Portfolio Management free essay sample

Analyze the relationship between risk and rate of return, and suggest how you would formulate a portfolio that will minimize risk and maximize rate of return. The relationship between risk and rate of return is risk determines expected rates of return on every existing asset investment. The Risk-Return relationship is characterized as being a positive or direct relationship. (Importance of risk relationship , 2001). In other worlds if the risk of investing on an investment is high then the return will also be high.. Alternatively, if an investment has relatively lower levels of expected risk then the investor will get relatively lower returns. The risk and rate of return relationship effects both business managers and individual investors. The higher the chance of risk the more likely it must be compensated with higher return. â€Å"Since investment returns reflects the degree of risk involved with the investment, investors need to be able to determine how much of a return is appropriate for a given level of risk. We will write a custom essay sample on Portfolio Management or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page †(Importance of risk relationship, 2001). In other words the risk for investment returns needs to be determined before the investment is carried out so that the investor knows what level of risk they are at. This process is called â€Å"pricing the risk. The price of risk is defined as the measure of risk quantified to determine how much risk is appropriate to bear for the investment. (Importance of risk relationship, 2001). When formulating a portfolio with minimal risk and maximum return, one must quantify the degree of risk they are willing to take towards the investment. One must also pick an investment that does not have much risk involved. For instance if they choose to invest in a rental property then the chances of risk are not as high as opposed to if the person invested in a restaurant. If the restaurant becomes a flop and has to shut down the owner would loose more money because it costs more to keep a restaurant. The chances of a real estate rental property becoming a loss are less because people always need a place to live. If the investor was unable to rent the property then he or she can always sell it. It would be easier to sell a rental property then it is to sell a commercial property such as a restaurant. Thus knowing the type of investment it is lets the person determine the degree of risk involved. Therefore to maximize risk and minimize one must pick a sound money making investment that does not involve much risk in the first place. 2. Formulate an argument for investment diversification in an investor portfolio. An investor should have a diverse portfolio because the diversification of portfolios lets the investor know which companies are best to invest in? Which companies have a better economic outlook in the future? Having a diverse portfolio also makes a investor a more round up individual. They gain more knowledge of where to invest their money and which investment has a higher return rather then risk. A person should also have a diverse portfolio because one never knows which asset will have a higher value over time. The highest returning asset will usually be the most risky one, so the chances of loss are greater, too. (Reilly, 2012). There are also time factors to take into consideration when deciding to hold an asset. Shares are the best performing asset over the long-term, but not always in the short term. A bear market in shares can savage your returns and your net worth. Another factor as to why one should have a diversified portfolio is because one never knows how their attitude will be towards the stock market, until the person has experienced it hitting their investment. 3. Address how stocks, bonds, real estate, metals, and global funds may be used in a diversified portfolio. Provide evidence in support of your argument. There are two types of diversifications horizontal and vertical diversification. Vertical diversification is when money is spread out between different types of assets such as cash, corporate bonds government bonds, and property. Where as Horizontal diversification is when one holds different instances of the same asset class. In other words one can have the same type of investment just in different times. Stocks, bonds, real estate, metals and global funds fall under vertical diversification. They are different types of assets that can be used to diversify a portfolio because they are different from one another. These types of assets add diversification to the portfolio because they are diverse from each other. They can also be used to maximize risk and minimize profit. According to the article titled â€Å"portfolio diversification† the very best mix of assets you can hold to maximize risk for a given level of return is called the efficient frontier. (Portfolio diversification 2009). In other words if one has a diverse mix of assets they are more likely to maximize their risk and maximize their profit. Therefore having a diverse portfolio with stocks, bonds, real estate, global funds and metals is beneficial and adds diversity to the portfolio because each asset has different characteristic and benefits for the investor. The difference between each type of asset is what adds diversity in a portfolio. 4. Evaluate the concept of the efficient frontier and how you will use it to determine an asset portfolio for a specified investor. The concept of the efficient frontier shows how volatilely increases the risk of one’s loss of principal. The efficient frontier also states that the risk worsens as the time horizon begins to shrink. All things held equal one would want to minimize volatility in their portfolio. The efficient frontier also states that if one limits themselves to low risk securities the return on the investment will be low too. So what one should really do is include some higher growth, higher risk securities in their portfolio, but combine them in a smart way, so that some of their fluctuations cancel each other out. Harry Markowitz and Bill Shape. For instance they believe that if one has data for a collection of securities like the S amp; P 500 stocks, and one graphs the return rates and standard deviations for these securities, and for all portfolios one can get by allocating among them. Markowitz showed that you get a region bounded by an upward-sloping curve, which he called the efficient frontier. Another characteristic of the efficient frontier is that its curved, not straight. This is actually significant in fact; it is the key to how diversification lets one improve their reward-to-risk ratio. Using the graphing method to understand where the investor stands can be determined by the efficient frontier. The curve and lines of the graph can determine where the asset investment stands in terms of value. 5. Consider the economic outlook for the next year in order to recommend the ideal portfolio to maximize the rate of return for the short term and long term. Explain the key differences between the short and long term. The U. S. economic outlook for next year is what economists call the fiscal cliff of 2013. This will be the expiration of enormous tax cuts and transfer payments. (Lei 2012) David Wessel a columnist for the wall street journal warned that the stock market and bond market, which thus far have ignored the 2013 fiscal cliff, are at danger of being effected by it. The economy will continue to shape up with unemployment rates dropping to 6. 5%. (Lei 2012). As for the global economy it will continue to expand; despite the risk from Europe and the Persian Gulf which will continue to slow down the expansion. According to Forbes the world economy is will a little bit better then recent years. (Conerly, 2012). The U. S. economy will grow about 2. 3% this year, which is an improvement from 2011, but this is still well below the rate needed. It is also reported that consumer confidence is up and consumes are opening their wallets. (Conerly, 2012). After saving up for the last 4 years consumers are finally starting to spend their money on goods. Solid corporate profits are also boosting sales this year. This in return will give business managers confidence towards hiring and investing. The ideal portfolio, which will maximize the rate of return for short term and long term according to this year and next year’s economic outlook should be one that is made up of diverse assets and investments. An investor should invest in goods and services that have a promising economic outlook. Stocks and bonds are a good investment in the long run. Stocks have the tendency to fluctuate so it is harder to predict when it is a good time to buy or sell the stock. Stocks are a good investment in the long run because the price of stock may increase after some time. Investing in real estate might also beneficial because the real estate market is set to pick up in the long run. The key difference between long and short-term investments is that a long-term investment is one that will earn the investor a profit as time passes. A person who invests in a short term investment such as a small business or service of some sort will tend to see results in profits quicker then the investor who put capital towards a long term investment, such as the real estate market.