INVESTMENT ANALYSIS - (PORTFOLIO SELECTION)

INVESTMENT ANALYSIS

Topic: Portfolio Selection

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INTRODUCTION

Portfolio selection is the process of identifying the most efficient combination of securities.  It can also be defined as the process of determining the most optimum portfolio.

An efficient portfolio is one that has a lesser risk than any other one with similar returns or the one with the highest return than any other within the same risk brackets.

Illustration

Suppose that the following portfolios are lying on the efficient or an efficient frontier of an opportunity sets, determine the best (Optimal) portfolio if the investment risk tolerance is 40%.

PORTFOLIO:-	A	B	C	D	E
Expected Return	7.60	9.13	9.43	9.73	9.85
Expected Variance	0.19	0.52	0.61	0.74	0.75
Standard Deviation	4.32	7.24	7.79	8.59	8.67

According to Prof. Williams, to select an Optimal Portfolio from a given sets of portfolios, emphasis should be given to the portfolio with the highest risk utility adjusted return.

Solution:

To determine the utility;

Utility = expected Return – Risk Penalty

Risk Penalty =          Risk²______

                              Risk Tolerance

Risk = Standard deviation

Solving for portfolio (A) Risk Penalty:

(4.32)²               =     18.66

   40%                     40

=0.47

I hope we all know how we got 4.32? That is the Standard Deviation of Portfolio A in the Table Above.  Then the 40% was given in the question as the Risk Tolerance.  Pls, don’t convert the %.

Now let’s solve for Portfolio B.

(7.24)²               =     52.42

   40%                     40

=1.3

Solving for portfolio (C) Risk Penalty:

(7.79)²               =     60.68

   40%                     40

=1.82

Solving for portfolio (D) Risk Penalty:

(8.59)²               =     73.79

   40%                     40

=1.84

Solving for portfolio (E) Risk Penalty:

(8.67)²               =     75.17

   40%                     40

=1.88

 

UTILITY:

A             :               7.06-0.47=7.13  

B             :               9:13-1.30=7.83  

C             :               9.43-1.52=7.91

D             :               9.73-1.84=7.90

E              :               9.85-1.88=7.97

Therefore: We will choose E since it has 7.97 as the highest. 

Note: You can recalculate to avoid mistake.  You really need to practice all of it over and over again. 

Best regards all.