Question

A portfolio is a group of assets in which investors prefer to deposit. The portfolio gives an opportunity to diversify risk. Diversification of risk does not mean that there will be an elimination of risk as future is always uncertain. With every asset, there is an attachment of systematic and unsystematic risk. Even an optimum portfolio cannot eliminate market risk, but can only reduce or eliminate the diversifiable risk. a. Help Mr. X prospective investor to manage return and risk of a security portfolio. b. Discuss the different types of inherent risks.

Answer 1

a. A Portfolio of assets is investment in more than one asset .

An investor should be well informed and decided about the various investment options, their returns and the level of risk involved & how much of the latter , he can shoulder, given his monetary conditions.

Portfolio management is investing and maintaining a group of assets at a specified proportion , depending upon the return required and the level of risk that can be tolerated , by the investor. This differs from investor to investor --ie. Individual approach & outlook about returns & the risk.

"Do not put all eggs in one basket " is a lesson our elders teach.That means, it is better to diversify the investments , that is investing in different sectors , so that fall in returns in one sector will not majorly affect the investor's income.

Systematic risks , that affect the whole market, irrespective of any particular industry--like inflation, recession, government regulations, change in the government,natuarl calamities(eg. Earthquake),etc, cannot be mitigated , but gone through.This risk affects return sof all portfolios alike.These cannot be avoided by diversifying the portfolio,ie. by allocating amounts to different assets that are not affected by this risk ,is practically not possible , at all.

Whereas,

Unsystematic risks are peculiar to one particular industry alone and this can be mitigated by investing in some other asset , till the time , it recovers.

Activities in one particular industry affects the share prices of that industry alone--like defects in Max 737 aircrafts of Boeing bringing instability to the company ,that the investors may turn down investment with them.

More than that , the more the risk, the more the returns offered.Converse is also true. Companies with stable returns are less risky, if not fully risk-free.It depends on the risk-tolerant/intolerant nature of the investor as also his monetary requirement or commitment .

b. All the investments, whether in stocks or bonds , carry some level of inherent risks such as the following:

Interest rate risk--ie. The quantum of interest decided the price of the security in the market. If interest rate increase, the price of the bond decreases.

Liquidity risk, ie. Convertibility to ready cash, when the investor wants to sell , may force him to sell at low prices.

Credit risk --is the risk that the issuer may not be able to pay periodic interest or repay the principal.But credit rating agencies give a ready reckoner on all these factors.

Reinvestment risk--ie. The risk of reduced reinvesting opportunities for the interests received as well as the principal on maturity.

Inflation risk --ie. Reduced purchasing power affecting the returns from investments, not being able to spend at the level contemplated--eating into the value.

The above are some of the risks associated with/inherent to all types of investments , which need to be carefully weighed and decisions taken , with optimal return-risk trade-off , in mind.