The primary objective of a rational investor or portfolio manager is to minimize the diversifiable risk and maximize gains. Usually, the diversifiable risk is minimized by maintaining an optimally diversified portfolio. The traditional portfolio management approach entails using non quantitative methods to establish a balance of securities that will lower the overall risks. In order to reduce the diversifiable risk, the securities selected are supposed to have negative or little correlation with one another. The modern portfolio theory is based on the statistical techniques for reducing portfolio risk, which quantify the diversification amount by calculating the standard deviation, and returns of the individual securities in order to assess their risk, and by calculating the securities coefficient of correlation with the aim of having efficient portfolio that yields highest returns for a given risk. Plotting the investment opportunity set shows the feasible and attainable portfolios. The following segments give the process used to create the investment opportunity by analyzing the stocks of Apple Company and Microsoft Company.
Overview of the process used to create the investment opportunity set
- Obtaining Daily Market Returns
The price of every security changes periodically due to changes in the market and economic factors over a given period. The security returns refers to the loss or gain derived in a given period. It call be looked to as the profit that an investor gains from the investment either in absolute terms (for example, dollars) or in percentage of the invested amount. Usually, the stock price reflects all the fundamental factors such, capital gains, income, economic performance and industrial projections. In evaluating the returns on the stock, usually the holding period returns is obtained (Campbell & Viceira, 2012). Daily holding returns for the stock is obtained as the difference between the previous day’s stock price and the current day is taken, which is then converted as a percentage of the previous day to obtain the parentage returns for the day. Obtaining the daily returns on the stock price of the companies’ targeted for the investment is the first step in establishing an opportunity set, that has all the feasible and tenable combination of securities that can give varying levels of returns for varying levels of risks.
- Calculating Beta For Each Security Using Linear Regression
In general terms, the investment beta is an indicator of whether the investment will be more or less volatile compared to the market. Obtaining a beta of less than one shows that the investment has less level of volatility compared to the market, while a more than one beta shows that the investment volatilities higher than that of the market. This means that a security with a beta of 1.8 on average moves 1.8 times the return in the market. For example, if it is a stock, its excess retunes over and above the short term money market rate, will be expected to move 1.8 times that of the excess return in the market The volatility is the measure of price fluctuations around the mean, that is the standard deviation. Beta is used to measure the systematic risk of the security or a given portfolio when compared to the entire market (as indicated by the benchmark indices such as S&P 500). Beta is used in CAPM to obtain the expected returns. The beta for the stock will be obtained by carrying out the linear regression analysis of the stock and the benchmark index.
- Calculating Expected Return For Securities
The third step of calculating the opportunity set is establishing the expected return for each of the security that is considered for inclusion in the portfolio. The expected returns refers to the amount that one would………………..