‘If we hold a portfolio of stocks, we need only consider the systematic risk of the securities.’

‘As a cautious investor we must always consider total risk.’

‘We should not buy anything if the expected return is less than the market as a whole, and certainly not if it is below the return on the risk-free asset.’

Requirements:
(i) Explain to the members of the board the meaning of systematic, unsystematic and total risk and advise them, briefly, how all three types of risk can be measured, (ii) Discuss the directors’ comments.
10 Portfolio Theory and CAPM. Rodfin plc is considering investing in one of two short-term portfolios of four short-term financial investments in diverse industries.
The correlation between the returns of the individual components of these investments is believed to be negligible.

Portfolio 1 Investment Beta Expected return (%) Std dev. of returnAmount invested £ million a 1.4 16 7 3.8 b 0 6 2 5.2 c 0.7 10 5 6.1 d 1.1 13 13 2.9 Portfolio 2 Investment Beta Expected return (%) Std dev. of returnAmount invested £ million a 1.2 14 9 7.1 b 0.8 11 4 2.7 c 0.2 7 3 5.4 d 1.5 17 14 2.8 The managers of Rodfin are not sure of how to estimate the risk of these portfolios, as it has been suggested to them that either portfolio theory or the capital asset pricing model (CAPM) will give the same measure of risk.
The market return is estimated to be 12.5%, and the risk free rate 5.5%. Required:
(i) Discuss whether or not portfolio theory and CAPM give the same portfolio risk measure.
(ii) Using the above data estimate the risk and return of the two portfolios and recommend which one should be selected.