Question

“If an investor holds shares of about 20 different businesses all of the risk is eliminated and the portfolio will give a return equal to the risk-free rate.” Discuss the statement. (Write minimum 1,000 words and prove proper referencing).

Answer 1

The above give statement can prove to be correct with lack of certainty. Because equality market is quite uncertain, As there are different factors affecting the companies share value in the listed stock market. In the above statement an investor made investment in 20 different business, and expecting the returns to be equal with risk free rate.

Risk free rate is the rate of return which is a gauranteed return available in the market. Usually interest rate on government are considered as risk free return (which is usually stands around 10%). Because government bonds are considered as most secure investment.

Diversification of portfolio is the always most preferable thing to do, As it reduces the risk to most extent. Also Investment in equity is defined as most safe and profitable source because we can generate revenue through dividends and sale of equity for higher value. But still there are different factors which will influence the market and reduces the value of share. Some of the factors are as follows

1. Interest rates: The U.S. Federal Reserve sets short-term interest rates, which will be having impact on loans, credit cards and mortgages. They reduce rates to spur economic growth and increases rates to control the inflation. Rise in rates leads to higher borrowing costs which reduces the savings in individual incomes and lower investments in businesses. This could lead to lower revenues and profit margins, which would reduce equity returns. Similarly lower interest rates leads to more consumer and business spending, which would improve margins and equity returns.
2. Employment: Lower employment rate leads to less disposable income from individuals, which will affect the revenues of the business. When an individual does not have employment he will spend only on essential things but not on other luxury stuff and this will have negative impact on the business and investor will loose their margin and returns.
3. Global economies: Global economic conditions also have impact on equity returns when companies do business across the borders. For example, Asian countries economy could affect the revenues and profit margins of U.S companies and European suppliers of Asian companies. Similarly, a credit crisis in Europe could impact revenues for U.S businesses which are having operations in Europe. Companies with operations in different countries can offset losses in one region with gains elsewhere. For example, economic strength in Asia could offset weakness in Europe, which could help maintain margins and stock prices.

Therefore, diversifying the investment will reduce the risk but it cannot be eliminated completely. For example, the rise in global oil prices will be having direct impact on the revenues of the airline industry, even though the performance of the company is good the economic condition for the oil prices are not suitable for the companies revenue. Hence, diversifying the portfolio and holding it for longer period of time is necessary by considering the Economic, Industry and Company factors.

Below is the list of companies which lost their business due to recession, even though they have good business in the past.

1. Lehman brothers

2.General motors

3.CIT group

4.Chrysler

5.Capmark Financial group

Conclusion: Diversification of investment will eliminate the risk and equals to risk free rate is uncertain, As different factors will be having impact on the business.