Optimization of Stocks Investment Diversifications Strategy to Maximize Returns and Minimize Risks … Research Paper
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¶ … Investment Diversifications Strategy of Optimization of Stocks to Minimize Risks and Maximize Returns
The study investigates an investment diversification that can be used to optimize a number of stocks to minimize the investment risks and maximize returns. The paper reveals that many investors are unable to realize profits from their investment because they put all their investment in one industry that can be affected by the same events. Thus, the investment mistake has made many individual investors as well institution investors to lose their entire investment fund. The study attempts to solve the problem by investing $700,000 on the selected stocks from diversified industries. The remaining $300,000 is invested in the 1-year Treasury bill. Using the historical data of 8-year period to calculate the stocks, the expected return from the diversified stocks is 22.95% showing that the investor will realize $209,650 annual returns from $700,000 hypothetical investment. The investor will also realize $14,500 from the remaining $300,000 realizing $224,150 annually from $1 million dollar investment
The results of sensitivity analysis show that the investor will record $105,000 from the stocks' investment if the annual returns decline to 15%. Thus, the overall returns for $1 Million investment will be $119,100. The paper has been able to achieve its research objective revealing that a diversification strategy is an effective investment tool to maximize return and minimize risks.
The primary goal of rational investors is to maximize returns and minimize risks. However, some investors allocate the entire investment fund in one class of asset or investment portfolio making their investment to react to the same events. Investing in one class of asset is similar to put all eggs in one basket. To guide against financial loss, financial professionals and other financial institutions are searching for a potent strategy that will make them maximize investment returns and minimize their risks since assets are influenced by different economic forces such as price volatility, change of interest rates, and inflation that may decline the values of assets. Thus, it will be a worst investment mistake to invest in the same class of assets that can react to the same events because this type of investment strategy can make investors lose their entire life savings. For example, investors who allocate all their investment portfolios in the banking industry or mortgage industry are not diversifying their investments because economic events such as credit crunch, recession, interest rates, and inflation can make investors lose all their investment portfolios. Between 2008 and 2009, the shares of many financial institutions lost value and some banks went bankrupt because they were affected by the economic events such as credit crunch and recession.
The goal of this research is to address the problem that investors may face in an investment environment by demonstrating the strategy to maximize returns and minimize the risks of their investment portfolios. The research is important because many people prefer investing in stocks after retirement, however, many potential investors do not possess require financial skills to maximize returns and minimize investment risks. Similarly, many investment companies and institutional investors make the same mistakes by focusing on high risks assets because these assets deliver high returns. In 2008, Lehman Brothers was bankrupt losing more than $630 billion worth of assets. The Lehman was an investment banking company investing in the securities of another financial institutions. However, Lehman Brothers lost their entire assets because they invested their entire assets in the subprime mortgage institutions. When the mortgage industry collapsed in 2008, the Lehman Brothers lost their entire investment leading to erosion of $10 Trillion worth of market capitalization. The 2003 and 2004 housing boom made the company put their investment portfolio on housing market, however, the investment option proved disastrous for Lehman Brothers.
This study attempts to demonstrate the investment diversification revealing the method of optimizing number of stocks to minimize the investment risks and maximize investment returns. The paper uses the MPT (Modern Portfolio Theory) to demonstrate the investment diversification strategy that can be employed to deliver the best investment opportunities for prospective investors. The theory argues that a key strategy to minimize risks is to allocate investment in a different class of assets, and asset allocation is an investment strategy by dividing the investment portfolios among a different class of assets such as stocks, market securities, and bonds. In essence, asset allocation is an effective and organized strategy of diversification. Thus, the study uses $1 Million hypothetical investment portfolios to demonstrate an effectiveness of investment diversification. The results reveal that an investor gains $224,150 from both the stocks and 1 year Treasury bill annually from the investment. The results of the sensitivity analysis also show that the investor records $105,000 of 15% expected annual returns from the stocks making the overall returns for $1 Million investment to be $119,100.
The results reveal that optimization of investment and investment diversification are the effective investment strategy for institutional and individual investors.
2. Problem Statement
The central problem that investors face is the identification of the strategy to use for the diversification of the assets to maximize returns and minimize the risks. In the contemporary business environment, an investment decision is not just to divide the wealth among securities, however, the optimal selection of the wealth among security is very essential. An effective selection of portfolio is the central problem of investor because an asset allocation involves selection of handful class of assets such as stocks, cash, bonds, gold and real estate. Since stocks from the same industry or closely related industries move together, investors will not derive benefits from selecting only stocks from the same industry because this type of investment strategy is void of asset correlation characterized with increased risks. The central goal of diversification is to meet a long year financial goal, thus, efficient diversification such as spreading the investment across various industries or sectors will reduce a price volatility because different sectors do not react to the same events. The modern portfolio theory argues that investors are able to arrive at optimal diversity after adding up to 20 stocks. Erkin, Mehmet, (2013) argue that correlation is very critical for investment decision because it provides essential information about the strategic to pool portfolio to achieve diversification objective. Nevertheless, exploiting information from the raw coefficient is still a difficult task for investors. Many individuals and institutional investors have not taken the advantages of Modern Portfolio Theory that demonstrates that the marginal benefits of diversification are greater than marginal costs. A major strategy to minimize the tracking errors is to use the optimization model, however, some investors have little understanding of the model that provides a greater understanding of a balanced asset allocation. Moreover, some investors face challenges in managing the underlying high risks and transaction costs associated with stock markets since investment strategies require investors to have a remarkable knowledge of correlative risk factors of stock markets. (Klaus, 2011).
Nwakanma, Cfia, & Gbanador, (2014) argue that "Investment in stocks and the associated expected return from such investment is usually fraught with risk. The idea of portfolio diversification as a strategy for dealing with the concerns of investors about risk and returns." (p 145).
This study attempts to address the problems by using asset allocation model dealing with the diversification of different asset class. Roll (1992) suggests that the goal of optimization is to minimize the tracking errors and improve the asset returns to enhance the optimal asset allocation. Alexander and Dimitriu (2005) estimate the effect of optimization on the S & P 500 for the 3-year daily data. The result reveals that the correlation and optimization procedures are able to lower transactional costs as well as delivering better Shape ratio. The study attempts to enhance a greater understanding of the associated benefits of stocks selection approach as well as optimization procedures. These factors are very critical for portfolio management. Nwakanma, Cfia, & Gbanador, (2014) believe that variant of Naive strategy refers to evenly splitting assets among the investment. The authors reveal that evenly distribution of assets falls short of sophisticated MPT because a portfolio should strike an optimal balance between the possible investing risks and the prospective return of investments. Given the sophistication of diversification strategy, this study uses the strategy to select a number of stocks to minimize risks and maximize returns.
3. Data Collection
The study constructs the investment portfolio by selecting 10 U.S. stocks from different sectors, and the stocks used to complete the project are as follows:
American Eagle Energy Corp.,
Ford Motor Co.
International Business Machine
Wells Fargo & Company
Laboratory Corp. of America
The paper uses the Microsoft Excel program to keep track of investment portfolio in an organized manner. The Excel assists investors to track positions such as returns and period closing prices. Another valuable benefit of Excel program is its ability to calculate the standard deviation of the investment portfolio.… [END OF PREVIEW]
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