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Portfolio investment is investment in a selection of securities with the purpose of earning financial gains without acquiring management control of the enterprises. Unlike direct investments, when investors intend to acquire foreign enterprises and participate in their management, the sole purpose of portfolio investment is earning highest possible returns from purchased securities.
The term “portfolio” refers to a collection of various financial assets, like stocks, bonds, currencies and commodities. Individual investors and financial institutions alike are involved in making portfolio investments. Modern portfolio theory is based on Harry Markowitz’s work. Markowitz’s work showed how portfolio performance can be measured in terms of portfolio expected return and variance, where variance represents the portfolio riskiness. It showed how the portfolio can be optimized: how portfolio variance can be minimized for a given level of expected return and similarly how the expected return can be maximized for a given level of variance.
Asset allocation is the assignment of funds to different categories of assets such as stocks, bonds, cash etc. In his study Markowitz illustrated how portfolio optimization is achieved by portfolio diversification strategy and asset allocation. The study revealed that by putting together assets from different asset classes and different issuers the overall portfolio performance is no longer damaged by performance of any single asset as a fall in the price of one asset gets offset by an increase in another’s price. So when two assets move in opposite direction their price swings offset each other which, results in lower variance or riskiness. This property of moving together is called correlation, and when asset prices move in opposite direction they are said to be negatively correlated. The degree to which two assets move together is measured by the correlation coefficient. Thus putting together different risky assets results in partial cancellation of asset price random fluctuations, which results in lower portfolio riskiness. Markowitz’s work illustrated further that by changing the asset allocation weights in a well-diversified portfolio - that is by changing the share of portfolio funds in individual assets, the portfolio riskiness can be minimized for a given level of return or the portfolio return can be maximized for a given level of variance.
William Sharpe developed the model further by exploring the market implications of portfolio optimization. By studying how the prices of securities are impacted by the choices of investors when portfolios are optimized, Sharpe established that the expected return of a security or a portfolio is equal to the rate on a risk-free security plus a market risk premium multiplied by the asset's systematic risk, beta. Asset’s systematic risk is a mathematical measure of the sensitivity of rates of return of a portfolio or a given stock compared with rates of return on the market as a whole. Thus a model was created that described how asset market prices are determined, which is known as the Capital Asset Pricing Model CAPM). By estimating the asset’s beta based on past performance data, and knowing the market risk premium and the rate of return on a risk-free security, the model determined what the expected return on the asset should be so that investors are content to keep the asset as part of their investment portfolio. When the price of the asset is set so high that it results in a lower expected return than the market required rate of return, it will be deemed overpriced and investors will want to reduce their holdings of the asset. The investors will start selling them, therefore causing a decline of the price to a level where it no longer is overpriced. The expected return of the asset then falls to the level equal to the market required rate of return, and investors are content to hold them in their portfolios. The opposite process happens when the price of an asset is set low, resulting in a higher expected return than the market required rate, causing the investors to bid for the asset, which increases its price.
By determining the asset returns based on the CAPM model, the return and riskiness of any portfolio can be estimated. Thus the investors can select their investments based on their personal preferences – how much risk they are ready to accept for achieving the returns they require. Investors thus can decide what type of portfolio investment they want based on their investment objectives. The investors who look for capital appreciation to use as source for a retirement fund have long investment horizons and can take more risk, therefore they can invest heavily in riskier assets like stocks. Retired Investors, who look for steady income source prefer the safety of highest grade debt instruments for investment and invest heavily in US government debt. Thus investors can decide what their investment goals are and invest in portfolios that correspond to their risk tolerance.
IFC Markets and NetTradeX companies have developed the NetTradeX advanced trading platform which traders can use together with the MetaTrader 4 trading platform to realize their investment strategies. The integrated software allows the traders to create portfolios using specific diversification strategies to achieve their investment goals. By changing the portfolio’s asset allocation and studying the change in portfolio’s performance profile the investor can choose the portfolio investment that provides their required return at a risk level they are willing to bear.
Besides the classical analytical tools that help the investors to carry out portfolio optimization the NetTradeX trading platform is equipped with advanced software that allows the traders to build unique investment portfolios and trade them. This is accomplished on the basis of GeWorko Method, an innovative portfolio investment strategy. GeWorko Method is based on a principle that is similar to the currency exchange rate. The investor builds a personal composite instrument (PCI) by composing two portfolios and quoting the value of one portfolio, called the base part, against the value of the second portfolio, the quoted part. The composite instrument price then expresses the base portfolio value in units of the quoted portfolio. When buying such a PCI, the components of the base portfolio are bought and the components of the quoted portfolio are sold. The trade operations are reversed when the PCI is sold.
PCIs provide a convenient implementation tool for many investment strategies such as spread trading when buying one portfolio or asset is carried out simultaneously with selling another one. Traders can study the relationships between assets and portfolios to learn how their values change relative to each other and trade the regularities that are revealed. With the tools provided by IFC Markets investors can develop their own trading strategies and test them on a wide variety of assets and portfolios. IFC Market offers best trading terms for all available assets like tight fixed spreads and intrabank swap rates.