Given the current credit crunch and recessionary forces in the environment, the debt yields are also low and the holding return from stocks is also low. However, this is also an attractive time for undertaking investments since stocks are available at very low PE ratios and once the economy rebounds, these stocks are expected to re-gain momentum and clock good returns on account of capital appreciation. Since the investment time horizon is long term and no additional constraints (liquidity, tax concerns) have been stated, stocks seem to be a good investment class.
The selection of the individual stocks has been made on the basis of relative valuation model as well as their aggregate risk in the context of the portfolio. Instead of focusing on a single sector, stocks of 4 companies from the different sectors of financials, telecommunication, retail and transportation were selected. This was because while retail is primarily a defensive sector (which would help to fulfill the objective of capital preservation), financials is mainly an aggressive sector (which would help to achieve the growth objectives of the investment mandate). Telecom and transportation sectors can be classified as middle-beta sectors compared to aggressive sectors (with beta greater than 1) and defensive sectors (with beta less than 1).
The significance of beta stems from the fact that beta measures the systematic risk of the portfolio and it is for bearing this risk only that investors are compensated. As per the Capital Asset Pricing Model, the expected return on any asset/security is given by:
Expected Return = Risk free return + Beta * Market Risk Premium.
The risk of any security can be divided into 2 parts – systematic (related to overall economy, non-diversifiable) and unsystematic risk (related to the particular company). As per the models of portfolio management, diversification across various asset classes leads to the elimination of the unsystematic risk of the individual components and the total risk of the portfolio is its systematic risk (represented by beta). Since investors are compensated for bearing systematic risk only, it is suggested to diversify across a large number of stocks so that the diversifiable component of the risk can be done away with, as shown in the diagram: