Lesson Corporate Finance: Portfolio of securities

A portfolio of securities is a collection of securities in different proportions. However, the collection is not constituted on a random basis, but is decided by careful study and calculations. The purpose for constructing a portfolio can be different.

1. Diversification: The portfolio tries to cancel the volatilities of the constituents by including uncorrelated securities. The excess risk is thus mitigated from the portfolio based on the construction. The portfolio still contains non-diversifiable risk and thus gives higher return than risk free investment.

2. Investment: Portfolios are also constructed with the purpose of investment and gaining higher returns than market. Although, some amount of diversification is also done for investment purposes, sometimes individuals/companies can have a view about a certain group of securities and may want to invest in only those. For example, an individual with a bullish view on pharmaceutical industry can construct a portfolio comprising of stocks and bonds of pharmaceutical companies and other entities directly related to it. The portfolio would thus contain the returns expected with the sector, but at the same time will eliminate the risks associated with a single company.

To calculate the expected return on portfolio, given the expected return on the constituents, the following formula can be used:





where Ri is the return on the security and Wi is the percentage weight of the security in the portfolio. For example, if a portfolio consists of three securities with returns as:
Security 1 = 5%, Security 2 = 6%, Security 3 = 7%.
The composition of portfolio (value wise) is:
Security 1 = 30%, Security 2 = 30%, Security 3 = 40%.

The return in this case, would thus be
Return = 5*30/100 + 6*30/100 + 7*40/100 = 6.1%
For calculating the return on a portfolio, use: Calculate Portfolio Return
For more information on portfolios, check out these: Portfolio, Modern Portfolio Theory