What is Portfolio Investment?

Types of Portfolio Investment

An investment gives returns in proportion to its risk factor. If one invests in highly risky assets like bitcoinBitcoinBitcoin is a digital currency that came into existence in January 2009, speculated to be created by Satoshi Nakamato, whose true identity is yet to be authenticated. It provides lower transaction fees than the traditional online payment systems, is controlled by the decentralized authority, and is not like government-issued currencies.read more, they can either get absurdly high returns or go to zero. But if one invests in treasury bondsTreasury BondsA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company.read more, the risk factor is almost zero, but the returns are also very low. And each financial investor will have their risk profile 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 securitiesInvestment SecuritiesInvestment securities are purchased by investors, with or without the assistance of a middleman or agent, solely for the purpose of investment and long-term holding. These are recorded in the financial statements as non-current investments and comprise fixed income and variable income bearing securities.read more 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 risk-based securities gives a blend of low-risk, decent returns.Medium Risk Portfolios – A portfolio with more risk-free securities than the high-risk portfolio but fewer risk-based assets.High-Risk Portfolios – This portfolio investment includes many 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 dynamicsMarket DynamicsMarket Dynamics is defined as the forces of market constituents responsible for the shift in the demand and supply curve and are therefore accountable for creating and reducing the demand and supply of a particular product.read more 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 neutralizes the benefit of the difference in returns for similar risk portfolios. This is called the 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.

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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 the US government backs them. So, the return’s net variability/risk/variance will be zero. This means that the returns will be only 2% per annum a hundred percent of the time.

Let us assume a stock with an average return of 10% and a variance of 2%. This means that if the returns are normally distributedNormally DistributedNormal Distribution is a bell-shaped frequency distribution curve which helps describe all the possible values a random variable can take within a given range with most of the distribution area is in the middle and few are in the tails, at the extremes. This distribution has two key parameters: the mean (µ) and the standard deviation (σ) which plays a key role in assets return calculation and in risk management strategy.read more, the net returns lie between 8% and 12% for 68% of the time.

Precisely the reason why portfolios exist. If an investor builds a portfolio by investing 50% of his money in bonds and the rest in stock, 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. 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 bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more.

Advantages of Portfolio Investment

The following are the advantages of portfolio investments.

  • An individual’s risk profile can be met using portfolio investment. It cannot be done by searching for a financial investment that allows the individual his risk profile.An individual can decide how to diversify his investments -by stocks, markets, or types of investmentsTypes Of InvestmentsStocks, bonds, and cash equivalents are the three main forms of investments. Investment, in general, refers to the purchase of anything for future use with the goal of generating a regular cash flow or increasing the value of something over time so that it can be sold for a higher price than it was purchased for, i.e. capital gains. read more.Suppose 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 have a steady flow of income or flow of income at a necessary time.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, they can choose to invest in a portfolio that helps them benefit from dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more and growth stocks.Investing in such multiple assets requires minimal management. This will reduce the transactional cost of investment and help save additional costs.For people investing in multiple securities, the individual security analysisSecurity AnalysisSecurity analysis is the process of interpreting the value of financial instruments such as stocks, bonds, debts, warrants, and other securities of a company to ensure that the investors are investing through publicly available information. The three related methods include fundamental, technical, and quantitative approaches.read more 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 marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more 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 gauge the market’s conditions and the general public. If the stock price moves after a certain decision, it helps the company decide whether it is a good decision. 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 done and a proper risk profile is not calculated, the portfolio will not yield optimum returns.To calculate the returns for a certain amount of risk, the person has to analyze multiple stocks and form a portfolio. Though companies available analyze these sorts of portfolios and provide them, that still does not benefit the user to a full extent.Financial knowledge is mandatory for people trying to invest by using a portfolio instead of individual stocks. The relations between individual stocks, stocks, and markets are difficult to analyze.

Conclusion

Like every investment in finance, the decision to invest in a portfolio or not is a choice. But the decision many people make 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 portfolio investment is & its definition. Here we discuss top 4 types of portfolio investment along with examples, advantages & disadvantages. You can learn about Portfolios from the following articles –

  • Combined RatioWho is a Portfolio Manager?Portfolio Diversification MeaningPortfolio Rebalancing Definition