Portfolio Analysis Essay Example | Topics and Well Written Essays - 1000 words

Portfolio Analysis - Essay Example Logically, then, the risk and return of an individual security should be analysed in terms of how that security affects the risk and return of a portfolio in which it is held. As mentioned in Finance for Non-Financial Managers by Lawrence W Tuller, Diversifiable risk is also known as company-specific, or unsystematic, risk. Market risk is also known as non diversifiable, or systematic, or beta, risk; it is that risk remains after diversification. Diversifiable risk is caused by such random events as lawsuits, strikes, successful and unsuccessful marketing programs, winning or losing a major contract, and other events that are unique to a particular firm. Since these events are random, their effects on portfolio can be eliminated by diversification- bad events in one firm will be offset by good events in another. The riskiness of a portfolios declines as the number of stocks in the portfolio increases. The smaller the correlation coefficient (the movements of two variables with respect to each other), the lower the risk in a large portfolio. If we could find a set of stocks whose correlation were negative or zero, all risk could be eliminated. Consider Stock M with the beta coefficient of 2 i.e. ... This is due to the diversification of risk in a portfolio. (2) Explain carefully how diversification leads to the construction of the Markowitz efficient frontier. Answer: As explained by Eugene Brigham and Gapenski, the computational procedure for determining the efficient set of portfolios was developed by Harry Markowitz and first reported in his article "Portfolio Selection", Journal of Finance, March 1952. Markowitz developed the basic concepts of portfolio theory. With only two assets, the feasible set of portfolios is a point within the curve. However if we increase the number of assets, we would obtain an area under the curve. The points A,B,C and D represent single securities. All other points with in the curve, including its boundaries, represent attainable set. The above Curve boundary from A to D however defines the efficient set of portfolios, which is also called efficient frontier. Portfolios to the left of the efficient set are not possible because they lie outside the attainable set. Portfolios to the right of the boundary line (interior portfolios) are inefficient because some other portfolio would provide either a higher return with the same degree of risk or a lower risk for the same rate of return. Markowitz efficient frontier model. The optimal portfolio for each investor is found at the tangency point between the efficient set of portfolio and one of the investor's indifference curves. This tangency point marks the highest level of satisfaction the investor can attain. The investor's risk/return trade off function is based on the standard economic concepts of utility theory and the indifference curves. Here we have 2 Stock holders. Mr Y and Mr Z. Mr Y is more risk