Portfolio Theory and Investment Analysis Assignment

Portfolio Theory and Investment Analysis - Assignment Example More specifically, the trustees want to know the following: (1) The impacts of having a small number of stocks in the portfolio and concentrating the investment in large stocks. (2) The benefits of moving some of the investment to international securities. (3) How derivatives may be used to enhance returns and manage risk. The answer to the first concern depends on the answer to the following basic question in the minds of the charity's trustees: what is the highest possible and most realistic annual return that the investment portfolio could earn It is not easy to predict the return of a portfolio because many things could happen to funds once these are invested. To find out the realistic historical returns for various investments, investors consult the Equity and Gilt Study of Barclays (2006), which has studied this for over half a century. Figures 1 (68) and 2 (69) show how equities performed better compared to gilts and T-bills over the last century since a 100 investment in equities at end-1899 was worth 1,340,324 by end-2005. The same investment in gilts was worth 20,159 and in T-bills 17,021. When adjusted for inflation, the investment in equities would be worth 22,426; gilts 337; and T-bills 284 (Barclays, 2006, p. 62-63). This proves that the strategy of investing in equities would give the highest and most realistic return. In the year 2005, for example, equities returned 18.8% for the year, much higher than gilts (6%) and T-bills (2.7%), all figures having been adjusted for inflation. The Barclays Equity Income Index is derived from the yield of the FTSE All-Share Index because in their view, this is "the most representative method of evaluating equity performance over the period" (Barclays, 2006, p. 59). Given these pieces of information, what would be the best return that the UK charity could expect from its investments The attractiveness of any investment, whether bonds, securities, real estate, or a corner street business, depends on two variables: (1) Expected return: how much the investment would earn over a period of time; and, (2) Risk: the uncertainty that the investment would earn the expected return. One finance model used to assess an investment's attractiveness based on these two factors is the Capital Asset Pricing Model or CAPM,1 which equates expected return with the market return, the risk free rate, and the relative behaviour - defined as beta () - of the price of a security relative to the behaviour of the market. The basic criterion of CAPM is straightforward: an investment is attractive if its risk premium (the additional return over the risk-free rate) is equal to or higher than the risk of the market. Given the charity's investment portfolio = 1.03, the investment gave a return that was 3% higher than the All-Share Index return. If the All-Share Index had an 18.8% return, meaning a 1 million investment was worth 1,018,800 by year-end, the charity's investment would earn an extra 3% and would be worth 1,019,364 instead. The , however, has a downside: if the All-Share Index dropped, the value of the charity's investments would drop by an additional 3%. Why this happens is explained by risk, which affects the return of any investment. Every investment is exposed to two types of risk: the risk affected by the factors to which the business is