Risk - Return Relationship & the effect of Diversification
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Computer Science Clay
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01-03-2009, 09:58 AM


Risk - Return Relationship & the effect of Diversification

Introduction:

"Sometimes your best investments are the ones you don't make." This is a maxim which best explains the complexity of making investments. There are many investment avenues available for investors today. Different people have different motives for investing. For most investors their interest in investment is an expectation of some positive rate of return. But investors cannot overlook the fact that risk is inherent in any investment. Risk varies with the nature of return commitment. Generally, investment in equity is considered to be more risky than investment in debentures & bonds. A closer look at risk reveals that some are uncontrollable (systematic risk) and some are controllable
(unsystematic risk). Risk can be categorized into two types:

The risk that cannot be diversified away like interest rate risk and recession is known as systematic risk. Unsystematic risk is stock specific and can be diversified away. Scarcities in raw material supply, labour strike, and management inefficiency are all problems specific to a company and are internal in nature. These negative factors can make the share price fall sharply but can be avoided if well thought. An investment in the shares of certain other companies with sound management can help minimize this risk.

Therefore diversification is the mantra for any prudent investor. Diversification is done in many ways. Investors can diversify across one type of asset classification - such as equities or among different asset classes such as stocks, bonds, fixed income and bullion etc. But the question to be answered is: How many stocks help diversify unsystematic risk? Theory suggests that 18-20 stocks in a portfolio helps to reduce unsystematic risk. But again, tracking 18-20 stocks becomes cumbersome for investor.

Whatever be the number of stocks, it is an undeniable fact that Diversification helps reduce unsystematic risk. This paper stands to investigate the effect of diversification on unsystematic risk by applying Sharpe's Single Index Model and also analyzes the relationship between return & risk.

Research Objective:

The broad objective of the paper is to examine whether unsystematic risk declines with diversification. Also effort has been made to find out the extent of correlation between portfolio return and risk i.e. the relationship between portfolio's beta & expected return. The analysis also makes an attempt to find out whether stocks with high beta values give high return to investors. For research purpose, 30 securities of the companies comprised in BSE Sensex between the period April 2006 to March 2007 has been selected

Sharpe's Single Index Model

The major assumption of Sharpe's single-index model is that all the covariation of security returns can be explained by a single factor. This factor is called the index, hence the name "single-index model." One version of the model, called the market model, uses a market index such as the BSE Sensex as the factor (any factor that influences security returns can serve as the index).
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