1. The effect of the portfolio on risk of a security
The diversification effects on a portfolio listing are based on the reduction of portfolio risk which creates the impression of imperfect correlations as compared to asset return pairs. It is rather crucial as correlations remain rather independent of the portfolio’s rate of return. Therefore, portfolio risk is extensively reduced while at the same time ensuring that the rate of return is not compromised (Oberuc, 2003). For instance, if several low-correlated assets are combined in order to create a pronounced high risk-adjusted return which capitalizes on portfolio improvement, then the diversification effect becomes a viable criterion (Pratt & Grabowski, 2010). If this management aspect is worthy of its implementation, then it is crucial to use it as a unit of measurement. This way, investors are in a position to effectively increase their risk-adjusted returns either through increasing their respective rates of return in relation to portfolio risk.
Else, investors could achieve the same through reducing risk relating to the rates of return. This could sound rather easy even though it is actually not. Expanding the rates of return and increasing risk is an initiative in violation of the CAPM theory and the principle that markets are independently efficient (Sharpe, 2000). However, the reduction of risk with respect to the rates of return through using diversification as a way of increasing risk-adjusted rates of return could also prove feasible. However, the risk and allocations imposed through individual return on asset places much influence on portfolio risk. As most portfolio management theories illustrate, correlation coefficients are not quantifiers of diversification effects as allocations and their respective risks that are imposed through individual asset returns often offset the imperfect correlation effects (Moles, Parrino & Kidwell, 2011). In this regard, the practical process of managing and constructing investment portfolios, the investors need not solely depend on correlation coefficients alone as they could fail the provision of the necessary information to financial planners in precisely measuring the portfolio’s performance.
2. The effect of the portfolio on the overall cost of capital to the company
Cost of capital is defined as the opportunity costs in making specific investments. This is the expected rate of return which an investment portfolio earns through putting the same financial contribution into another subsequent investment with relevant risk (McGill, 2008). Therefore, the costs of capital in any portfolio the rates of return that are necessary in persuading the investors into making a particular investment. The overall Costs of capital to any organization are established and determined by the respective markets and are a representation of the level of perceived risk by its investors (Elton, Gruber, Brown & Goetzmann, 2009). If given an option between any two investments of similar risks, the investors generally opt to have any one of them providing higher returns.
Companies usually borrow money for making various investments, and could make mistakes of equating the overall costs of capital with interest rates on the money amounts. It is of paramount importance to have profound remembrance that the costs of capital are not expressly dependent on where and how the investment capital is raised (Dash, 2009). Further, the costs of capital are dependent on the fact of using the respective funds and not sourcing them. The higher rates of return are progressive reflections of the fact that particular information will increase the risks involved in having uninformed investors to hold the stock due to the fact that informed investors are in better positions to shift the weights of their portfolio in incorporating new information.
Dash A., (2009) Security Analysis and Portfolio Management. New York: I. K. International Pvt Ltd
Elton E., Gruber M., Brown S., Goetzmann W., (2009) Modern Portfolio Theory and Investment Analysis. New York: John Wiley & Sons
McGill W., (2008) Critical Asset and Portfolio Risk Analysis for Homeland Security. New York: ProQuest
Moles P., Parrino R., Kidwell D., (2011) Fundamentals of Corporate Finance. New York: John Wiley & Sons
Oberuc R., (2003) Dynamic Portfolio Theory and Management. New York: McGraw-Hill Prof Med/Tech
Pratt S., Grabowski R., (2010) Cost of Capital: Applications and Examples. New York: John Wiley & Sons
Sharpe W., (2000) Portfolio Theory and Capital Markets. New York: McGraw-Hill