What is portfolio investment or portfolio diversification

Portfolio investments

What is portfolio investment?

Portfolio investments are investments in a group of assets (stocks, debt, mutual funds, derivatives, or even bitcoins) rather than a single asset with the aim of generating returns that match the investor's risk profile. Portfolio investments can vary from a small segment of an industry to a broad market as a whole.

Types of portfolio investments

An investment provides a return in proportion to its risk factor. Investing in high-risk assets like Bitcoin can either deliver absurdly high returns or go to zero. However, when investing in government bonds, the risk factor is close to zero, but the returns are also very low. And every financial investor has his own risk profile, which is tailored to his specific investments.

However, the investments available in the market are not tailored to these needs. Therefore, every investor has a specific requirement that a portfolio can sustain. The different types of portfolio investments are as follows:

  • Risk Free Portfolios - Risk-free portfolios are those that have securities related to government bonds and where the risk is close to zero but returns are low.
  • Portfolios with low risk - A portfolio of largely risk free assets combined with some risk based securities to achieve a mix of low risk and reasonable returns.
  • Portfolios with medium risk - Portfolio with more risk-free securities than the high-risk portfolio but less risk-based assets.
  • High Risk Portfolios - This type of portfolio investment involves many high risk securities that benefit from high returns.

The idea that you can get high returns with low risk is hard to discern. The dynamics of the free market call it arbitrage - when two similar risk profiles pay off on different scales, one has an advantage over the other. Such a difference slows investors to seize the opportunity and neutralize the benefit of return differentials for similar risk portfolios. This is called the law of price, and such a law of price does not allow the same risk-weighted assets to have the same price. This should be taken into account when creating a portfolio - returns above the specific risk rate will not stand the test of time.

Portfolio investment example - return and risk

Let's take an example scenario to see how the returns and risks of portfolio investments are calculated and presented.

To do this, we imagine a government bond that generates a return of 2% per year. Government bonds are considered risk-free because they are backed by the US government. So the net variability / risk / variance in returns is zero. This means that one hundred percent the return is only 2% per year.

Let's say a stock with an average return of 10% and a variance of 2%. This means that with a normal distribution of the returns, the net returns will be between 8% and 12% in 68% of the cases.

If an investor builds a portfolio by putting 50% of their money in bonds and the rest in stocks, they can get an average return of around 6%. This is higher than the average return on bonds and lower than the average return on a stock. Exactly why portfolios exist. If the investor wants to increase their risk, they can increase the equity component, and if they want to reduce their risk, they can increase the bond component.

Benefits of portfolio investments

Below are the benefits of portfolio investing.

  • A person's risk profile can be achieved with the help of portfolio investment. This cannot be achieved by finding a financial investment that allows the individual to develop their own risk profile.
  • A person can choose how to diversify their investments by stocks, by markets, or by type of investments.
  • Suppose the investor wants to manage different points of liquidity. It cannot be managed by a stock or a bond. However, having a portfolio of assets helps him achieve a steady flow of income or a flow of income when it is necessary.
  • Not all stocks pay dividends. Some stocks pay dividends, and some stocks are growth stocks. If the investor's investment needs are somewhere in between, they can invest in a portfolio that will help them take advantage of dividends and growth stocks.
  • Investing in such multiple assets requires minimal management. This reduces the transaction investment costs and helps to save additional costs.
  • For individuals who invest in multiple securities, individual security analysis is not as important as conjoint analysis. This helps in reducing the social cost of the investment.

Disadvantages of portfolio investments

Below are the disadvantages of portfolio investments.

  • One of the important reasons for the smooth functioning of the exchange is the flow of information. The flow of information is the theory that, because of money, decision-making during stock price movement helps the company assess the conditions of the market and the public. When the stock price moves after a particular decision, it helps the company decide whether or not the decision made is a good one. However, with portfolio investments, the movement of such stock prices becomes more uncertain because the risk is measured overall and therefore the flow of information is uncertain.
  • If proper research is not carried out and an appropriate risk profile is not calculated, the portfolio will not deliver optimal returns.
  • In order to calculate how high the return needs to be for a given risk, the person has to analyze several stocks and build a portfolio. Although there are companies that analyze and deliver this type of portfolio, it still does not fully benefit the user.
  • Financial literacy is mandatory for anyone trying to invest in using a portfolio rather than individual stocks. The relationships between stocks, stocks and markets are difficult to analyze.

Conclusion

As with any investment in finance, the decision whether or not to invest in a portfolio is a choice. However, the decision many people are making here shows the obvious importance of portfolios to modern investing. They provide a method of customization exactly where it is needed.

Recommended articles

This has been a guide to portfolio investing and how to define it. Here we discuss the four main types of portfolio investments along with examples, pros and cons. For information on portfolios, see the following articles:

  • Combined ratio
  • Who is a Portfolio Manager?
  • Importance of portfolio diversification
  • Definition of portfolio rebalancing