution between high-risk and high-return investments like stocks, and low-risk but low-return assets like bonds or fixed-income securities.
A periodic review is also necessary to keep track of your investments and the yearly growth of your portfolio. With time you can gain a finer insight into the behavior of your portfolio and how best to improve it. More importantly, it ensures that your portfolio keeps pace with your changing requirements.
Bottom Line
The purpose of an investment portfolio is to ensure your financial stability and independence. It allows you to plan for emergencies, ensure regular income, and provide you with the financial freedom to meet your expenses. By setting aside adequate savings each month, we also gain financial discipline and the self-confidence for making judicious decisions regarding finances and future planning.
What are the steps in building an optimal portfolio?
Step 1: Assess the Current Situation..
Step 2: Establish Investment Goals..
Step 3: Determine Asset Allocation..
Step 4: Select Investment Options..
Step 5: Measure and Rebalance..
What are the three steps of portfolio management?
The three steps in the portfolio management process are planning, execution, and feedback. In this step, the portfolio manager needs to understand a client's needs and develop an investment policy statement (IPS).
What are the 3 types of investment portfolios?
4 Common Types of Portfolio.
Conservative portfolio. This type is also called a defensive portfolio or a capital preservation portfolio. ... .
Aggressive portfolio. Also known as a capital appreciation portfolio. ... .
Income portfolio. ... .
Socially responsible portfolio..
What are the 3 key factors to consider in investment?
There are three key factors that determine which investment strategy is right for you..
Risk tolerance..
Expected returns..
Effort required to implement the strategy..
