1.0 INTRODUCTION
In this case the Sandra is a good wife and good mother for her 2 child. After her husband William pass away she realized about she was unprepared for the complex decision have to be made for managing his wealth. The objective of this case study is to get a good portfolio and also to get higher returns and lower return. The problem is Sandra has don't know about the various nuances of risk, expected return and portfolio management. The financial advisor, Bolton using certain theory to solves the Sandra's problem. There is Risk and Return, Portfolio and Capital Asset Pricing Model.
2.0 RELATIONSHIP BETWEEN RISK AND RETURN OF INDIVIDUAL STOCK
The relationship between risk and return is the basis of financial relationships that affect the expected rate of return investments available. The risk and return relationship is marked as a "positive" or "direct" relationship, which means that if there is hope that a higher level of risk associated with certain investment and greater return is required as compensation for higher risk is expected. Alternatively, if the investment is relatively lower level of risk that investors expect it satisfied with the results of the relatively lower.
Bolton refers for example according to appendix 1 the relationship between risk and return shows, if the return is high the risk will be low. If the risk is high the return will be low. For example High Tech Company's return is 9.7% and the risk is 3%. But the other company, there is Counter Cyclical Company's return is 5% and the risk is 12%.
3.0 MEANING OF BETA
Beta is a compute of stock price instability in connection with the rest of the market. In other words, how the stock price moves qualified to the overall market. Beta reflects the understanding of the return of certain stocks to go back on the market portfolio. Beta measures the relationship between price activities of an individual share of the market portfolio. We are not risk assets such as treasury bills is 0. Market portfolio beta is 1.0. If higher beta stocks are more than one, it is risk of the market.
3.1 HOW RELATED TO REQUIRED RETURN OF THE STOCK
To explain Sandra it should be show the appendix 2. Based on the appendix 1 the beta is related by if the beta is more than 1 the return will be high. If the beta is low than 1 the return will be low. For example the composite index's beta is 1, and then the required return is 18.7%. The High Tech Company's beta is more than 1, there are 4.043 and the required return is 60.4%. The Utility Company's beta is less than 1, there is 0.529 and the required return is 12.2%. If the beta is negative and the required return also will be in negative.
4.0 MEANING AND ADVANTAGE OF THE DIVERSIFICATION
The definition of diversification is a risk management method that mixes a broad variety of investments within portfolio. The portfolio strategies intended to decrease disclosure to risk by combining a variety of investments such as bonds and stocks, which is not likely to moving towards the same. The use of diversification is to decrease risk in the portfolio.
Advantage of diversification is that the inspiration to expand the market to swing. The most sector likely to experience growth in the long term, so that the total diversity of the portfolio should grow regularly. Diversification will take advantage of obtainable knowledge, skill and resources in the company when increasing into new activities. It will give better risk control by no longer rely on a single market and also providing the movement away from the declining activities.
Bolton can demonstrate to Sandra about diversification by showing appendix 3. In appendix 3 tell, if Sandra choose one company the return will be low and the risk will be high. If Sandra choose equally invest in two company the portfolio become the return will be high than risk. For example if Sandra only choose High Tech Company's portfolio the return is 10% and the risk is 22%. If Sandra chooses only the counter cyclical company's portfolio the return is 5% and the risk is 12%. If Sandra chooses both companies with equally portfolio the return is 7.5% and the risk 7%.
5.0 SECURITY MARKET LINE
Security market line is present by graphically of Capital Assets Pricing Model or CAPM. SML will display an individual security by the expected rate of return as a function of beta. Security market line is a straight slack line which gives the connection between expected rate of return and market risk of over all market. As follow the graph at appendix: The market risk or beta is present by the X- axis and Y- axis signifies the expected return in percentage in point of line. Normally the risk-free rate of return investment signifies in line parallel to X- axis, there is from the start of SML. Security market line is a simply powerful device for searching the risk and return with a portfolio. Sandra can plot individual stock beta and expected return against SML. If her expected return from the stock the security market line considered undervalued is to offer good return for risk taken. If her expected return fall below security market line the stock will be overvalued. It will be Sandra offer low return for the risk taken.
6.0 EFFECT OF INTEREST RATE ON PORTFOLIO
If Sandra chooses a well diversification portfolio, first Sandra must know about market risk premium. Market risk premium is the return that an individual stock or surplus stock has more than the level of risk. The risk free rate directly relate to interest rate. There is if increase in the interest rate guides to a increase in the risk-free rate, but finally decreases in the market risk premium. If decrease in interest rates it guides to decrease in risk free rate but finally increase in the market premium. CAPM (Capital Asset Pricing Model) help to determine the suitable discount rate. If Sandra borrows more money to invest money to stock, the interest rate on recently-issued bond will go up.
Interest rate and bond price are conversely linked. That is they moving in opposite direction. The coupon interest rate is equal with the rate of interest when a fixed-rate bond sold at par value. A fixed-rate bond sold at a discount below the par value when the rate of interest is above the coupon rate. If the current interest rate is below the coupon, fixed interest rate obligation to sell the premium "above its nominal value.
When Sandra invests her money to stock equally she get lower return and higher risk. CAPM statement will control a good diversification portfolio when Sandra worries about market risk.
INVESTING MONEY IN FIXED INCOME SECURITIES
The fixed income securities are an investment that give in the form of fixed interrupted payments and finally return the principal at maturity. Disparate a variable-income security, where payments vary on some underlying calculate such as short-term interest rates and the payments of a fixed-income security are recognized in advance. Normally the fixed income's product is bond.
Sandra investing money in fixed income securities are an essential element for a portfolio because the diversification across in the different classes of asset. Previously, the bond having more returned than investment of cash and also exhibited volatility less than stock. In other word, the bond's return has frequently equalized the negative stock's return throughout period of market depression. Generally lowers risk for all portfolios in investing bond to all stock. Sandra should keep in mind that still in asset sections, Sandra like stock or bonds, Sandra must having diversification by many individual securities.
The fixed income securities functions are offer the possible for a fixed income. Normally, less volatile than other investment with changes in fixed income securities principal. Nevertheless, ownership of fixed income securities, there is Sandra involves a variety of risks that attend the probable returns while with financial assets.
HOT TIPS REGARDING UNDERVALUED STOCK
Definition of undervalue stock is a stock that is sells at lower value than its potential value. First we should identify what creates a stock undervalue. There is a stock is usually appreciated if the value is lower than others in the company without a reason. Stocks are also usually cheaper than appreciated if the point of view of growth assessment. Stock growth of undervalue is to earliest perform a price per earnings stock's growth ratio. Price per earning growth is taking the price per earning and divides by expected return of the company. If the price per earning growth ratio is lower than 1, it's considered undervalued stock. There must be having high beta to provide changes in market. In other word, the undervalue stock mostly give higher return with lower risk.
INVEST 50% HIGH-TECH AND 50% COUNTER CYCLICAL
Sandra decides to invest her money equally to High-tech and counter cyclical stock. Based on appendix 5 the High Tech Company is constantly increasing but in counter cyclical company is decreasing. It is considered perfectly negative correlated. Correlation is a movement of typically calculated. The coefficient will quantified between -1 and +1. +1.0 Correlation is a perfect positive correlation, means the two asset move together. Correlation -1.0 is perfectly negative, means the two assets move together in opposite direction. After Sandra invests equally to that stock, the level of her portfolios expected return and risk is the return is 29.50% and the risk is 23%. Even though the correlation is perfectly negative, but the return higher than risk. But this expectation is not realistic.
COMBINATION OF 70% HIGH-TECH AND 30% INDEX FUND
Sandra were put 70% of her portfolio in the High-tech stock and 30% in the index fund. Based on the appendix 6, the High Tech and index fund is also perfectly negative correlated. Because the movement of both company stock is not equal. This combination of stock is not better for Sandra because it have high risk there is 18.54% and low return there is 9.52%. Sandra should propose possible portfolio to make better combination.
PROPOSING A POSSIBLE COMBINATION PORTFOLIO
Based on the calculation in appendix 5 and appendix 6, Bolton should propose a possible combination to portfolio to Sandra. According to appendix 7, choose 20% in High Tech Company and 80% in Utility Company. Combination of this level of investment is suitable for Sandra because this is perfectly positive correlation and also will get higher return and lower risk. There is 9.76% of return and 6.36% risk. This expectation will be realistic for her company.
CONCLUSION
A good company must have higher return and lower risk. The combination High Tech Company and Utility Company is form as low risk stock portfolio. Risk can reduce by diversification but it cannot be eliminated. Well diversification will make better portfolio. If the beta higher than 1.0 the expected will be high, so Sandra must having beta higher than 1.0 to get more profit. This expectation will give more profit for Sandra. Sandra can invest her money 20% in High Tech Company and 80% in Utility Company. Sandra can find her stock is overvalued or undervalued by straight market line.
