1 Introduction
This report intends to explain the aims and objectives of the portfolio project
undertaken. In order to determine whether any aims and objectives have been
achieved, relevant theory and analysis of findings will be used. The aims of this
portfolio project was to invest a notional principal amount of £200,000 was made
available to invest in securities on the London Stock Exchange during the period from
4th October 2010 till the 1st April 2011, on which date the portfolio will be liquidated
and any gains realised. Furthermore the project will be split between the two terms, in
which to different investment strategies will be applied, in the first term an active
trading strategy shall be adopted whereas in the second term a buy and hold strategy
shall be put into place. The objective of this project was to develop an understanding
of the stock market and to create a portfolio that is well diversified and minimises
total risk. Moreover, this report shall explain any relevant theory in order to and
demonstrate how this affected the strategy that was adopted for investment and how it
was used in practice. It will also outline any limitations that were found through the
project. Furthermore, the findings will be explained, showing how using different
strategies affected the profit from investment, for example if active trading gave
higher profit than buying and holding the shares. Finally, the report will come to a
conclusion which will show in general how the market has performed and if the
project would be approached differently if done again.
2 Theory:
2.1 Stock Market.
The stock market acts as an efficient allocator of funds within the financial economy.
The stock market is split into the primary and secondary markets. The primary market
is there so newly issued shares can be sold to raise capital for the company. The
secondary market is for existing shares and involves in the buying and selling these
shares.
2.2 Relationship between risk and return
The risk of a security is the uncertainty that the actual return will vary from the actual
return. In an efficient capital market investors are risk averse and will want greater
levels of return for being exposed to higher levels of risk. However with greater levels
of risk the investor has a higher chance of earning greater returns. The risks that the
investors are likely to face are systematic and unsystematic risk. Systematic risk is the
, inherent market risk that every business and investor faces and cannot be reduced
with diversification, the amount of systematic risk the investor is out of their control it
controlled by factors in the environment surrounding the market and therefore is
unavoidable. Unsystematic risk is the company or industry specific risk and can be
reduced with the appropriate diversification; it is caused by a number of factors e.g.
managerial inefficiency. Unsystematic risk is broken down into 2 categories; Business
Risk and Financial Risk. Business risk is the risk associated with circumstances of
the particular company which may affect the ability of the company to produce stable
earnings. Financial risk of the company is affected by the level debt to equity
financing it has, with higher levels of debt the investor has a higher risk of losing their
investment if the company goes into administration.
2.3 Portfolio Theory:
Portfolio theory was developed by Harry Markowitz, 1952, in order to quantify the
risk of an investment portfolio, and to help investors develop an optimal portfolio.
This a theory where the investor creates a portfolio in order to maximise their return
from their investment at a given level of portfolio risk by diversification and using
proportions of various securities. Modern Portfolio Theory is based on a number of
assumptions in order for the model to hold. The assumptions of the theory include;
there are no transaction costs or taxes, all investors will have access to information at
the same time, all investors are price taker and therefore do not have an effect on the
share price, all investors will try to maximise economic benefit and all investors will
be able to accurately predict possible returns. However some of the assumptions that
are needed for the model for hold are unrealistic. In reality investors are subject to
taxes and transaction cost and therefore their optimal portfolio will be different from
the one calculated with the model. Moreover, the model also assumes that investors
are price takers; however in reality if investors were to buy and/or sell shares in large
quantities then they would have an effect on the share price. Furthermore, the model
assumes that shares can be split into fractions in order to have correct proportion that
should be invested, however in reality this may not be possible and the investor may
be required to purchase a minimum order of shares and therefore this would also
affect the optimal portfolio that was derived from the model. Therefore portfolio
theory is a useful tool for quantifying risk and creating a portfolio using
diversification in order to reduce risk, however the optimal portfolio produced by the
model may have to be adjusted because of the unrealistic assumptions.
, 2.4 Efficient Market Hypothesis
“The Efficient Market Hypothesis implies that, if new information is revealed
about a firm, it will be incorporated into the share price rapidly and rationally,
with respect to the directions of the share price movement and the size of that
movement” (Arnold, 2008, p. 563) For a stock market to be efficient, it has to be
Operationally, Allocationally and Pricing Efficient. The market is operationally
efficient when transactions take place at the lowest possible cost, speedily and
reliably. A market is allocationally efficient when resources are allocated to the firms
which will use them to be the most productive. “The major implication for
investment is that investors cannot expect to beat the risk-adjusted average,
except by chance. Investors should instead seek to maximise the effectiveness of
diversification in their portfolio.” (Firth et al, 1986, p. 12) Furthermore, a market is
pricing efficient when the investor can only earn a risk adjusted return from their
investments as prices move immediately and unrelated to announcement. Within an
efficient market, investors will not be able to make any abnormal profits because all
historical and present information about the company will be reflected in the share
price, and only new information will bring a change in the share price, and as news is
unforecastbale as a result future prices are as well. Within the efficient market there
is three levels of efficiency; weak-form, semi-strong form and strong-form efficient.
In a Weak-form efficient market the current share price will reflect all information
that caused past price movements. In a Semi-strong form efficient market current
share prices will reflect all information available to the public, such as earnings
reports and dividend announcement, and therefore assuming that there will be no
point in analysis publicly available information after release as it will be incorporated
in the share price. In a Strong-form efficient market all relevant information about the
company has been reflected within the share price and no one, not even people with
inside information, is able to make an abnormal profit. In reality, stock markets are
seen to be closer to semi-strong form efficiency because most investors are only able
to view publicly available information, but are not able to use that information to
make a gain as it will be reflected in the share price instantaneously. This is backed up
by Firth (1967a, 1979, 1980) who found that after the announcement of a takeover bid
share prices were instantaneously and fully adjusted to their correct levels.
2.5 Random Walk Theory:
This report intends to explain the aims and objectives of the portfolio project
undertaken. In order to determine whether any aims and objectives have been
achieved, relevant theory and analysis of findings will be used. The aims of this
portfolio project was to invest a notional principal amount of £200,000 was made
available to invest in securities on the London Stock Exchange during the period from
4th October 2010 till the 1st April 2011, on which date the portfolio will be liquidated
and any gains realised. Furthermore the project will be split between the two terms, in
which to different investment strategies will be applied, in the first term an active
trading strategy shall be adopted whereas in the second term a buy and hold strategy
shall be put into place. The objective of this project was to develop an understanding
of the stock market and to create a portfolio that is well diversified and minimises
total risk. Moreover, this report shall explain any relevant theory in order to and
demonstrate how this affected the strategy that was adopted for investment and how it
was used in practice. It will also outline any limitations that were found through the
project. Furthermore, the findings will be explained, showing how using different
strategies affected the profit from investment, for example if active trading gave
higher profit than buying and holding the shares. Finally, the report will come to a
conclusion which will show in general how the market has performed and if the
project would be approached differently if done again.
2 Theory:
2.1 Stock Market.
The stock market acts as an efficient allocator of funds within the financial economy.
The stock market is split into the primary and secondary markets. The primary market
is there so newly issued shares can be sold to raise capital for the company. The
secondary market is for existing shares and involves in the buying and selling these
shares.
2.2 Relationship between risk and return
The risk of a security is the uncertainty that the actual return will vary from the actual
return. In an efficient capital market investors are risk averse and will want greater
levels of return for being exposed to higher levels of risk. However with greater levels
of risk the investor has a higher chance of earning greater returns. The risks that the
investors are likely to face are systematic and unsystematic risk. Systematic risk is the
, inherent market risk that every business and investor faces and cannot be reduced
with diversification, the amount of systematic risk the investor is out of their control it
controlled by factors in the environment surrounding the market and therefore is
unavoidable. Unsystematic risk is the company or industry specific risk and can be
reduced with the appropriate diversification; it is caused by a number of factors e.g.
managerial inefficiency. Unsystematic risk is broken down into 2 categories; Business
Risk and Financial Risk. Business risk is the risk associated with circumstances of
the particular company which may affect the ability of the company to produce stable
earnings. Financial risk of the company is affected by the level debt to equity
financing it has, with higher levels of debt the investor has a higher risk of losing their
investment if the company goes into administration.
2.3 Portfolio Theory:
Portfolio theory was developed by Harry Markowitz, 1952, in order to quantify the
risk of an investment portfolio, and to help investors develop an optimal portfolio.
This a theory where the investor creates a portfolio in order to maximise their return
from their investment at a given level of portfolio risk by diversification and using
proportions of various securities. Modern Portfolio Theory is based on a number of
assumptions in order for the model to hold. The assumptions of the theory include;
there are no transaction costs or taxes, all investors will have access to information at
the same time, all investors are price taker and therefore do not have an effect on the
share price, all investors will try to maximise economic benefit and all investors will
be able to accurately predict possible returns. However some of the assumptions that
are needed for the model for hold are unrealistic. In reality investors are subject to
taxes and transaction cost and therefore their optimal portfolio will be different from
the one calculated with the model. Moreover, the model also assumes that investors
are price takers; however in reality if investors were to buy and/or sell shares in large
quantities then they would have an effect on the share price. Furthermore, the model
assumes that shares can be split into fractions in order to have correct proportion that
should be invested, however in reality this may not be possible and the investor may
be required to purchase a minimum order of shares and therefore this would also
affect the optimal portfolio that was derived from the model. Therefore portfolio
theory is a useful tool for quantifying risk and creating a portfolio using
diversification in order to reduce risk, however the optimal portfolio produced by the
model may have to be adjusted because of the unrealistic assumptions.
, 2.4 Efficient Market Hypothesis
“The Efficient Market Hypothesis implies that, if new information is revealed
about a firm, it will be incorporated into the share price rapidly and rationally,
with respect to the directions of the share price movement and the size of that
movement” (Arnold, 2008, p. 563) For a stock market to be efficient, it has to be
Operationally, Allocationally and Pricing Efficient. The market is operationally
efficient when transactions take place at the lowest possible cost, speedily and
reliably. A market is allocationally efficient when resources are allocated to the firms
which will use them to be the most productive. “The major implication for
investment is that investors cannot expect to beat the risk-adjusted average,
except by chance. Investors should instead seek to maximise the effectiveness of
diversification in their portfolio.” (Firth et al, 1986, p. 12) Furthermore, a market is
pricing efficient when the investor can only earn a risk adjusted return from their
investments as prices move immediately and unrelated to announcement. Within an
efficient market, investors will not be able to make any abnormal profits because all
historical and present information about the company will be reflected in the share
price, and only new information will bring a change in the share price, and as news is
unforecastbale as a result future prices are as well. Within the efficient market there
is three levels of efficiency; weak-form, semi-strong form and strong-form efficient.
In a Weak-form efficient market the current share price will reflect all information
that caused past price movements. In a Semi-strong form efficient market current
share prices will reflect all information available to the public, such as earnings
reports and dividend announcement, and therefore assuming that there will be no
point in analysis publicly available information after release as it will be incorporated
in the share price. In a Strong-form efficient market all relevant information about the
company has been reflected within the share price and no one, not even people with
inside information, is able to make an abnormal profit. In reality, stock markets are
seen to be closer to semi-strong form efficiency because most investors are only able
to view publicly available information, but are not able to use that information to
make a gain as it will be reflected in the share price instantaneously. This is backed up
by Firth (1967a, 1979, 1980) who found that after the announcement of a takeover bid
share prices were instantaneously and fully adjusted to their correct levels.
2.5 Random Walk Theory:
