Page 267 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes Effect of Portfolio Size on Portfolio Risk

Observe the above diagram, which depicts the decline in size of portfolio risk as the number of
individual stocks increase in a portfolio. That portion of the total risk, which declines due to
diversification of investment, from a single asset to others is called diversifiable risk or firm-
specific risk. It may arise due to the internal firm level or company level or industry level
reasons like strikes and lockouts, sudden fall in demand for the product, entry of new technology,
specific governmental restrictions, fluctuating growth to the given industry. On the other hand,
the diversifiable risk, which is also called ‘systematic risk’, is that portion of risk, which cannot
be further reduced by adding any number of newer scrips to the given portfolio. It is called
‘systematic’ or ‘market risk’ as the reasons like general changes in the economy, political and
market fluctuations, inflation and interest rates, which have a common bearing on all stocks. As
these factors simultaneously affect all industries as well as firms alike this risk is universal to all
risky assets.
This aspect brings a new dimension to the risk-return analysis. In efficient market Assets are
expected to be priced in such a way that they yield a return proportional to the size of risk that
the asset carries. Which risk is generally rewarded? Is it the total risk that the asset brings or
something else? Certainly, the market is not expected to reward the risk, which can be diversified
by putting investment across different stocks. Then the relevant individual stock is its contribution
to the systematic risk in a well-diversified portfolio. How to identify this contribution? William
F. Sharpe has given an answer to this. He has established the contribution of each single asset to
the portfolio risk by developing a ‘Single-Index Market Model’.

10.4 Traditional Portfolio Analysis

Traditional security analysis recognizes the key importance of risk and return to the investor
traditional approaches, which rely upon intuition and insight. The results of these rather
subjective approaches to portfolio analysis are covered under the realm of the traditional analytical
approach.
Most traditional methods recognize return as some dividend receipts and price appreciation
over a forward period portfolio or combination of securities are thought of as helping to spread
risk over many securities.

Case Study A Calculated Risk

"Only those who risk going too far can possibly find out how far one can go."
- T.S. Eliot

"Investing is a risky business." We have all come across this statutory warning or have
learnt it the hard way while investing in the stock market. Let us take a step back to
understand what is 'risk'.
The word is commonly used to describe the chance of a loss.
Chance: the Webster's Dictionary defines this word as "something that happens
unpredictably without discernible human intention or observable cause." In other words,
risk in the financial context stands for the uncertainties associated with future cash flows.

Contd...

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