THE RELATIONSHIP BETWEEN PORTFOLIO SELECTION AND PERFORMANCE OF LARGE CAPITALIZATION STOCKS IN KENYA

ABSTRACT 
Stock markets form a very important component of wealth generation and wealth redistribution in the Kenyan economy. Given that Kenya is one of the fast Developing countries Africa, it has attracted a wide range of investors both local and foreign who have a high appetite in investing in local firms which have a high growth potential. Moreover, the Kenyan economy is growing at a significantly positive way reflecting to an increase in disposable income for the population such that they are able to put their disposable income into investments which are desirable and promising higher returns. The NSE provides one of the platforms for investment into the Kenyan economy and as such, it has generated the interest of many investors which has resulted to the development of various Indices in NSE and has made it necessary to analyze the performance of the Kenyan Stock Market which helps to guide investors on their diversification strategies. The study aimed at analyzing the relationship between portfolio selection and performance of the NSE with specific reference to the large cap stocks in Kenya. The study applied the Sharpe Single Index model for analysis. Firstly, the study established that there exists an inverse relationship between portfolio risk and performance of the large cap stocks in Kenya. Secondly, the study identified that there is an inverse relationship between portfolio return and performance of large cap stocks in Kenya. However, the inverse relationship between portfolio risk, portfolio return and performance of large cap stocks in Kenya is insignificant. This can be attributed to the various micro and macro-economic factors which influence the performance of the securities market. Thirdly, the study established that there exists a positive relationship between security weights and performance of the large cap stocks in Kenya. The study also noted the simplicity and suitability in application of the Sharpe single index model. The study recommended that investors should apply the SIM for portfolio construction and analyze assets with consideration of other market factors other than the risk free rate of return.

CHAPTER ONE 
INTRODUCTION 
Background of The Study 
A rational investor‘s intent is to maximize return while minimizing risk and due to this concept, the portfolio theory was developed by Harry Markowitz in 1952. Investors continually deal with the trade-off between risk and return while striving to maximize their growth potential with the minimum possible risk hence facing conflicting objectives of maximizing expected return and minimizing uncertainty or risk which must be balanced against each other. Thus, to make wise decisions in investment, there is a need for knowledge on security analysis and portfolio management (Nalini, 2014). 

The objective in portfolio selection is reducing the investment downside risk while maximizing the intended returns for wealth maximization. One of the main advantages of investing in more than one asset is the possible reduction of risk. Intuitively, by sharing resources among several different assets, even if one of them has a disastrous (very low) payoff due to its variability, chances are the others will not and as such, reduces the level of loss that could have been experienced should all the resources had been invested in a single asset. 

Risk refers to the probability of financial loss facing an investor who has committed funds into an asset or assets. It occurs when the actual returns differ from the expected return that had attracted an investor into investing in a particular asset or combination of assets. Thus, it is the volatility of future returns from an investment. Return on the other hand is the basic motivating force and the principal reward in any investment process. Return is measured as the gain or loss to an investor over a given period of time. Markowitz (1952) settled on the idea that investors would demand higher returns on a market portfolio than a risk-free investment, the relationship between risk and return has been subjected to extensive theoretical and empirical enquiry (Mandimika and Chinzara, 2010). 

The risk-return trade-off is explained by the Capital Asset Pricing Model (CAPM), which relates the required return on investment to the risk of undertaking such an investment. Specifically, 

Merton‘s (1973) Inter-temporal Capital Asset Pricing Model (ICAPM) hypothesizes a positive correlation between expected return on an investment and the associated risk. The rate of return on an investment is weighted by the perceived risk of undertaking such an investment implying that a direct relationship between market risk and return for the reason that risk-averse investors require additional compensation for assuming extra risk (Raputsoane, 2009). The volatility of the return on the market portfolio is inversely related to the ratio of expected profits to expected revenues for the economy (Binder and Merges, 2001). 

One well-understood and seemingly well-heeded investment axiom on investing is; don‘t put all your eggs in one basket (Qian, 2005) and according to Gregory, Matatko, & Luther, (1997); by holding a portfolio of diverse individual stocks, the risk level will be lesser than the risk inherent in holding any one of the individual stocks provided the risks of the various stocks are not directly related. Nawrocki, (1999) acknowledged that the Portfolio theory uses decision-making tools to solve the problem of managing risky investment portfolio. Some of the basic building blocks of modern portfolio theory are the mean-variance efficiency frontier of Markowitz, (1952) and the reward to variability ratio of Sharpe (1966). The risk of a stock portfolio depends on the proportions of the individual stocks, their variances, and their co-variances. A change in any of these variables will change the risk of this portfolio. It is generally true that when stocks are randomly selected and combined in equal proportions into a portfolio, the risk of the portfolio declines as the number of stocks increases (Evans and archer, 1968). Evans and Archer (1968) further observed that the risk reduction effect diminishes rapidly as the number of stocks increases. 

As noted by Nyariji (2002), in consideration of the all securities in the NSE, to yield the maximum benefits of diversification required investors to make a portfolio consisting of 13 securities. However, with the same considerations, Mbithi (2015), found out that an optimal portfolio in the Kenyan Securities Market is made up of between 18-22 securities. According to a research done by Nalini (2014), in consideration to fifteen selected securities, the optimal portfolio in the BSE was made up of 4 securities which derived maximum returns for the investors. 

Thus, via the use of portfolios, investors are able to come up with different combinations of assets which aids in the reduction of risk. Risk is one of the factors that hinder investors from committing their funds into particular assets due to the fear of loss. Therefore, Markowitz (1952) decided to come up with the efficient portfolio theorem which aimed at bringing out the possibility of investment combinations which would reduce perceived risk by investors while at same time maximizing the return potential that investors would yield from committing their funds into such asset combinations. Similarly, risk managers use portfolios to diversify away the un-priced risk of individual securities. 

The Nairobi Securities Exchange (NSE) has a history that can be traced to the 1920‘s when it started trading in shares while Kenya was still a British colony (CBK, 1984). Ngugi, (2003) noted that while share trading was initially conducted in an informal market, there was a growing desire to have a formal market that would facilitate access to long-term capital by private enterprises and also allow commencement of floating of local registered Government loans. The exchange was constituted in 1954 as a voluntary association of stockbrokers registered under the Societies Act and was charged with the responsibility of developing the stock market and regulating trading activities (NSE, 1997). 

Currently, it is regulated and supervised by theCapital Markets Authority (CMA) through legislative power of theCMA Act of 1989 that came into effect in 1990. The Authority supervises and regulates the activities of market intermediaries including the stock exchange, central depository and settlement system and all other persons licensed under Capital Markets Act. This capital market is thus a part of the financial markets that provides funds for long-term development facilitating mobilization and allocation of capital resources to finance long-term productive investments. 

There are five indices in the NSE, the NSE-20 Share index, the FTSE Kenya 15 and 25 share Indices and the NSE All Share Index (NASI) which provide a basis of comparing the market performance. There are 64 companies listed on the Main Investment Market Segment (MIMS) of the NSE. Trading at the exchange is on the equities of these listed companies and immobilized corporate and government bonds (NSE, 2014). Osoro and Jagogo (2013) says that, to be effective, an index should be accurate; implying that the index movement must correspond to all underlying price movements at the market so as not to mislead the parties who rely on the index for decision making as they undertake their investments. On its part, the FTSE Kenya 15 Index is a portfolio made up of the 15 large cap stocks in the NSE and was used for this research purpose. 

Statement of The Problem 
Stock markets provide an opportunity to earn significantly higher returns on investing in them. However, it involves significant proportions of risk. Unlike dealing in riskless investments where investors are certain of gaining some return without worry of losing their capital, when investing in the securities exchange, investors face a higher level risk of losing their money should their stocks fall in value. Risk and return analysis is important in making any decision regarding investing and the determination of an optimal portfolio within stocks can be achieved by the use of the Single Index (beta) Model as projected by Sharpe. According to Duncan (2008), given the high level of risk, the securities exchange has the potential for higher rewards, especially when putting more funds into the riskier securities. Mbithi (2014) says that most investors want to maximize returns without considering risk and this is attributed to the herd mentality. This study aimed at establishing the optimal portfolio size among the large cap stocks in the NSE Index and moreover, the study shows that the optimal portfolio size significantly changes with time making investors to be in a better position to determine their investment strategies on both the portfolio size and also on whether to take an active or passive investment strategy in addition to the ability to determine the best assets to commit their funds into.

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Item Type: Kenyan Postgraduate Material  |  Attribute: 78 pages  |  Chapters: 1-5
Format: MS Word  |  Price: KSh900  |  Delivery: Within 30Mins.
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