Question

1) Answer the folowing in complete sentences.

A) Describe, explain, and discuss the portfolio effect and portfolio consideration when evaluating risk

B) Explain and discuss Market Efficiency as it relates to capital markets. Why is it important?

Answer 1

(1) (A). Portfolio Effect while evaluating risk : Portfolio effect is very important factor while evaluating risk of the portfolio. When we diversify our risk including more assets to the portfolio it reduces the overall risk of the portfolio as we add more assets to that. It is also considered as the reduction of the value of assets relative to the reduction in the value of the portfolio.

Example: Suppose we have three stocks in a portfolio stock "X", stock "Y" and stock "Z" the proportion is 50%, 30% and 20% respectively. Suppose stock "X" declines 20% and stock "Y" and "Z" both declines 10%. What would be the portfolio effect?

Portfolio effect = Weight of stock "X" * %decline + stock "Y" * %decline + "Z" * %decline.

Therefore, portfolio effect = 0.5*0.2 + 0.3*0.1 + 0.2 * 0.1 = 0.15 or 15% decline in the value.

Here we have seen that proportion of a stock plays very important role in the over all portfolio effect. Thus in the reduction of risk or risk evaluation, financial analysts suggest portfolio diversification which means using a number of stocks in portfolio instead of using one or two.

To minimize the risk of the portfolio we should add more stock from different sectors so that the correlation between stocks can be minimized.

Portfolio Consideration: When we have calculated the portfolio effect it was showing the value of diversifying your investments. If you invest in two companies which are competitors of eachother, so the returns on one stock and on the other will rise or fall depending upon many factors. But if we are investing across the industries this effect will reduce.

Example: In above example if we suppose the portfolio is having only two asstes in the 60% and 40% ratio and the stock "X" is declining 30% and "Y" is declining 10% as it was above.

so the new portfolio effect will be = 0.6*0.3 + 0.4*0.1 = 0.22 or 22% decline. Now it is showing the value of diversification how it effects while evaluating the risk of the portfolio.

(B). Market Efficiency: Efficiency of the capital market is described by the degree or the extent to which current stock prices accurately reflects given all the relevant information related to stock of the company.

So in an efficient market all the available informations about the stock is reflected by the price of the stock and we can't beat the market as these informations are available to every investor.

Why Market Efficiency is important:

• It is very important for the investors because in an efficient market all the informations are available and reflected by the prices of the stocks, so it helps them making more sensible decisions regarding, buying, selling or holding a particular stock.
• It is not possible in the efficient market to earn more than the average profit, but we can exploit the abnormalities of the market.
• It is very difficult to outperform market only using trading strategies. But if we see the history many traders have been successful in that so it is possible.
• In an efficient market cost of equity reseach and valuation both are very high and they don't have much benefits.
• In an efficient market the strategies used to randomly diversify the stocks is always considered as good compared to other strategies.