The Early History of Portfolio Theory: 1600–1960, Essay Example

Your friend is facing an important decision. She was recently hired by a large bank, First Global, as a junior associate. Her primary responsibility is reviewing loan applications for completeness and conducting an initial analysis of the credit information. She is very knowledgeable about loans; however, she has come to you with a dilemma. The decision she is facing does not involve a work-related task, rather it involves questions regarding how she should set up her retirement account. She wants to get started investing early in life as she understands the power of compound interest, but she is unclear about where she should allocate her money. She has heard that you have a solid understanding of investments, particularly the risk and return of securities. She has narrowed her options down to three choices and would like your input. The first option is to invest in a mutual fund that is comprised of a wide variety of common stock from large, domestic firms. The second option is to invest in a low-risk government security, such as U.S. Treasury bills (T-bills). The third option is to invest in the common stock of First Global. Your friend is very worried about losing her money and would like to keep her investment choice simple. For that reason she is considering choosing to invest in First Global common stock as she has calculated an average return for the stock that seems acceptable. Currently, your friend has £5,000 to invest.

Based solely on the information that you have at this point, what advice would you give your friend regarding her choice of investment? What recommendations would you have for her? How would you explain your choice?

Buying t-bills has the highest risk among the three different forms of investment presented among the choices. Relatively, t-bills value depends so much on the GDP rate of the nation’s overall performance in the market. Being a public stock it is expected to fluctuate even more frequently compared to other forms of investment. The performance of the nation’s economy in place of other subjects of development could be measured fully depending on the frequency of fluctuation that the public stocks take into account. Hence, there is a risk that when t-bills are bought at a particular price, they would not be able to yield as much profit or returns as expected if the value invested is not of high value as well.

On the other hand, compared to a mutual fund, investing in common stocks would of course be of a higher point of valuation. With a much lower rate of risk considered. Common stock values are noted to not fluctuate at a faster rate. Being a more stable form of investment, common stock investments are much more capable of providing the most needed form of profit returns only at a much gradual pattern of gaining income from the said investment.

Common stocks have a standing point of advantage especially that it requires a much lower value of investment but has a much better promise of yielding higher value of returns. The only possible disadvantage on the matter would be that of the fact that the returns earn up gradually. However, since the investor does not point out the need to receive the returns immediately, it could be realized that this form of investment would be the best choice for her to take into account.

You have decided to gather more quantitative information about each of the investment choices. You have found that, over the long-term, the risk-free rate is approximately 3.4%. Over that same period of time, you have found that the stock market has averaged a return of 13.1%. The covariance between the common stock mutual fund and the market is 0.01575 and the covariance between First Global and the market is 0.0285. The variance of the market is 0.015. The beta for the government security is 0. Using the CAPM method, what is the expected return for each of these investment options (you will need to calculate the betas for the mutual fund and First Global)? How can you explain to your friend why the expected returns of each investment are different?

The Capital Asset Program Model is something that provides a more definite insistence on how value of investments could be measured accordingly. he said form of investment measurement follows the following formula:

From this formula and the given data, it could be noted that the covariance between the market and the First Global Stock value provides a more definite insistence on how much the investment would be able to yield in the end. The covariance between the First Global and the market amounts to 0.0285 while the standing covariance of the market amounts to 0.015. Relatively, these data provide a definite indication on the higher amount of returns that the First Global Stocks could provide alongside the assumed rate of profit of at least 3% returns at the end of the target final date.

After careful consideration, you believe that your friend should hold a portfolio, rather than a single investment. You recommend investing in both the common stock mutual fund and the government security. You believe that 80% of the portfolio should consist of the mutual fund and 20% should consist of the government security. Based on the calculations you completed in the previous question, what is the expected return of the portfolio? What is the standard deviation of the portfolio if the variance of the mutual fund is 0.076, the variance of the government security is 0.010 (assuming this is the risk-free asset), and the covariance between the mutual fund and the government security is -0.0037? What reasoning could you provide to your friend as to why to have a portfolio rather than just a single investment? Why would you not recommend investing only in the stock of First Global?

Portfolio investment is understood to be a much less riskier choice compared to other forms of investment. Relatively, it could be understood that a portfolio investment is one that enables an investor to put his assets in a much controlled environment compared to other forms of company or stocks investment especially when value management is involved. Relatively, the portfolio investment allows her to put her assets in separate forms of investment; one that would allow her to divide the risks and gain as much return from the investment she puts forth due to the fact that the returns would come from different sources of policies. While such option lessens or weakens the risk, it does not fully remove all risks accordingly. Noticeably, it is with this option of determining the dividends of a particular asset from different points of value determination.

Your friend likes the idea of holding both the common stock mutual fund and the government security, but she thinks that your suggestion to hold 80% of the former and 20% of the latter is too risky. She mentions that the maximum level of risk she is willing to assume is a portfolio with a standard deviation of 15%. How would you find a combination that meets this requirement? You might want to use Excel to solve this problem, but you should provide the equation(s) showing your calculations of the weights of each security and the expected return. You should also explain to your friend in plain English the approach you are following here.

Considering that she would be willing to risk at least 15% of the deviation of her investment [amounting to £5000], it could be realized that the best form of combination investment she could use would be that of a 10% on mutual fund, 15% on government security and another 10% on the common stock. This combination, however, would put her point of gaining profit from the investments she makes to come from a much slower and gradual form of returns.

Reference

Markowitz, Harry M. (1999). The early history of portfolio theory: 1600–1960, Financial Analysts Journal, Vol. 55, No. 4

Mehrling, Perry (2005). Fischer Black and the Revolutionary Idea of Finance. Hoboken: John Wiley & Sons, Inc.

Mossin, Jan. (1966). Equilibrium in a Capital Asset Market, Econometrica, Vol. 34, No. 4, pp. 768–783.

Ross, Stephen A. (1977). The Capital Asset Pricing Model (CAPM), Short-sale Restrictions and Related Issues, Journal of Finance, 32 (177)