Risk and Investment

Paper Summary:

This paper studies how a hypothetical stock broker managing a diverse stock portfolio would evaluate the risks and return on his clients' various investments. The paper provides a valuation and analysis of individual securities and a valuation of CAPM and APT models to estimate the value of securities; discusses possible problems related to the models; explores diversification and selection of a portfolio of securities; and details the risks and returns of the portfolio.

Development of a Basic Model
Some Problems
Diversification
Portfolio Selection
Risks and Returns

From the Paper:

"What does a reliable fund manager have to do today to ensure that his clients will obtain a realistic picture of the risks and returns of investing in his portfolio? The first part of the investment decision process involves the valuation and analysis of individual securities, which is referred to as security analysis. The valuation of securities is a time consuming and a difficult job. First of all, it is necessary to understand the characteristics of the various securities ad the factors that affect them. Secondly a valuation model is applied to these securities to estimate their price or value. Value is a function of the expected future returns on a security and the risk attached. Both of these parameters must be estimated and brought together in a model. For bonds, the valuation process is relatively easy, because the returns are known and the risk can be approximated from currently available data. Interest rates are primary factor affecting bond prices, but no one can consistently forecast changes in these rates. The valuation process is much more difficult for common stocks than for bonds because the investor must deal with the overall economy, the industry, and the individual company; both the expected return and the risk of common stocks must be estimated. The secondary major component of decision process is portfolio management. After securities have been evaluated, a portfolio should be selected. Having built a portfolio, the astute investor must consider how and when revising it. If the investor pursues an active strategy, the issue of market efficiency must be considerated; if prices reflect information quickly and fully, investors should consider how this will affect their buy and sell decisions. Even if investors follow a passive strategy, questions to be considered include taxes, transaction costs,and maintenance of the desired risk level, and so on."

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