Does Financial Leverage Influence Investment Decisions? Empirical Evidence From KSE-30 Index of Pakistan

Abstract

The article shows that the rate of return on well diversified low risk portfolios is significantly lower than the return on well diversified higher risk portfolios. It shows how diversification can be utilized to offset the riskiness of individual securities, so that portfolios consisting of large numbers of higher risk securities may be less risky than portfolios consisting of small numbers of low risk securities, yet earn a substantially higher rate of return. The correlation of the portfolio to the market index, measured by R-square, indicates how much of the variability in the returns on the portfolio is associated with variability in the market. Selecting stocks to minimize risk in the individual stock on grounds of safety/quality/prudence, rather than in the context of a diversified portfolio, restricts the very risk that theory suggests bears systematic compensation in favor of risks that do not bear compensation. Investment performance can often be improved by expanding the list of qualified securities to include higher return, higher risk stocks, while offsetting the increase in market risk through more effective diversification. Small accounts should be encouraged to pool their assets to exploit these possibilities.