Re: Portfolio’s Risk and Return Tradeoff
Profitable Portfolio construction is a difficult task and a task that demands huge knowledge and analysis. More than the monetary investment, it needs investment in the form of research about the past performance, current performance, and the future prospect as well as the research about the industry. Apart from that, balancing the risk and the return stands as the determining factor in the construction of the portfolio. An investor must also simultaneously look for the tradeoff of the risk and return of the entire portfolio rather than of the single stock. As an investment advisor of the company, I was allocated the resource of $800,000 to choose few profitable stocks among many and create the portfolio. This memo will highlight the stocks of my selection to construct the portfolio, discuss various parts of portfolio construction and review, and provide the suggestion for the future to enhance the financial position of the company through portfolio investment.
On 18th March, 2x05, after the extensive analysis of the stock, CFO and I, as an investment advisor, listed out four different stocks to create a portfolio. CFO and I created this list differently after weighing the risk and expected returns from the stocks. However, later a single list was prepared for investment with highest possible diversification to eliminate the unsystematic risk from the portfolio. The stocks that were included in the portfolio after proper evaluation of the companies, as well as the industry, were Desktop, Inc., Levinthal Defense System, Transconduit Inc., and Goldstein & Delaney Bank. The profile of the stocks that are selected in the portfolio is explained below:
1. Desktop, Inc.- It is the largest seller of the office supplies around the world. It sells the products related to printing, copying, mailing and other office equipment.
2. Grand Capital Insurance- It is a financial institution with more than 50 years of successful history. It is listed in Fortune 500.
3. Levinthal Defense Systems- A company with many clients around the globe is the third in the list. It works as a defense contractor to build radar and targeting systems, missiles, navigation and reconnaissance systems. It conducts billion dollars of the transaction with the government of US as a major customer.
4. Goldstein & Delaney Bank: Serving with more than 3,500 branches in 21 states of the United States, the bank stands as one of the largest banks in America. It offers diversified financial services including retail account, investment and loan services.
Casa Bonita Ceramics Company has always emphasized on the protection of the shareholder's wealth and even increasing it. So, it is not recommended to invest in the stocks that bear very high risk even if it would meet the company's return requirement. The stocks that are included in the company's portfolio meet the risk and return requirement of the company while it is well diversified. The stocks like Desktop, Inc. and Levinthal Defense system have a high prospect of return because their business has always been in the green zone. With the minimal risk in the business, they are more likely to earn a higher profit for the stockholders. Similarly, the stocks like Grand Capital insurance and Goldstein & Delaney Bank have high risk yet can provide elevated returns on the investment. So, there is a mix of highly risk stocks (stocks from bank and insurance) with the high prospect of the return and the stocks with moderate risk and return.
The next important thing to consider was to allocate $800,000 in the stock portfolio to earn the maximum return. However, it was also clearly instructed in the company's investment policy that the total investment return must be a minimum of 12% while the portfolio risk must not exceed 22%. By using the theories of investment into the practical ground, the efficient frontier graph was constructed. Because the stocks were of similar nature (no stock had the least risk), the graph showed the equal amount of investment to be preferable considering the return possibility. The return must be justified with the amount of the risk taken by an investor. Considering the fact that the treasury securities provided low-interest rate, the investment in those securities were not priorities. Even though they had minimum risk, the minimum return requirement of 12% forced us to drop the idea of including the government securities in the portfolio. Hence, $200,000 was invested in the stocks of the four companies listed above with expected portfolio return of 12.74%, risk of 20.45% and the sharpe ratio of 38.46%. The Sharpe ratio is one of the popular measures to calculate the risk-adjusted return. It is defined as the average return that is earned over risk-free rate for each unit of total risk taken. This ratio can be the useful tool to compare the change in the portfolio's total risk-return continuum when the stocks in the portfolio are altered (O'Loughlin, & O'Brien, 2006). If the portfolio has high Sharpe ratio, then it reflects that the portfolio has better risk-adjusted performance. So, it is always good to have high Sharpe ratio. In the case of our portfolio, 38.46% is a high value.
After a year in 2x06, the value of portfolio grew to $757,614 with the loss of $42,386. This loss was from the stocks of Levinthal Defense System and Transconduit, Inc., while two other stocks were in a green zone. The overall portfolio risk was 17.19%, and return was just 9.2% below the required rate. The Sharpe ratio was also 25.86%, fall by about 13%.
This reflects that the company has failed to some extent in maintaining its portfolio well diversified. There was no tradeoff between the risk and return. Even by taking the risk of 20.45% , the company could not earn the minimum return of 12%. This might be because of the less diversified portfolio or because of, the fewer assets in the portfolio. It becomes very important for the company to discuss its risk-return preferences with its investment executives openly in the future. Rather than giving the task of investment to few top employees, the company must make this task a common task of the entire finance department where all the staffs of the department will come together in the portfolio construction with more alternatives. In addition to this, the company must look forward to including more stocks in the portfolio to increase the probability of profitable return and ensure the diversification in the future.
References
O'Loughlin, B., & O'Brien, F. (2006). Fundamentals of investment: An Irish perspective. Dublin: Gill & Macmillan.
