Portfolio is the overall collection of financial assets held by an entity or individual. Financial assets are all the non-physical assets of a firm i.e. stocks, bonds and cash held by a firm, individual investors or other financial organizations. Financial professionals, hedge firms and other relevant financial firms can manage portfolio. There is, therefore, need to choose the grouping of those assets carefully in order to minimize the risk inherent and maximize the returns from a firm’s portfolio. This is because different assets change in value and in different directions as compared to prices in the market.
Diversification is placing the assets of a firm in different investment areas. Simply put, there is more risk in dropping an egg placed in one basket but a larger risk in dropping the basket that carries all your eggs. Hence the saying, ‘Do not put all your eggs in one basket’. It is riskier for instance to hold only one stock. If that stock falls by for example 40%, then the investor or the firm suffers greatly. On the contrary, it is very rare for a portfolio of say ten stocks to fall by that much in the same market. This is so because some companies are growing, some are new in the market and yet others are mature (Liyanarachchi, 23).
Diversification also takes the form of investing in different countries and in different asset classes such as infrastructure, Gold or Real estate.
Each entity needs to manage the risks in its portfolio in order to grow financially since that is the core reason for investing. Risk is simply defined as a deviation from the normal or expected outcome. Risks cannot be separated from any business operations and need not be seen as a threat to the survival of a firm but rather opportunities to succeed if carefully handled.
Financial Risk Management
This is the use of financial instruments to manage exposure to risk in order to create value for the organization. The main types of risks are; Market Risk, Credit Risk, Volatility Risk, Inflation Risk, Liquidity Risk and Foreign Exchange Risk.
The process of managing financial Risks involves
- Identifying the sources of the Risks
- Measuring the risks and
- Planning how to address the risk
Identifying the sources of financial risks
The process could take either a qualitative or a quantitative form depending on the size and nature of operations of a firm. If for example investors can hedge a risk by themselves, then, it is not advisable for the firm to hedge them at the same cost. Hedging of risks externally by a firm may be only appropriate if it is less expensive than hedging them internally.
Financial risk management aims at doing everything that will prevent the reduction of the value of the financial assets of a company. This reduction could be due to the actions of stakeholders either internally or outside the organization. To identify the financial risks facing a firm, first look at all the operations that the firm is generally involved in. these are all those activities undertaken by the employees and other stakeholders of the firm.
Having identified the various, risk exposures the firm then goes on to analyze the level of risk i.e. the cost to the firm in case the risk occurs. This is done through mathematical calculations of the affected asset portfolio or analyzing the money value that may be incurred in case the risk touches on other non- financial assets such as good will and customer loyalty.
Once the asset risk levels are determined, the firm finds the best way to hedge against them. This could be through internal measures, insurance or by passing the risks to shareholders themselves. The firm then goes on to choose those portfolios with less relative risks as compared to the rest of the of the selection. That final group of financial assets held by the firm can therefore, be called their asset portfolio.
Asset Allocation of Portfolio
This is a strategy that tries to balance the risks relating to an asset with the expected rewards the asset allocation is mainly determined by three factors i.e. period of investment and the ability to tolerate risk. If a firm wishes to invest for a long time in a specified portfolio, then, it may feel more comfortable taking on a riskier investment as compare to a firm investing for only a short period. Asset allocation can also be referred to as the dollar value of each asset in the portfolio. This value greatly affects the risk to reward ratio of the asset portfolio.
If a firm on the other hand has the tolerance to lose part or all of its initial investment for a greater potential of returns, then it may be more willing to invest in riskier portfolio as compared to a firm that is weary with its investment chances. The asset allocation of a firm may also be determined by other factors and forces acting in the market such as economic recessions, inflation or depreciation in the value of the dollar (Hooper, 12).
Journal Article Review
Shell BP is a company majorly involved in oil trade. The company has made numerous profits for the last few decades. It is expected to keep the trend in the near future. This is because of the companies sound asset portfolio selection and investment decisions. Shell has grown due to sustainable risk management procedures. The company has constantly increased its capacity by optimizing existing assets and increased new infrastructural investments. Though the Gulf oil spill affected the company’s reputation, it was able to recover so quickly and moves on. The company provides a range of products.
Production earnings for the first quarter of 2011 was 3.04 million barrels of oil as compared to a 2% lower level in the first quarter of 201(Financial Times.com)]. It is therefore; clear that these levels of output could have been far much lower after the spill had the company not wisely diversified its assets in different areas. The company is still not considering splitting into two i.e. to do both explorations of oil and selling but rather it wishes to keep driving value between the upstream and the downstream through technology and innovation (Macchiarola, 203).
Risk is inseparable from business investment. Any company, firm or even individual that wishes to be successful in the market has to choose its asset portfolio wisely. This will ensure that the firm hedges against risks, makes profits, increases value for shareholders’ and still remains competitive in the market.
Elliot, Brother. Financial Accounting and Reporting. London: Prentice Hall, 2004.
Hooper, Davey. Conceptual Issues In Accounting:A New Zealand Perspective. Melbourne: Cengage Learning, 2009.
Liyanarachchi, Gilbert. Creative Accounting and Professional Development. Melbourne: Cengage Learning, 2008.
Macchiarola, Michael. Inside the Fed – Monetary Policy and Its Management, Martin through Greenspan to Bernanke. Journal of Current Economic Analysis and Policy, 10. 3 (2009): 201-205.