What is Portfolio Investment?
Portfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns is commensurate with the risk profile of the investor. Portfolio investments might vary from a small segment of one industry to a wide-ranging – entire market.
Types of Portfolio Investment
An investment gives returns in proportion to its risk factor. If one invests in highly risky assets like bitcoin, they can either get absurdly high returns or go to zero. But if one invests in treasury bonds, the risk factor is almost zero, but the returns are also very low. And each financial investor will have their own risk profile which is tailored to their specific investments.
But the investments available in the market are not tailored to such needs. Hence each investor will have a specific requirement that can be maintained using a portfolio. The different types of portfolio investment are as follows:
- Risk-Free Portfolios – Risk-free portfolios are the ones that have investment securities regarding treasury bonds and such where the risk is almost nil but low returns.
- Low-Risk Portfolios – A portfolio with majorly risk-free assets combined with some risk-based securities to give a blend of low risk, decent returns.
- Medium Risk Portfolios – Portfolio with more risk-free securities than the high-risk portfolio but fewer risk-based assets.
- High-Risk Portfolios – This type of portfolio investment includes a lot of high-risk securities that benefit with high returns.
The thought that one can attain high returns with low risk is a difficult one to perceive. The free market dynamics call it arbitrage – when two similar risk profiles pay off at different scales, one of them has a benefit over the others. Such a difference slows the investors to pounce on the opportunity and neutralize the benefit of difference in returns for similar risk portfolios. This is called as law of one price and such a law of one price does not allow the same risk assets to have the same price. One should keep this in mind while preparing a portfolio – any returns more than that for the specific risk rate, will not stand the test of time.
Example of Portfolio Investment – Returns & Risks
Let us take an example scenario to see how portfolio investment returns and risks are calculated and represented.
For this, we will imagine a treasury bond that yields a return of 2% per annum. Treasury bonds are considered risk free because they are backed by US govt. So, the net variability/risk/variance in the returns will be zero. This means that a hundred percent of the time, the returns will be only 2% per annum.
Let us assume a stock with an average return of 10% and a variance of 2%. This means that if the returns are normally distributed, the net returns lie between 8% and 12% for 68% of the time.
If an investor builds a portfolio by investing 50% of his money in bonds and the rest in stock, then he can have an average return of about 6%. This is higher than the mean returns of bonds and lower than the mean returns of a stock. Precisely the reason why portfolios exist. If the investor wants to increase his risk, he can increase the share of stocks and if he wants to decrease his risk, he can increase the share of his bonds.
Advantages of Portfolio Investment
The following are the advantages of portfolio investments.
- An individual’s risk profile can be met using the portfolio investment. It cannot be done by searching for a financial investment that allows the individual his own risk profile.
- An individual can decide how to diversify his investments -by stocks, or by markets, or by type of investments.
- If the investor wants to manage different points of liquidity. It cannot be managed by one stock or one bond. But having a portfolio of assets will help him in having a steady flow of income, or flow of income in a necessary timing.
- Not all stocks pay dividends. Some stocks pay dividends and some stocks are growth stocks. If the investor’s requirements from an investment stand somewhere in between, then they can choose to invest in a portfolio that helps them in having the benefits of dividends and growth stocks.
- Investing in such multiple assets requires minimal management. This will reduce the transactional cost of investment and will help in saving additional costs.
- For people investing in multiple securities, the individual security analysis is not as important as the conjoint analysis. This helps in reducing the social cost of the investment.
Disadvantages of Portfolio Investment
The following are the disadvantages of portfolio investments.
- One of the important reasons for proper stock market functioning is the information flow. Information flow is the theory where, because of the money involved, the decision making during the stock price movement helps the company in gauging the conditions of the market and of the general public. If the stock price moves after a certain decision, it helps the company in deciding whether the decision made is a good decision or not. However, with portfolio investment, the movement of such stock prices becomes more uncertain as the risk is gauged as a whole, and hence the flow of information is uncertain.
- If proper research is not made and proper risk profile is not calculated, the portfolio will not yield optimum returns.
- In order to calculate what the returns have to be for a certain amount of risk, the person has to analyze multiple stocks and form a portfolio. Though there are companies available that analyze these sorts of portfolios and provide them, that still does not benefit the user to a complete extent.
- Financial knowledge is mandatory for people who are trying to invest in using a portfolio instead of individual stocks. The relations between individual stocks, between stocks and markets, is a difficult thing to analyze.
Like every investment in finance, the decision to invest in a portfolio or not is a choice. But the decision many people make over here shows the obvious importance of portfolios in modern investing. They provide a method of customization exactly where it is necessary.
This has been a guide to what is portfolio investment and its definition. Here we discuss the top 4 types of portfolio investment along with examples, advantages, and disadvantages. You can learn about Portfolios from the following articles –