Introduction
Before, investing, it is important to evaluate the risk-return profile of an individual security and entire portfolio. Further, when selecting a stock to include in a portfolio, it is important to take into account the concept of diversification. Diversification lowers the overall risk of a portfolio (Brigham & Michael 2009). The paper seeks to advise an investor who intends to spend a sum of $500,000 in a portfolio that is made up of shares from three sectors. In the end, the investor will be advised on the amount of money to invest in each stock, the resulting portfolio risk, and return. The targeted sectors are industrial, finance, and health sectors. Further, 5 companies are selected from each industry and this brings the total number of shares in the portfolio to 15. A summary of the companies selected is presented in appendix 1. Historical monthly share prices for the companies are collected for 5 years. This is equivalent to 60 months. The expected return and beta for each portfolio will be calculated using the data for monthly share prices. Further, the data for the S&P 500 index will be collected to represent movement in the market.
Discussion
The results in appendix 2 show that the companies have different values of expected return and risks. Companies operating in the industrial and financial sectors tend to have a low of both expected return and standard deviation. This can be an indication that the two industries are less volatile. On the other hand, companies in the health sector have a large range of both risk and return. Thus, risk-averse investors might prefer to invest in the industrial and financial sectors while investors who are risk-takers will prefer to invest in the health sector because they offer high returns. Under the industrial sector, Apple, Inc. had the highest value of the expected return while Hewlett Packard Corporation had the least amount of return (Simon 2012). The calculations show that the stock of Hewlett Packard Corporation had the highest risk level risky while that of Deere & Company had the least amount of risk. Under the health sector, Achillion Pharmaceuticals, Inc. had the highest value of the expected return while American Caresource Holdings, Inc. had the least amount of return. Further, the stock for Achillion Pharmaceuticals, Inc was most risky while that of Cooper Companies, Inc. was the least risky. Further, in the case of the Finance sector, Prudential Financials, Inc. had the highest value of the expected return while Bank of America had the least amount of return. In terms of risk, Bank of America was the most risky while Wells Fargo was the least risky in this category. In the entire portfolio, Achillion Pharmaceuticals, Inc. had the highest return with the highest amount of risk. The company also had the highest value of systematic risk (beta). A review of risk and return is important because investors have different attitudes towards risk (Shepherd 2008). The total return for the entire portfolio is 0.0174.
After the estimation of risk and return for individual security and for the portfolio, a model will be built to solve the puzzle of the amount to invest in each security. The model is built on various assumptions. First, the maximum amount available for investment is $500,000. Secondly, the beta for the entire portfolio should be 1.1. Further, the minimum expected return of the portfolio should be 0.08. Also, not more than 12% of the entire capital should not be allocated to one stock and not more than 15% of the total capital should be allocated to all companies that the value of beta exceeds 1.2. Some limitations are put on the amounts allocated for each industry; at most 15% of the entire capital should be in the health sector, at least 10% in the industrials and a minimum of 20% in the financial sector. A spreadsheet model is constructed to solve the problem. The model is presented in appendix 3. All these assumptions are taken into account in the model (Falkenstein 2009).
Solution and recommendation
The solution for the investment problem is presented in appendix 4. The goal of the investor is to maximize the expected return and minimize risk. An efficient portfolio gives a combination of securities that offers the highest return at a given level of risk or the least amount of risk for a given level of return (Block & Hirt 2007; Damodaran 2008). The solution shows that two companies should be dropped, these are 3M Company and American Caresource Holding, Inc. These two companies were not attractive. The results also show that the maximum possible allocation will be made to companies such as Apple, Inc., Deere, and Company, and Wells Fargo among others. The solution is made up of companies from all the three sectors Besides, they have different amounts of risk and return. The portfolio will satisfy the customer’s need for an 8% return and 1.10 for systematic risk.
References
Block, S & Hirt, G 2007, Foundations of financial management, McGraw-Hill/Irwin, USA.
Brigham, E & Michael, J 2009, Financial management theory and practice, South-Western Cengage Learning, USA.
Damodaran, A 2008, Strategic risk taking: a framework for risk management, Pearson Education Inc., US.
Falkenstein, E 2009, Finding alpha: the search for alpha when risk and return break down, John Wiley & Sons, US.
Shepherd, S 2008, Cash holdings, stock split, and mergers: examining risk and return in the equity markets, ProQuest, US.
Simon, A 2012, CAPM vs behavioural finance: risk and return – does behavioural finance provide better explanations than the CAPM?, GRIN Verlag, Germany.
Appendices
Appendix 1
Summary statistics for the companies selected
Appendix 2
The estimated values of beta and expected return for the companies selected
Appendix 3
A spreadsheet model for solving the portfolio problem
Appendix 4
Solution to the portfolio problem