Research Proposal on "Investment Portfolio All Equity Investing Is Risky"

Research Proposal 22 pages (6002 words) Sources: 15

[EXCERPT] . . . .

Investment Portfolio

All equity investing is risky, by simple virtue of the fact that companies can and do go bankrupt, wiping out their equity and taking share values down to zero. Even without bankruptcy, stocks can fall in value and remain at low levels, representing a loss to the shareholders. Risk is typically measured against key stock market indices, such as the Dow 30 or the S&P 500. Modern portfolio theory holds that by building a diversified portfolio, much of the firm-specific risk can be eliminated. Total market risk remains, but in theory the fluctuations of one firm or industry are offset by movements in the opposite direction of other stocks within the portfolio (McClure, 2011).

A diversified portfolio can be obtained using a relatively small number of investments, if those investments are sufficiently diversified from one another. A portfolio should therefore consist of securities in different industries sectors and from countries around the world. As a result, it is important to choose stocks carefully, so that they increase the total diversification within a portfolio. In addition, the stocks chosen should be from companies with strong growth prospects in general -- while diversification is the ultimate goal if the companies chosen are all strong they may be able to outperform the market in the long run.

This portfolio will be constructed with both diversification and long-term growth in mind. There will be 15 securities in six major industry sectors, plus a 10% cash component. This paper will outline the case for each component of the portfolio, and will provide background information on the different companies to justify their inclusion in the portfolio.

Investment Goals

The portfolio will be constructed with a long-term time horizon in mind. This is an important characteristic of portfolios constructed according to the principles of modern portfolio theory. In the short-run, diversification is unlikely to provide complete immunity from firm-specific shocks, because the timing of sharp movements is unpredictable and arbitrary. It is only with the passage of time that movements are likely to offset one another. The time horizon is important for the selection of companies, because a short-run perspective would imply that the companies selected should all have strong short-run prospects. This is not necessarily going to result in a fully balanced portfolio. In addition, for most investors an equity-weighted portfolio is only appropriate for those with a long-term time horizon. Equity markets are highly volatile relative to many other investment instruments, so the equity portion of any investment portfolio is typically viewed as the long-term portion.

In general, the objective of a balanced portfolio is to match the market performance. Historically, this is average market return is 6.3% (Burtless, 1999). This forms the core of our investment objectives. However, there are two adjustments to this core objective. The first is that for safety purposes, 10% of this portfolio is going to be held in cash. These funds will be invested in Treasury bills, which currently have a very low short-term rate of return. This will reduce the total returns of the portfolio. The other adjustment is that a portfolio selected on the basis of individual stock selection should outperform the broad market. If matching market performance is the sole objective, this can be achieved in a relatively risk-neutral manner with the purchase of an Index fund or an exchange-traded fund such as RSP on the New York Stock Exchange, which provides weighted exposure to all of the firms in the S&P 500. Thus, selecting individual stocks by its nature is an activity oriented to generating superior returns on a risk-adjusted basis. The diversification of the portfolio is intended to deliver the risk of the broad market, but the specific stock selection is intended to deliver superior returns.

When these ideas are combined, our approach becomes evident. The first part of the strategy is to identify the broad investment categories that will effectively mirror the broad market. The second element is to find those companies that can provide above-average growth and/or consistent dividends. This places emphasis on firms with strong long-term prospects, rather than those that are presently hot but have limited long-term upside. If this strategy is effective, the resulting portfolio will deliver superior growth at market level risks, thereby outperforming the broad market.

The risk tolerance that underlies this portfolio is a high risk tolerance. It is assumed that the investor is relatively young, and does not need this money for at least ten years. The $100,000 in this portfolio does not comprise the sum total of the investor's wealth, but rather comprises of discretionary funds. The long time frame and the fact that the money is not needed for the essentials of daily life or any expected expenditures allows for the high risk tolerance. A high risk tolerance allows the portfolio to be oriented towards long-term equity investing.

Rationale for Asset Allocations

When determining asset allocations, the most important factor is to look at the industries that drive global growth and will continue to do so over the coming years. No matter what happens in the economy as a whole, there are certain segments that will continue to drive growth, and those are the segments that lead the market and the segments in which we want to be invested. There are a number of different factors that should be taken into account when analyzing the different industries. These include the pace and drivers of economic recovery and the impact that broad-based global trends are going to have on different industries around the world.

In the long-run, the world is seeing a population explosion, most of which is taking place in the developing world. Many developing world nations are also rapidly industrializing. This places significant demand on commodities, the supplies of which are generally constrained. As a result, commodity prices are generally increasing. This points to the value of being invested in key commodities -- mining stocks and the oil & gas business.

The population trends indicate that there is considerable growth potential in the developing world, more so than in the traditional core markets of North America and Europe. Foreign stocks -- which are traded in New York as American Depository Receipts (ADRs) -- should therefore be an important component of the portfolio. In addition, technological innovation is a key source of growth. Therefore it is important to maintain some representation from the technology sector in any growth-oriented portfolio.

Lastly, population growth and the prospects for a long-term economic recovery highlight the value of being involved in consumer sectors, either at the retail or manufacturing level. A balanced portfolio should include elements of products for which there is everyday demand. Consumer durables are often a source of stability in a portfolio, and the biggest consumer durables or retailing companies offer an element of low risk that can be utilized to offset some of the volatility associated with other elements in the portfolio.

The following chart presents the asset allocation that has been selected for the portfolio:

Each component of this portfolio plays a specific role within the context of the overall portfolio. Precious metals are often viewed as a safe haven when other investment instruments are facing downturn. Thus, precious metals can be expected to move counter to some of the other elements in the portfolio, providing some insulation from political uncertainty and inflation. The oil and gas sector is going to benefit from long-term demand increases. The production of oil and gas is subject to finite supply, political uncertainty and increasing demand as the world industrializes. There is only one direction for oil and gas prices to go -- up. Consumer staples was included to help stabilize the portfolio. ADRs give the portfolio greater access to the growth in international markets. Technology is a global growth driver. Industrials are like consumer staples -- good for stability. Cash is the most stable element of the portfolio.

Individual Stock Selection

There will be fifteen stocks in total. Within each industry segment, there will be two or three stocks that are selected. The mining segment comprises 10% of the total portfolio. The firm selected are Newmont Mining is a Denver-based gold and silver producer and will comprise 6% of the portfolio. The other mining firm will be Sterlite Industries, a Mumbai-based copper producer that also has upside in alternative energy. Sterlite will also comprise 4% of the total portfolio. The industrial segment will consist of Caterpillar 5%), the heavy equipment maker and Boeing, the aircraft maker and defense contractor (5%). The oil and gas sector will comprise 20% of the total portfolio. Firms selected will include Texas-based Valero, a refining and retailing petroleum firm; Encana, the massive Canadian gas producer; and Exxon Mobile, the oil giant. In consumer durables, General Motors and Molson Coors have been selected. Three ADRs have been selected. These include Chinese search engine Baidu; the Brazilian petrochemical company Braskem and Irish pharmaceutical company Elan. For technology stocks, cutting edge retailer Amazon is included along with Taiwan Semiconductor and Cerner,… READ MORE

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