PORTFOLIO MANAGEMENT

APPROACH
By: Joseph Ventinilla

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Portfolio

What is Portfolio?
■ Portfolio is a group of financial assets such as shares, stocks,
bonds, debt instruments, mutual funds, cash equivalents, etc.
A portfolio is planned to stabilize the risk of non-performance
of various pools of investment.
■ Portfolio refers to invest in a group of securities rather to
invest in a single security.
■ “Don’t Put all your eggs in one basket”
■ Portfolio help in reducing risk without sacrificing return.

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Management

What is Management?
■ Management is the organization and coordination of the
activities of an enterprise in accordance with well-defined
policies and in achievement of its pre-defined objectives.

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Portfolio Management

Portfolio + Management
■ Portfolio Management is the process of creation and
maintenance of investment portfolio.
■ Portfolio management is a complex process which tries to
make investment activity more rewarding and less risky.

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Portfolio Management

■ Porfolio is a combination of securities such as stocks, bonds and money

market instruments.
■ The process of blending together the broad asset classes to obtain
optimum return with minimum risk is called portfolio construction.
■ Two approaches of portfolio
Traditional approach – investor’s needs in terms of income and capital
appreciation (According to that appropriate securities are selected).
Modern Approach (Markowitz efficient frontier approach) – Maximize
expected returns for a given level of risk.It views portfolio construction in
terms of the expected return and risk associated with obtaining the expected
return.

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Traditional approach

■ Determining the objective of the portfolio.

■ Selection of securities to be included in the portfolio.

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Traditional approach
1. Analysis of constraints
Income needs – need for current income or constant income
(inflation reduces purchasing power)
■ Liquidity
■ Time horizon – investment planning period of the individuals
3 stages – carrer, mid-career & retirement
■ Safety
■ Tax considerations
2. Determination of objectives
■ Current income – 60% in Debt & 40% inequities
■ Growth income – 60 to 100% in equities & 0 to 40%
■ Capital appreciation –
■ Preservation of capital
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 Traditional approach

3. Selection of portfolio
■ Bonds
■ Bonds and common stocks
■ common stock
4. Assessment of risk and return analysis
■ The ability to achieve higher returns is dependent upon his
ability to judge risk and his ability to take specific risks.. The
investors analyses the varying degrees of risk and construct
portfolio.
5. Diversification

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 Traditional approach

6. Portfolio revision
■ Portfolio is to be periodically revised like shift from one stock
to another or from stock to bond and vice versa. It may called
sector rotation.
7. Performance evaluation
■ These involves quantitative measurement of actual return
realised and risk borne by the portfolio over the period of
investime.

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Modern Approach

■ Traditional approach is based on Comprehensive financial plan

for the individual.
■ Markowitz gives more attention to the process of selecting the
portfolio.
■ His planning can be applied more in the selection of common
stocks portfolio than the bond portfolio.
■ The stocks are selected on the basis of risk and return analysis
and not on the basis of need for income and capital appreciation.
■ In the modern portfolio the Final step is ASSET allocation. –
choose the portfolio that meets the requirement of the investor.
■ Risk taker – choose high risk portfolio
■ Lower tolerance of risk – choose low risk portfolio.

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MARKOWITZ MODEL

■ Markowitz model was developed by Harry Max Markowitz is an

American economist
■ Harry Markowitz introduced new concept of risk measurement
and its application of the selection of the portfolio.
■ He is best known for his pioneering work in Modern Portfolio
Theory.
■ It studies the effects of asset risk, return, correlation and
diversification on investment portfolio returns.
■ It is based on the assumption that the utility of the investor is a
function of two factors namely,
 Mean return i.e. expected return
 Variance return i.e. square root of deviation.

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MARKOWITZ MODEL

■ It is referred to Mean – Variance portfolio or Two – Parameter

Portfolio Theory.
■ An efficient portfolio is expected to yield the highest returns
for a given level of risk or lowest risk for a given level of
return.

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Assumptions under
Markowitz model
■ The market is efficient and all the investors have full knowledge about the stock market.
■ Investors make superior returns either through TA or by FA.
■ All investors are aim of risk avoidance
■ An investor is rational in nature
■ All investors would like to attain the maximum rate of return from their investment.
■ The investors take their decisions based on the expected rate of return on an investment.
■ The rate of return and Standard deviation are important parameters for finding out whether the
investment is a worthwhile or not.
■ The investor can reduce the risk if he increases investment to his portfolio.
■ The investors assumes that:
 High risk – high returns,
 Low risk – low returns

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Capital Asset Pricing Theory
or CAPM Theory
■ The CAPM theory helps the investors to understand the risk and return
relationship of the securities.
■ Markowitz, William Sharpe, John Lintneer and Jan Mossin develop d this
model.
■ It is a model of linear general equilibrium return.

ASSUMPTIONS
1. An individual buyer or seller cannot affect the price of a stock.
2. This assumption is the basic assumption of Perfectly competitive market.
3. Investors make their decisions only on the basis of the expected returns,
standard deviations, and co-variances of all securities.

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4. The investors can lend or borrow any amount of funds at the
riskless rate of interest.
5. Investors could buy any quantity of share.
6. There is no transaction cost. i.e. no cost involved in buying and
selling of stocks.
7. There is no personal income tax.8. Unlimited quantum of short
sales is allowed.

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The expected return on the combination of risky and
risk free combination is

Rp = RfXf + Rm(1-Xf)
Where:
■ Rp = Portfolio return
■ Xf = The proportionate of funds invested in risk free assets
■ 1-Xf = The proportionate of funds invested in risky assets
■ Rf = Risk free rate of return
■ Rm = Return on risky assets

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■ The capital asset model consists of Capital Market Line (CML)
and Security Market Line(SML).
■ The CML relates expected return and risk for a portfolio of
securities. CML states that there is a risk free rate. i.e. zero
risk.
■ The SML relates expected return and risk of individual
securities.

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Phases of Portfolio
Management
■ Portfolio management is a process of many activities that
aimed to optimizing the investment. Five phases can be
identified in the process:
1. Security Analysis.
2. Portfolio Analysis.
3. Portfolio Selection.
4. Portfolio revision.
5. Portfolio evaluation.
■ Each phase is essential and the success of each phase is
depend on the efficiency in carrying out each phase.

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Security Analysis

■ Security analysis is the initial phase of the portfolio

management process.
■ The basic approach for investing in securities is to sell the
overpriced securities and purchase under priced securities
■ The security analysis comprises of Fundamental Analysis and
technical Analysis.

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Portfolio Analysis

■ A large number of portfolios can be created by using the

securities from desired set of securities obtained from initial
phase of security analysis.
■ It involves the mathematically calculation of return and risk of
each portfolio.

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Portfolio Selection

■ The portfolios that yield good returns at a level of risk are

called as efficient portfolios.
■ The set of efficient portfolios is formed and from this set of
efficient portfolios, the optimal portfolio is chosen for
investment.

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Portfolio Revision

■ Due to dynamic changes in the economy and financial

markets, the attractive securities may cease to provide
profitable returns.

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Portfolio Evaluation

■ This phase involves the regular analysis and assessment of

portfolio performances in terms of risk and returns over a
period of time.

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3 Methods of portfolio evaluation
Sharpe’s performance index
■ Sharpe’s performance index gives a single value to be used
for the performance ranking of various funds or portfolios.
■ Sharpe index measures the risk premium of the portfolio
relative to the total amount of risk in the portfolio.
Risk premium = Portfolio’s average rate of return - riskless rate or
return.
The standard deviation of the portfolio indicates the risk. The
index assigns the highest values to assets that have best risk-
adjusted average rate of return.

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Treynor’s Performance Index
■ Characteristic line: The relationship between a given market
return and the fund’s return is given by the characteristic line.
■ The fund’s performance is measured in relation to the market
performance.
■ The ideal fund may place its fund in the treasury bills or short
sell the stock during the decline and earn positive return.
■ Beta co-efficient is treated as a measure of undiversifiable
systematic risk.

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JENSEN’S PERFORMANCE INDEX
■ The absolute risk adjusted return measure was developed by Michael Jensen
and commonly known as Jensen’s measure.
■ It is mentioned as a measure of absolute performance because a definite
standard is set and against that the performance is measured.
■ The standard is based on the manager’s predictive ability. Successful
prediction of security price would enable the manager to earn higher returns
than the ordinary investor expects to earn in a given level of risk. The basic
model of Jensen is given below

R p = ά β (R m - R f )

R p = average return of portfolio

R f = riskless rate of interest
ά = the intercept
β = a measure of systematic risk
R m = average market return

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“Don’t Put all your eggs in one basket”

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