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PROJECT SYNOPSIS 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 BY CHARLES MAINA WAINAINA REG: D53/OL/15284/08 A PROJECT SYNOPSIS SUBMITTED TO THE DEPARTMENT OF ACCOUNTING AND FINANCE, SCHOOL OF BUSINESS AS A PARTIAL FULFILMENT FOR THE DEGREE OF MASTERS OF BUSINESS ADMINISTRATION- FINANCE OF KENYATTA UNIVERSITY DATE (AUGUST 2010)

DECLARATION
This research proposal is my original work and has not been presented for a degree in any University or for any other award.

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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 firmspecific 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

1.1.4 Research Questions


The research will answer the key question which is: in Nairobi stock Exchange context, how diversification impact on the risk reduction of a portfolio of financial securities? In line with this the study will answer the following research questions: 1. How do stocks comprising a portfolio supposed to behave in order to reduce overall portfolio risk? 2. What type of risk do investors care about? 3. Why should investors diversify? 4. What is the risk premium on any asset, assuming the investors are well diversified?

1.2 THEORY
One of the most influential economic theories dealing with finance and investment, MPT was developed by Markowitz and published under the title portfolio selection, in the1952 journal of finance. MTP 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. MPT quantifies the benefits of diversification, also known as not putting all eggs in one basket. Each stock has its own standard deviation from the mean, which MPT calls risk.

2 .0 L I T E R A T U R E R E V I E W
Markowitz (1952, 1959) developed a basic and most accepted model for portfolio selection, by introducing the usage of expected rate of return and expected risk for a portfolio. He identified the risk-reduction benefits associated with holding a diversified portfolio of assets. Fama (1976) tested the theory of diversification by randomly selecting 50 New York Stock Exchange (NYSE) listed securities and calculated their standard deviation based on monthly data from July 1963 to June 1968. Fama (1976) selected one security noted its standard deviation, and then went on adding securities and creating equally weighted portfolios. The standard deviation continually decreased and almost all diversification was achieved in the first 10-15 stocks. Evans and Archer (1968), in a similar study, suggested that as few as 20 securities are adequate to have a well diversified portfolio. They further concluded that a randomly selected and equally weighted portfolio provides a little risk reduction to be obtained from expanding a portfolio beyond 10 to 15 securities. Elton and Gruber (1977) studied and discussed the previous literature and developed an exact expression formula for determining the effect of diversification on risk. By using this approximation they found that total risk goes down at lower rate as more securities are added. They recommend that 15 stocks would appear to be significant for good diversification. Statman (1987) analyzed the return of 500 stock portfolio traded in NYSE and S&P index. The study concluded that a

well-diversified portfolio must contain at least 30 stocks. A recent study by Boscaljion, Filback and Cheng-Ho (2005), suggested that a randomly selected portfolio of 30 stocks or less selected from industry leaders and equally weighted stocks could provide the same level of diversification as the S&P 500 Index. The conclusions of this study were consistent with a study by Statman (1987). This study analyzed the return of 500 stock portfolio traded in NYSE and S&P index. The study concluded that a well-diversified portfolio must contain at least 30 stocks. A study on diversification in the Malaysian Stock Market by Zulkifli, Basarudin, Narzaidi and Siong (2008) concluded that 15 stocks are enough to diversify away a satisfied amount of diversifiable risk. A simple approach for constructing portfolios is constructing equally weighted portfolios. DeMigeul, Garlappi and Uppal (2005, 2007) studied the efficiency of the equal weights to all assets in a portfolio and concluded that this strategy is not inefficient and it outperforms models, such as sample-based mean variance model, minimum variance and value-weighted portfolio model, for selecting an optimal portfolio. Therefore the 1/N strategy is a good benchmark for constructing portfolios and testing portfolio diversification. In a very recent study Duchin and Levy (2009) also concluded that the 1/N strategy for individual portfolios outperforms another renowned strategy for portfolio selection, called Markowitzs Mean-Variance rule.

3.0 METHODOLOGY
When writing a research project, the chosen methodology helps the author to investigate and write a Project that fits the specific needs and wants, and will provide the best to answer the specific questions. The choices of methods have to be done to reach the best possible conclusions. Which types of methods and approaches that are used are determined by the set purpose: The purpose of this project is to investigate the effect of portfolio diversification on risk and return of financial assets.

Some types of choices that have to be made are whether to conduct a qualitative- or quantitative method, inductive- or deductive approach, whether to use primary or secondary data for the project.

Quantitative vs. Qualitative In order to obtain the information needed in a project like this, there are two methods that can be used, a qualitative- and a quantitative method (Svenning, 2003). They have the same purpose, which is to create a better understanding of a phenomenon and how it all affects us. Which method to use depends on if there is a need of a total perspective, quantitative or a deeper understanding, qualitative. Different fields of studies require different methods. Method chosen should be based on the theory used, the set purpose and what the authors wants to accomplish. The quantitative method is based on the transformation on information into numbers in order to make an assumption and to get a conclusion (Holme & Solvang, 1997). With this method the researcher gathers information in the form of data from example databases, a large sample and with a statistical method concludes the problem. According to Holme and Solvang (1997) this method goes more wide than deep. This method is very structured and gives a straight forward result. The analysis can be used as a measure of the whole population, if it is done in a proper manner.

The qualitative method is more based on different patterns and to give a deeper understanding about the subject and the set problem. The patterns are analyzed and according to Holme and Solvang (1997) the goal is to find unique details. The information in this method is carefully picked, mainly from interviews and observations. It is more unstructured and unsystematic (Holme & Solvang, 1997). The disadvantage of the qualitative method is that the information gathered is often biased by the authors own opinions. The focus of this project is on the valuation of the MPT, in the field of finance. In a research like this, mathematical and statistical models are used to explain relationships. The most valid method is to use the quantitative method because of the fact that researcher will almost exclusively use measurements and interpretations of numerical data. The use of historical data will be used to predict a possible future outcome. The data-set is interpreted in a way to give the best possible explanation. With this dataset the researcher will analyze the set problem and the purpose with this project. Deductive vs. Inductive Approach To further investigate a problem or a situation, one has to decide which approach to use when attacking the problem. When doing the research it is very important to establish what is true or false when it comes to the theory. There are two ways or approaches that can be used to draw conclusions, what is true or false, these are deductive- and inductive approach. The deductive approach is according to Eriksson and Wiedersheim-Paul (1999) based upon existing theory by using, adapting or developing that theory, and come up with a conclusion. The inductive approach aims to point out the empirical findings and to build up a new knowledge that will contribute to some new theories.

The research approach will be deductive, which means that the researcher will use existing theory and common principles as a starting point, and then base this project from the foundations from the theory. This way will give a logical conclusion if it is logically connected (Eriksson & Wiedersheim-Paul, 1999). For this project, the information and the dataset that will be collected is determined by the theory, also how it should be interpreted, in order to produce an accurate analysis. While using existing theories, the researcher has greater chance to stay objective. However, to be finite to existing theories also hinders the researcher from reaching new aspects to the problem (Patel & Davidsson, 1994). The deductive approach aims to explain reality but also to predict the future. The deductive approach is often supplemented by empirical verification in form of data of stock prices or this case index prices. This is exactly what the purpose of this project is, to use historical data and with this try to predict or at least state what the result could be. Give a picture of what investors with the use of the MPT may accomplish. 3.1 DATA Monthly closing prices, for the past one year that is 2010 were taken for six randomly chosen stocks. The data for prices will be taken from the Nairobi Stock Exchange data base. The data will be fed in a spreadsheet for the calculation of the individual stocks, the returns of the portfolio and returns of the market based on historical prices. The returns will then be used to in the calculation of mean, variance and standard deviation. The portfolio mean, variance and standard deviation will also be calculated to allow the demonstration of the effects of diversification.

REFERENCE
Elton, E. J, and Gruber, M. J.(1977) Risk reduction and Portfolio Size; An Analytical Solution. Journal of Business, 50, No 4 (Oct 1977), pp 415- 437. Markowitz, H.M.(1952) Portfolio Selection. The Journal of Finance, 12, 77-91. Markowitz, H.M.(1959) Portfolio Selection: Efficient Diversification of Investment. New York: John Wiley & Sons.
Markowitz, H. M. (1987), Mean-Variance Analysis in Portfolio Choice and Capital Markets, Basil Blackwell, paperback edition, Basil Blackwell, 1990.