74 Corporate Finance
DO INDIVIDUAL INVESTORS HOLD
DIVERSIFIED PORTFOLIOS?
Studies conducted in America indicate that a typical investor’s stock portfolio contains only a small frac-
tion of the available securities and the number of stocks in a portfolio range from 9 to 12. Why do investors
forgo the benefits of diversification? Is it because they don’t know the benefits of diversification? What
does under-diversification imply for pricing of risky financial assets? Some academicians observe that due
to under-diversification even unsystematic risk may be priced in markets. Investors might not hold diver-
sified portfolios; it’s enough if they price securities as though they are diversified. This reinforces CAPM.
Is There a Risk-free Asset?
Investors hold assets in anticipation of returns from them. The actual return may deviate from the expected
return. The variance in actual return from the expected is the risk in holding that asset. For an asset to be risk-
free the actual return from the asset should always equal the expected return. For instance, an investor may
buy a T-bond that promises to pay 12 percent. Since sovereign governments are usually free of default risk,
the actual return will be 12 percent. For an asset to be classified as risk-free, the first qualification is that
it should be free of default risk. Even the highest rated companies will have some default risk in them.
This precludes them from being classified as risk-free. The second qualification is that the asset should not
have any reinvestment risk. Reinvestment risk arises from reinvesting coupon payments at rates below that
prevailing at the time of buying. To illustrate, if interest rates decline from 10 to 8 percent after buying, the
investor can reinvest coupon payments only at 8 percent. So he will not realize the YTM promised at
the time of issue. For this reason even treasury securities cannot be considered risk-free.
Some Observations on Risk Premium
The risk premium, Rm – Rf, is usually estimated by looking at the historical premium earned by stocks over
government bonds over long periods (over 60 years in the case of the US). In India, however, due to non-
availability of data, 18 year period is used.^3 The historical risk premium is used as proxy for future (Exhibit 3.15
presents the risk premium for countries around the world).
Exhibit 3.15 Risk premia for select countries
Annual equity return Bond return Risk premium
Country (percent) (percent) (percent)
Australia 8.47 6.99 1.48
Canada 8.98 8.30 0.68
France 1.51 9.17 2.34
Germany 11.30 12.10 –0.8
Italy 5.49 7.84 –2.35
Japan 15.73 12.69 3.04
Singapore 15.48 6.45 9.03
Hong Kong 20.39 12.66 7.73
Switzerland 13.49 10.11 3.38
UK 12.42 7.81 4.61
(^3) As on the date of the book.