Portfolio Theory and Investment Analysis

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The charity uses the dividend income from this investment portfolio to provide funds for supporting its operations.&nbsp. Therefore, the objective of the investment strategy is to maximize the value of the investment to give the highest possible annual return.
More specifically, the trustees want to know the following: (1) The impacts of having a small number of stocks in the portfolio and concentrating the investment in large stocks. (2) The benefits of moving some of the investment to international securities. (3) How derivatives may be used to enhance returns and manage risk.
The answer to the first concern depends on the answer to the following basic question in the minds of the charity’s trustees: what is the highest possible and most realistic annual return that the investment portfolio could earn?&nbsp. It is not easy to predict the return of a portfolio because many things could happen to funds once these are invested.&nbsp. To find out the realistic historical returns for various investments, investors consult the Equity and Gilt Study of Barclays (2006), which has studied this for over half a century.
Figures 1 and 2 show how equities performed better compared to gilts and T-bills over the last century since a £100 investment in equities at end-1899 was worth £1,340,324 by end-2005.&nbsp. The same investment in gilts was worth £20,159 and in T-bills £17,021.&nbsp. When adjusted for inflation, the investment in equities would be worth £22,426. gilts £337. and T-bills £284.&nbsp. This proves that the strategy of investing in equities would give the highest and most realistic return.&nbsp. In the year 2005, for example, equities returned 18.8% for the year, much higher than gilts (6%) and T-bills (2.7%), all figures having been adjusted for inflation.&nbsp. The Barclays Equity Income Index is derived from the yield of the FTSE All-Share Index because, in their view, this is “the most representative method of evaluating equity performance over the period” (Barclays, 2006, p. 59).&nbsp. Given these pieces of information, what would be the best return that the UK charity could expect from its investments?
The attractiveness of any investment, whether bonds, securities, real estate, or a corner street business, depends on two variables: (1) Expected return: how much the investment would earn over a period of time. and, (2) Risk: the uncertainty that the investment would earn the expected return.