The importance of the CML from an investment, and particularly a cash flow point of view, is that the CAPM can be used to determine the price of risk for the optimal portfolio. The potential effects of market risk, which by definition emanates from the macro-economy which impact on a investment, can be quantified and an adjustment in the investment strategy can therefore be made.
The CAPM reduces risk through diversification until a point is reached where risk can’t be diversified any more within the asset class. The risk that remains is termed non- diversifiable- or systematic risk The investor will thus receive no reward taking on additional risk beyond the optimum point allowed by the investment parameters or resources available. This is also termed market risk, since risk will increase only if there is a total shift of demand, thus changing the investment parameters.
2.4.2 The Securities Market Line (SML)
The CAPM may also be used to determine the expected return of a security. If the market as a whole moves in a particular direction, shares or securities will move in the same direction, but at different rates (Goodall, 2005). This attribute of the behaviour of a security or share constitutes a major component of the security’s contribution to the overall risk of the portfolio. This relationship is measured by the share/security’s beta coefficient (β). Beta indicates the manner in which a security’s return changes systematically with changes in the market’s return. Beta above +1 indicates above average risk and –1 indicates below average risk. The investment decision is thus not based on specifics, but rather on whether the particular investment is below or above the risk contained in the market.
Figure 2.5
(from Goodall, 2005, Part2, Chp 2, p8)
2.5 SUMMARY
The portfolio environment provides the vehicle for managing internal- or unsystematic risk to investors in the Securities Market. MPT has diversification as its foundation, where by assets that show less than perfect correlation in terms of their risk and return characteristics, are combined in an investment vehicle (portfolio). The desired results would be to obtain better or the same returns in the portfolio compared to the sum of the underlying assets in their individual capacity, but with a reduced total (portfolio) risk. To summarise, the key aspects of Modern Portfolio Theory are as follows:
1. Internal risk may be managed through portfolio investing and the concept of diversification.
2. Diversification is achieved by constructing an optimum portfolio along the efficiency frontier.
3. Negative correlation is important when combining assets and is essential for internal risk reduction.
4. Calculating the co-variance between assets allows the quantification of the net risk of the portfolio. It is a measure of the interactive risk between portfolio assets.
5. The co-variance may be used to calculate the correlation coefficient between assets, thus enabling the optimisation of asset selection based on their risk/ return cycles.
6. Risk / return combinations may be further optimised according to the investor’s risk profile through a distinction to be made between the portion of capital invested in the optimum portfolio and the portion invested in a risk-free investment.
7. The construction of an efficient portfolio may be based on the profile of the market portfolio, which is representative of the whole market (dominant factor). The introduction of an additional security into the portfolio may be evaluated in terms of the interactive risk between the efficient portfolio and the security. 8. Returns may be increased or decreased through the increase and decrease in risk
exposure, by including securities in the portfolio based on their risk profile in relation to the market portfolio. This may be achieved through either borrowing funds and investing in the efficient portfolio, or capital may be loaned and invested in a risk-free investment.
In essence the use of MPT enables the investor to manage internal risk through the reduction of the overall combined risk of the portfolio, whilst bettering or at least equalling the sum of returns of the individual securities / assets contained in the portfolio. The use of particularly the Capital Asset Pricing Model and the Capital Market Line enables the determination of a price for market risk (external- or systematic risk). The investor is thus not only in a position to put counter measures for risk in place, but also formulate an investment vehicle to optimise returns. The portfolio investment strategy centres around obtaining returns from income-bearing securities / assets, which are less than perfectly positively correlated to one another with respect to their income patterns.
Contemporary investment theory suggests that favourable correlation to achieve diversification is more likely when assets are combined from different markets as well as from different economic sectors.
In addition, it is also important to note here that the historical information on the returns of securities in the securities market are well documented and are accurate reflections of historical market activity. The use of market indices are therefore considered to be acceptable sources of information for use in the critical calculations required for the implementation of MPT. The indices referred to therefore functions as suitable links between investments and their relevant markets. This may not be necessarily the case with direct property investments, but is a topic which will be further elaborated on in the remainder of this report.
The concepts of Modern Portfolio Theory highlighted in this chapter represent key elements and processes which may be used as criteria to be met in the application of MPT to a direct property investment, in an attempt to facilitate the implementation of MPT as an acceptable risk management strategy. In following chapters, direct property as an investment vehicle will be scrutinised in terms of its ability to fulfil this criteria. The applicability of these principles to a single property investment will logically depend on whether a direct property as an investment vehicle, has the necessary attributes to facilitate this. A suitable format of analysis is needed to act as a vehicle for analysis. The following chapter will investigate direct property as an investment vehicle from a cash flow point of view, with the aim to establish the areas where risk originates in the investment.