Intro to Finance
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For debt portfolios, the bonds type has to be taken in consideration to estimate the risk of the investment. The higher the spread of a bond (which is the difference between its return and that of the Treasury-bond issued by the government), the riskier the investment. An investor can invest in:
-Government bonds, that are almost risk free but offer low returns
- Investment grade corporate bonds which are companies bonds that have high credit ratings by Standard and Poor�s or Moody�s, and thus low risks but also relatively low returns
- Junk bonds, or high yield bonds which are also corporate bonds but with low grades and thus high risks.
-municipal bonds that present some tax advantages.
Diversification is the most effective way to reduce the overall risk of a portfolio. It is designed to minimize the impact of any one security on overall performance. For example, consider an investor constructing a portfolio with two oppositely correlated stocks: when stock X �s price is up, stock Y falls down and vice-versa. This portfolio will present steady returns and the losses occurred by stock X will be compensated by the gains of stock Y and vice versa. If the investor had only invested in stock X or Y alone, any negative shift in the market would have provoked uncompensated losses. However, it is clear that in order to get big returns, a portfolio manager has to take some risks and not over-diversify.
All portfolios are usually compared to benchmarks to measure their performances. Standard indices for equity portfolios include the S&P 500 and Russell 2000. For fixed income portfolios, we have for example the Lehman Government/Corporate bond index.
Some people construct portfolios that mimic the composition of these benchmarks, these are the passive investors and their portfolios are thus called index funds.
On another hand, people who construct portfolios on their own without imitating the benchmarks and relying mostly on their personal analysis are known as active investors.
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