Portfolio Theory and Investment Analysis Term Paper

Portfolio Theory and Investment Analysis - Term Paper Example wa + wb + wc = 1. E(rp) = waE(ra) + wbE(rb) + wcE(rc ) 0.6(-0.2) + 0.3(0.1) + 0.1(0.04) = -0.086 Hence the strategy before the 2007 economic crisis would have realised an expected return of -8.6% on investment. The strategy adopted from 2007 onwards in the light of the crisis would realise: E(rp) = waE(ra) + wbE(rb) + wcE(rc ) 0.4(-0.2) + 0.4(0.1) + 0.2 (0.04) = -0.032 The strategy adopted after 2007 would realise an expected return of -3.2% on investment. As a result, the benefit of the strategy adopted from 2007 would be a reduced lose of 5.4% II. Advisability of investing more funds in UK equities. With the managers of the funds thinking of investing more funds into equity in the market, it is important for the managers to analyse the UK equities in a risk-return relationship. Hence when analysing the risk premium of the equity with the rest of the asset class, the return differential will be attributed to the difference in the risk associated with equity as opposed to bonds. The equity line will be normally "shakier" than the bond line. As evident from the data provided, Wealth invested in equity for the past 20 years has been more volatile than wealth invested in bonds (the UK equity having a risk of 16% as compared to 5% for bonds and cash for 0.3% in derivatives). Despite the higher return, the risks were higher as well. The fund’s managers should care about the riskiness of any investment especially in a volatile market. As a result, they should also be willing to trade a lower rate of investment return for "insurance" that their principal will be secure. This is called risk-aversion -- and all things being equal, most investors would prefer less risk to more. At the same time, when analysing the Standard Deviation as a measure of risk, the UK equity returns are riskier and more volatile. Even with the future projections of 8% returns per annum, the projected risk is projected to be at 18% for UK equity and 19% for overseas equity respectively an d at the same time, their correlation is very high at 0.8% between the UK and overseas equity making diversification not an option since it will not create any positive benefits of diversification. Due to the fact that the fund’s managers will be holding different portfolios, it would be important for them to use other statistical and non statistical data to be able to make informed decisions like the beta in respect to the market, fundamental ratios such as Book to Market Ratio and Earnings Price Ratio. III. Advantage of investing in the funds in international equities rather than UK equities. Due to the fact that stock market investing is risky, in the wake of the financial crisis, it is recommended for the fund’s managers to hold a well-diversified portfolio (including international diversification) to reduce risk as supported by the Capital Asset Pricing Model (CAPM) and the Modern Portfolio Theory (MPT). The fund’s manager, after analysing international mar ket correlations in relation to the returns of various national markets due to difference in levels of economic growth and timings of business cycles, would allocate investments among these markets as a means of rebalancing their portfolios and reducing risks in favor of foreign equities (Rezayat and Yavas 440-458). In analysing the data provided, international equity portfolio diversification would be recommended based on the existence of low correlations among national stock markets and