Portfolio Theory
1 Introduction
In this and the following chapter on Capital Asset Pricing Model, we will look at what determines the return that shareholders require and therefore the cost of equity.
You cannot be asked for calculations on portfolio theory, but you are expected to be aware of the ideas involved, and this chapter is a vital lead-in to capital asset pricing model which certainly does involve calculations.
2 What determines the rate of return that shareholders require?
Why is it that shares in some companies are viewed as inherently more risky than shares in other companies? It is because the nature of their business is more risky. As a result, the potential fluctuations in profits (and hence dividends) in the future are greater. If things go well shareholders may well expect much higher dividends, but the risk is that things may go badly in which case they will receive much lower dividends. The greater the potential fluctuations in returns, the greater we say that the risk is.
3 What do we mean by risk?
The reason that we regard companies as risky is that their future earnings are not certain - they may increase or they may decrease. If we were certain that a company was going to earn $100,000 per year in the future then we would say that there was zero risk. However, this is obviously not the case in practice - we may be expecting an average of $100,000 a year, but clearly the actual earning may end up being higher or lower. That is the risk inherent in every company, and the more the potential fluctuations in earnings then the more risk there is in the company.
4 What creates the risk?
There are two reasons for the potential fluctuations in earnings and hence the risk.
The first reason relates to the industry within which the company operates. For example, the accountancy industry may be less risky that the oil industry. All companies are affected by the same general economic factors (such as the rate of inflation, the exchange rate) but different industries are affected to different degrees. Companies that import and export a lot will be affected by changes in exchange rates to a much greater degree than companies that do little or not importing and exporting.
This risk is known as systematic or market risk. Again, this is risk due to general economic factors, occurs in all companies, but the level of this risk differs between different types of businesses (different sectors).
So why therefore do not all oil companies have exactly the same level of risk?
This is because there is a second factor involved which is factors in the specific company. For example, a company (whatever sector it is in) may have just appointed a new managing director who may turn out to be excellent or may not. A company may have has poor labour relations in the past and lots of strikes - in the future things may get worse or, of course may improve. These are both examples of factors that create extra risk in the company over and above the systematic risk of the industry.
This risk is known as unsystematic or company specific risk.
5 How can an investor minimise the risk?
Rather than invest all ones money just in one share (and therefore being subject to both the systematic and unsystematic risk), and investor should spread their money between several shares. In this way the unsystematic risk can be removed - some companies may do better, some may do worse, but they ‘cancel’ each other out. We call this diversifying away the risk by creating a portfolio of shares.
The systematic risk cannot be removed - all companies are affected by general economic factors and there is nothing we can do about this. We can choose the level of systematic risk that we want, by deciding which sectors (or mix of sectors) that we choose to invest in, and it is then the level of systematic risk that will determine the return required - more systematic risk then greater return, and vice versa.
This is the basis of the capital asset pricing model that we will look at in the next chapter. We assume that shareholders of large quoted companies are well-diversified, and have therefore diversified away the unsystematic risk. The only risk they are therefore concerned about is the level of systematic risk, and it is this that will determine the required return.
A well-diversified investor is one who has created a portfolio where the unsystematic risk has been fully diversified away. The only risk remaining will be systematic risk and it is the level of systematic risk that will determine the return required by the investor. It is this statement that forms the basis of the Capital Asset Pricing Model which will be covered in the next chapter.