Comparing risk and rewards for portfolio selection strategies

Abstract

The purpose of this study is to obtain an effective solution to the portfolio selection problem, for different risk measures. There is a trade-off between risk and return. We want to determine how an investor should invest an amount of money, in a number of funds, in terms of specific risk-reward objectives. That is, to maximise return for a given risk level or to minimise risk for a given expected return level. An important element of effectively managing risk is the ability to measure it with relative precision. One of the most common ways to describe investment risk is to relate it to the uncertainty or volatility of returns from an investment over time. For example, an investment whose returns range between 0 and 2 percent is less volatile than an investment whose returns range between -10 and 12 percent (Clark, 1994:45). Because risk is therefore important, the literature review presents an overview of risk and risk management. This includes the following: sources of investment risk, investment risk classifications, different risk measures, the risk management process and strategies for risk management. In order to find the optimal or best strategy, different investment strategies are compared over different time horizons (comparison is done by using some risk measures, which are minimised, as criteria for selecting the best strategy. The investment strategies that are used include: models for decision making under uncertainty and decision making under risk. The empirical results of both these approaches are presented in this study. The optimal strategy was the half yearly pessimistic Hurwicz criterion strategy and for the individual funds, S³,. The investor doesn't always have to select the optimal strategy, but he can also select a good model. Thus, a strategy that has a slightly lower return, but it also shows lower risk.