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THE EFFECT OF PORTFOLIO DIVESIFICATION ON RISK AND RETURNS OF FINANCIAL ASSETS: AN APPLICATION OF MODERN PORTFOLIO THEORY TO STOCK INVESTMENT IN THE NAIROBI STOCK EXCHANGE
ABSTRACT
Investment in stocks and expected return from such investment always comes with risk. Financial economists and financial analysts have been working for years to find ways to minimize risk. What all financial analysts believe is that creating well-diversified portfolio can minimize risk. Fama (1976), Elton & Grubber (1977), Evans & Archer (1968) and many other analysts have shown that well-diversified portfolios can actually minimize risk and have suggested the minimum number of stocks required for a well-diversified portfolio. For this project, modern portfolio diversification theory will be applied for the investors investing in the Nairobi Stock Exchange. Six (6) securities will be randomly selected and equally weighted portfolios will be created. Standard Deviations for all portfolios will be calculated and the results will be analyzed.
1.0 INTRODUCTION
Investments in stocks (and all other financial assets) have two basic parameters: Risk and Return. These two parameters have an inverse relationship and all investors face a trade-off between risk and return. There are two types of risks: systematic and unsystematic risk. Systematic risk is the risk that exists inherently with investment due to changes in the whole economy and is unavoidable. The major factors for such risks are economic political and social conditions. Systematic risk is non- diversifiable. Unsystematic risk, however, is firm-specific and is diversifiable. It is contributed by problems and risks involved in one company. Modern Portfolio theory suggests that as the number of securities in a portfolio increases the portfolio risks decrease. It basically implied that by investing in more securities, investors can avoid the specific risks involved in individual firms. This project will apply this theory on securities traded on the Nairobi Stock Exchange. Starting from making a portfolio with 100% investment in one security to an equally weighted investment in six (6) securities, the project will analyze the risk pattern of portfolios.
1.1 BACKGROUND
1.1.1 Problem of the Study
Modern portfolio theory postulates that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification chief among them a reduction in the riskiness of the portfolio. Diversifying in several securities decreases the exposure to firm-specific factors, this leads to portfolio volatility continues to decrease. But even with a large number of assets, it is not possible to avoid all risk. All portfolios are affected by the macroeconomic factors that influence the market (Bodie et Al., 2004).
The question of how to select and allocate assets to form a well diversified portfolio that will give an investor maximum profit at a lower risk requires a thorough examination of the extent to which the returns on the different securities tend to vary either together or in the opposite direction.
To test the effect of diversification in a portfolio we require an analysis of covariance and the correlation coefficient. The covariance is calculated similar to the variance, but instead of measuring the difference of an asset from its expected value, it is measured to the extent of the returns from the different assets reinforce or offset each other.
1.1.2 Significance and Justification of Study
Diversification has a huge impact on the portfolio riskiness, mainly its specific risk, at which it can be eliminated up until the systematic risk of the portfolio. If a portfolio manager could look ahead and pinpoint the precise timing of a single event, he would naturally follow the right course. But since this is virtually impossible to do, he seeks to minimize the ever present possibility of error by hedging his position through diversification. This study will be useful to investors and portfolio managers for this will present significant findings on the impact of diversification to the reduction in portfolio risk. Moreover, this study will be an important contribution to a body of research concerning risk and returns and how it affects portfolio risk.
1.1.3 Objective of Study
The main purpose of this study will be to examine how diversification contributes to reduction of portfolio risk in the Nairobi Stock Exchange. The study will seek to accomplish the specific objectives:
1. To explore the relationship between risk and expect return of a stock
2. Determining the expected return of a portfolio of stocks
3. Establishing how correlation of coefficient (covariance) between the returns of individual stocks comprising a portfolio contributes to the reduction of the entire portfolio risk