Risk perception a crucial factor in portfolio selection

Jul 22 2014, 00:00 IST
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SummaryCreating an optimal portfolio is an important objective for any investor.

Creating an optimal portfolio is an important objective for any investor. During this process, several factors and investment characteristics need to be considered. The most important of these are risk and return of individual assets under consideration. Correlations among individual assets, along with risk and return, are important determinants of portfolio risk. Portfolio creation requires an understanding of the risk profile of the investor.

Risk and return are basic characteristics of any investment as financial assets are generally defined on their basis. A comparison along these two dimensions simplifies the process of selecting from millions of assets and makes financial assets substitutable. These characteristics distinguish financial assets from physical ones, which can be defined along multiple dimensions. Although financial assets are generally claims on real assets, their commonality across the two dimensions, namely risk and return, simplifies the issue and makes them easier to value than real assets.

Risk aversion and portfolio selection

Equity shares, bonds and treasury bills provide different levels of returns and have different levels of risk. Although investment in equities may be appropriate for one investor, another may not be inclined to accept the risk that accompanies a share of a company and prefer to hold more cash. The concept of risk aversion is related to the behaviour of investors under uncertainty.

Assume that an individual is offered two alternatives: (a) one where he will get Rs 500 for sure and (b) the other one is with a 50% chance that he gets Rs 100 and 50% chance he gets nothing. The expected value in both cases is Rs 50, one with certainty and the other with uncertainty. What will an investor choose? There are three possibilities: an investor goes for the gamble, chooses Rs 50 with certainty, or he is indifferent. An investor is said to be risk-seeking if he choses the option b. He is considered risk averse if he chose option a and termed as risk-neural if he is indifferent. In general, investors are likely to shy away from risky investments for a lower, but guaranteed return. That is why they want to minimise their risk for the same amount of return, and maximise their return for the same amount of risk. A risk-neutral investor would maximise return, irrespective of risk, and a risk-seeking investor would maximise both risk and return.

Diversification will not always help

Diversification is one of the most important and powerful concepts in

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