Characteristics of investment

Risk: Every investment carries some degree of risk. This means that there
1S a possibility that you could lose some or all of your investment. The
amount of risk associated with an investment will vary depending on the
type of investment and other factors.
Return: The return on an investment is the amount of money that you make
or lose on your investment over time. Returns can be measured in terms of
income, capital gains, or a combination of both.
Safety: The safety of an investment refers to the likelihood that you will
receive your original investment back, plus any returns. Investments in
government bonds, for example, are generally considered to be very safe,
while investments in stocks are riskier.
Liquidity: The liquidity of an investment refers to how easily you can sell
it and convert it into cash. Some investments, such as stocks and bonds, are
very liquid and can be sold quickly and easily. Other investments, such as
realestate., are less liquid and may take longer to sell.
Time horizon: The time horizon for an investment is the amount of time
that you plan to hold the investment. Some investments, such as savings
accounts, are designed for short-term goals. Other investments, such as
retirement savings accounts, are designed for long-term goals.
Objectives of investment

The main objectives of investment are to:

Grow your money: nvesting can help you to grow your money over time,
either through income, capital gains, or a combination of both. This can
help you to achieve your financial goals, such as buying a house, retiring
comfortably, or saving for your children's education.
Protect your money from inflation: Inflation is the gradual increase in the
prices of goods and services over time. Investing can help to protect your
money from inflation by allowing it to grow at a rate that is faster than the
inflation rate.
Generate income: Some investments, such as bonds and dividend-paying
stocks, can generate income for you on a regular basis. This can be a
helpful way to supplement your retirement income or to create a passive
income stream.
 Reduce your tax burden: Some investments, such as retirement savings
accounts and tax-exempt bonds, can help to reduce your tax burden. This
can save you money on your taxes and allow you to keep more of your
investment earnings.
When choosing investments, it is important to consider your individual
investment objectives, risk tolerance, and time horizon. You should also diversify
your portfolio by investing in different types of assets to reduce your overall risk.
Investment Process

The investment process is a systematic approach to identifying, evaluating, and

managing investments in order to achieve financial goals. It is important to note
that there is no one-size-fits-allinvestment process, as the best approach will
vary depending on the individual investor's circumstances and goals. However,
there are some general steps that all investors should follow:

1. Set your investment goals.What do you want to achieve with your

investments? Do you want to save for retirement, buy a house, or start a
business? Once you know your goals, you can start to develop an
investment strategy that is aligned with them.
2. Determine your risk tolerance. How much risk are you comfortable with?
Some investments, such as stocks, are riskier than others, such as bonds.
It is important to choose investments that are appropriate for your risk
tolerance.
3. Allocate your assets. Once you know your investment goals and risk
tolerance, you can start to allocate your assets. Asset allocation is the
process of dividing your investment portfolio among different asset
classes, such as stocks, bonds, and cash. Asset allocation is one of the
most important factors in determining the overall risk and return of your
portfolio.
4. Select your investments. Once you have allocated your assets, you need
to select specific investments within each asset class. This involves
researching different investment options and choosing those that you
believe have the potential to meet your goals.
5. Monitor and rebalance your portfolio. Once youhave invested your
money, it is important to monitor your portfolio's performance on a
regular basis. This will help you to identify any investments that are not
performing well and to make adjustments as needed. Rebalancing is the
process of adjusting the asset allocation of your portfolio to ensure that it
remains aligned with your goals and risk tolerance.
Risk and Return concepts

Risk and retum are two of the most important concepts in investing. Risk is the
possibility of losing money on an investment, while return is the amount of
money that you make or lose on an investment over time.

There is a direct relationship between risk and return. In general, higher-risk

investments have the potential to generate higher returns, while lower-risk
investments have the potential to generate lower returns. This is because
investors demand higher returns for taking on more risk.

There are many different ways to measure risk and return. Some common
measures of risk include:

Standard deviation: Standard deviation is a measure of how volatile an

investment is. A higher standard deviation indicates that an investment is
more volatile and therefore riskier.
Beta: Beta is a measure of hoW much an investment's returns move
relative to the market. A beta of 1.0 indicates that an investment's returns
move in line with the market. A beta of greater than 1.0 indicates that an
investment's returns are more volatile than the market, while a beta of less
than 1.0 indicates that an investment's returns are less volatile than the
market.

Some common measures of return include:

Total return: Total return is the total amount of money that you make or
lose on an investment over time, including both income and capital gains.
Annualized return: Annualized return is the average total retun that an
investment has generated over a period of time, expressed as an annual
percentage.

It is important to understand the relationship between risk and return when

making investment decisions. You should choose investments that are
appropriate for your risk tolerance and investment goals. If you are not
comfortable with taking on a lot of risk, you should choose investments that
have a lower risk profile. If you are willing to take on more risk, you may be
able to generate higher returns.

Here are some tips. for managing risk and return:

 Diversify your portfolio. Diversify ing your portfolio means investing in
different types of assets and different sectors of the economy. This will
help to reduce your overall risk.
Rebalance your portfolio regularly. Rebalancing your portfolio involves
adjusting the asset allocation of your portfolio to ensure that it remains
aligned with your risk tolerance and investment goals.
Invest for the long term. Investing for the long term will help you to ride
out short-term market volatility.

Ifyou are new to investing, it is a good idea to consult with a financial advisor.
A financial advisor can help you to develop an investment plan that is tailored
to your individual needs and goals.
 UNIT III
TECHNICAL ANALYSIS

Technical analysis involves a study of market generated data like prices and volumes
todetermine the future direction of price movement.

The technicalapproach to investing is essentially a reflection of the idea that prices move in
trends which aredetermined by the changing attitudes of investors toward a variety of
economic monetarypolitical and psychological forces.

The art of technical analysis for it is an art is to identifytrendchanges at an early stage and to
maintain an investment posture until the weight of the evidenceindicates that the trend has
been reversed.

Basic assumption

The basic premises underlying technical analysis are

1. Eventsare usually discounted in advance with movements as the likely result of informed
buyers andsellers at work.

2. Before a stock experiences a mark-up phase, whether it is minor or major, a period

ofaccumulation usually will take place. Accumulation or distribution activity can occur
withinnatural trading trends. The ability to analyse accumulation or distribution within net
naturalprice patterns will be therefore a most essential pre-requisite.

3. The third assumption is an observation that deals with the scope and extends of
marketmovements in relation to each other.

Differences between technical analysis and fundamental analysis

The key differences between technical analysis and fundamental analysis are

1. Technical analysis mainly seeks to predict short term price movements, whereas
fundamentalanalysis tries to establish long term values.

2. The focus of technical analysis is mainly on internal market data, particularly price
andvolume data. The focus of fundamental analysis is on fundamental factors relating to
theeconomy, the industry, and the firm.

3. Technical analysis appeals mostly to short-term traders, whereas fundamental analysis

appealsprimarily to long-term investors.

CHARTING - A TECHNICAL TOOL

Technical analysts, while defining their own theory about stock price behavior and criticizing
the fundamental school, do feel that there is some merit in the fundamental analysis also.
Butaccording to them, the method is very tedious and it takes a rather long time for the
commonman to evaluate stocks through this method. They consider their own techniques and
charts as
superior to fundamental analysis.

Concepts Underlying Chart Analysis

The basic concepts underlying chart analysis are: (a) persistence of trends; (b) relationship
between volume and trend; and (c) resistance and support levels.

Trends: The key belief of the chartists is that stock prices tend to move in fairly
persistenttrends. Stock price behavior is characterized by inertia: the price movement
continues along acertain path (up, down or sideways) until it meets an opposing force, arising
out of an altered supply demand relationship.

Relationship between volume and trends: Chartists believe that generally volume and trend
gohand in hand. When a major upturn begins the volume of trading increases as the price
advancesand decreases as the price declines. In a major down turn, the opposite happens; the
volume oftrading increases as the price declines and decreases as the price increases.

Support and Resistance levels: Chartists assume that it is difficult for the price of a share to
riseabove a certain level called the resistance level and fall below a certain level called a
supportlevel.
If investors find that prices fallafter their purchases, they continue to hang on to their shares
in the hope of a recovery. Andwhen the price rebounds to the level of their purchase price,
they tend to sell and have sign ofrelief as they break even.

Stock chart showing levels of support (4, 5, 6, 7, and 8) and resistance (1, 2, and 3); levels of
resistance tend to become levels of support and vice versa.

There are many types of charts that are used for technical analysis. However, the four types
that are most common are line chart, bar chart, point and figure chart and candlestick chart.
Line charts: A line chart is the figure that, perhaps, automatically comes to mind when you
think of a chart. The line chart has the stock price or trading volume information on the
vertical or y-axis and the corresponding time period on the horizontal or x-axis. Trading
volumes refer to the number of stocks of a company that were bought and sold in the market
on a particular day. The closing stock price is commonly used for the construction of a line
chart.
Once the two axes have been labelled, preparation of a line chart is a two-step process. In the
first step, you take a particular date and plot the closing stock price as on that date on the
graph. For this, you’ll put a dot on the chart in such a way that it is above the concerned date
and alongside the corresponding stock price.
Let’s suppose that the closing stock price on December 31, was Rs 120. For plotting it, you’ll
put a dot in such a way that it is simultaneously above the marking for that date on the x-axis,
and alongside the mark that says Rs 120 on the y-axis. You will do this for all dates. In the
second step, you will connect all the dots plotted with a line.

Bar charts: A bar chart is similar to a line chart. However, it is much more informative.
Instead of a dot, each marking on a bar chart is in the shape of a vertical line with two
horizontal lines protruding out of it, on either side. The top end of each vertical line signifies
the highest price the stock traded at during a day while the bottom point signifies the lowest
price at which it traded at during a day. The horizontal line to the left signifies the price at
which the stock opened the trading day. The one on the right signifies the price at which it
closed the trading day. As such, each mark on a bar chart tells you four things.
A bar chart is more advantageous than a line chart because in addition to prices, it also
reflects price volatility. Charts that show what kind of trading happened that day are called
Intraday charts. The longer a line is, the higher is the difference between opening and closing
prices. This means higher volatility. You should be interested in knowing about volatility
because high volatility means high risk.

Candlestick charts: Candlestick charts give the same information as bar charts. They only
offer it in a better way. Like a bar chart is made up of different vertical lines, a candlestick
chart is made up of rectangular blocks with lines coming out of it on both sides. The line at
the upper end signifies the day’s highest trading price. The line at the lower end signifies the
day’s lowest trading price. The day’s trading can be shown in Intraday charts. As for the
block itself (called the body), the upper and the lower ends signify the day’s opening and
closing price. The one that is higher of the two is at the top, while the other one is at the
bottom of the body.
The candlestick charts give information about volatility throughout the period under
consideration. Bar charts only display volatility that occurs within each trading day. Candles
on a candlestick chart are of two shades-light and dark. On days when the opening price was
greater than the closing price, they are of a lighter shade (normally white). On days when the
closing price was higher than the opening price, they are of a darker shade (normally
black).A single day’s trading is represented by Intraday charts. Higher the variation in colour,
more volatile was the price during the period.
Point and figure charts: A point and figure chart bears no resemblance with the other three
kinds of charts discussed above. It was used extensively before the introduction of computers
to stock analysis. These days, however, it is used by a very limited number of people. This is
because it is complex to understand and provides limited information. A point and figure
chart essentially displays the volatility in a stock’s price over a chosen period of time. On the
vertical axis, it displays the number of times stock prices rose or fell to a particular extent. On
the horizontal axis, it marks time intervals. Markings on the chart are exclusively in the form
of X’s and O’s. X’s represent the number of times the stock rose by the specified limit, while
O’s represent the number of times it fell by it. The specified amount used is called box size. It
is directly related to the difference between markings on the y-axis.
Technical analysts believe that certain formations or patterns observed on the bar chart or line
chart have predictive value. The most important formations and their indications are given
below.
Market Indicators
There are two basic types of technical indicators:

Overlays: Technical indicators that use the same scale as prices are plotted over the top of
the prices on a stock chart. Examples include Moving Averages and Bollinger Bands.

Oscillators: Technical indicators that oscillate between a local minimum and maximum are
plotted above or below a price chart. Examples include the Stochastic
Oscillator, MACD (Moving Average Convergence Divergence)or RSI (Relative Strength
Index)

Moving averages

The moving average (MA) is a simple technical analysis tool that smooth’s out price data by
creating a constantly updated average price. The average is taken over a specific period of
time, like 10 days, 20 minutes, 30 weeks or any time period the trader chooses.

Bollinger Bands

Bollinger Bands are a technical analysis tool for trading stocks. The bands comprise a
volatility indicator that measures the relatively high or low of a security’s price in relation to
previous trades. Volatility is measured using standard deviation, which changes with
increases or decreases in volatility. The bands widen when there is a price increase, and
narrow when there is a price decrease. Due to their dynamic nature, Bollinger Bands can be
applied to the trading of various securities.
Bollinger Bands are comprised of three lines: upper, middle and lower band. The middle
band is a moving average, and its parameters are chosen by the trader. The upper and lower
bands are positioned on either side of the moving average band. The trader decides the
number of standard deviations they need the volatility indicator set at. The number of
standard deviations, in turn, determine the distance between the middle band and the upper
and lower bands. The position of these bands provides information on how strong the trend is
and the potential high and low price levels that may be expected in the immediate future.

Stochastic oscillator

It is a momentum indicator comparing a particular closing price of a security to a range of its

prices over a certain period of time. The sensitivity of the oscillator to market movements is
reducible by adjusting that time period or by taking a moving average of the result. It is used
to generate overbought and oversold trading signals.

%K = {(C – L14) / (H14 – L14)} x 100

%K – The current value of the Stochastic oscillator

C – The most recent closing price

L14 – The lowest price traded of the 14 previous trading sessions

H14 – The highest price traded during the same 14 day period
MACD (Moving Average Convergence Divergence)

It is a trend following momentum indicator that shows the relationship between two moving
averages of a security’s price.

MACD= (12 Period EMA – 26Period EMA)

Moving Average Convergence Divergence (MACD) is calculated by subtracting the 26-

period exponential moving average (EMA) from the 12-period EMA.

MACD triggers technical signals when it crosses above (to buy) or below (to sell) its signal
line.

The speed of crossovers is also taken as a signal of a market is overbought or oversold.

MACD helps investors understand whether the bullish or bearish movement in the price is
strengthening or weakening.

Exponential Moving Average (EMA)

It is a type of moving average (MA) that places a greater weight and significance on the most
recent data points. The exponential moving average is also referred to as the exponentially
weighted moving average.
Relative Strength Index (RSI)

The is a momentum indicator used in technical analysis that measures the magnitude of
recent price changes to evaluate overbought or oversold conditions in the price of a stock or
other asset. The RSI is displayed as an oscillator (a line graph that moves between two
extremes) and can have a reading from 0 to 100.

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a
security is becoming overbought or overvalued and may be primed for a trend reversal or
corrective pullback in price. An RSI reading of 30 or below indicates an oversold
or undervalued condition.

RSI = 100 – {100 / (1 + (Average gain / Average loss)}

Traders often use many different technical indicators when analyzing a security. With
thousands of different options, traders must choose the indicators that work best for them and
familiarize themselves with how they work. Traders may also combine technical indicators
with more subjective forms of technical analysis, such as looking at chart patterns, to come
up with trade ideas. Technical indicators can also be incorporated into automated trading
systems given their quantitative nature.

EFFICIENT MARKET THEORY

The efficient market hypothesis is a central idea of a modern finance that has
profoundimplications. An understanding of the efficient market hypothesis will help to ask
the rightquestions and save from a lot of confusion that dominates popular thinking in
finance. Anefficient market is one in which the market price of a security is an unbiased
estimate of itsintrinsic value. Note that market efficiency does not imply that the market price
equals intrinsicvalue at every point in time.
A corollary is that investors will also be less likely to discover great bargains and thereby
earnextraordinary high rates of return. The requirements for a securities market to be efficient
market are

Prices must be efficient so that new inventions and better products will cause a
firm’ssecurities prices to rise and motivate investors to supply capital to the firm (i.e., buy its
stock)

Information must be discussed freely and quickly across the nations so all investors can react
to new information

Transactions costs such as sales commissions on securities are ignored

Taxes are assumed to have no noticeable effect on investment policy

Every investor is allowed to borrow or lend at the same rate and finally,

Investors must be rational and able to recognize efficient assets and that they will want
toinvest money where it is needed most (i.e., in the assets with relatively high returns).

Forms of Efficient Market Hypothesis

Three levels of market efficiency.

Weak-form efficiency - Prices reflect all information found in the record of past and volumes

Semi-strong form efficiency - Prices reflect not only all information found in the record
ofpast prices and volumes but also all other publicly available information

Strongform efficiency - Prices reflect all available information, public as well as private.

Weak form of EMH

The week form of market holds that present stock market prices reflect all known information
with respect to past stock prices, trends, and volumes. This form of theory is just the opposite
ofthe technical analysis because according to it, the sequence of prices occurring historically
doesnot have any value for predicting the future stocks prices. The technical analysts rely
completelyon charts and past behavior of prices of stocks.

Three types of tests have been commonly employed to empirically verify the weak-form
efficientmarket hypothesis: Serial correlation tests,Run tests, and Filter rules tests.

Serial Correlation Test: Serial Correlation is said to measure the association of a series
ofnumbers which are separated by some constant time period. One way to test for
randomness instock price changes is to look at their serial correlations. Is the price change in
one periodcorrelated with the price change in some other period? If such auto-correlations are
negligible,the price changes are considered to be serially independent. Numerous serial
correlation studies,employing different stocks, different time-lags, and different time-periods,
have been conductedto detect serial correlations

Run Test: Ren Test was also made to find out its price changes were likely to befollowed by
further price changes of the same sign. Run Test ignored the absolute values ofnumbers in the
series and took into the research only the positive and negative signs. Given aseries of stock
price changes, each price (+) id it represents an increase or a minus (-) if itrepresents a
decrease.

A run occurs when there is no difference between the sign of twochanges. When the sign of
change differs, the run ends and a new run begin. To test a series ofprice changes for
independence, the number of runs in that series is compared to see whether it isstatistically
different from the number of runs in a purely random series of the same size. Manystudies
have been carried out, employing the runs test of independence. They did not detect
anysignificant relationship between the returns of security in one period and the returns in
priorperiods and made a conclusion that the security prices followed a random walk.

Filter Rules Test: The use of charts is essentially a technique for filtering out the
importantinformation from the unimportant. The price andvolume data are supposed to tell
the entire story we need to know to identify the important actionin stock prices. They applied
filter rules to see how well price changes pick up both trends andreverses which chartists
claim their charts do. If a stock moves up X per cent, buy it and hold itlong; if it then reverses
itself by the same percentage, sell it and take a short position in it.

Semi-Strong Form of Efficient Market Hypothesis

The semi strong form of the efficient market hypothesis concentrates on how rapidly and
efficientlymarket prices adjust to new publicly available information. In this state, the market
reflects eventhose forms of information which may be concerning the announcement of a
firm s most recentearnings forecast and adjustments which will have taken place in the prices
of security.

Theinvestor in the semi-strong form of the market will find it impossible to earn a return on
theportfolio which is based on the publicly available information in excess of the return
which maybe said to be commensurate with the portfolio risk.

Many empirical studies have been made onthe semi-strong form of the efficient market
hypothesis to study the reaction of security prices tovarious types of information around the
announcement time of the information.
Two studiescommonly employed to test semi-strong form efficient market are event study
and portfoliostudy.

Event Study examines the market reactions to and the excess market returns around a
specificinformation event like acquisition announcement or stock split. The key steps
involved in anevent study are

Identify the event to be studied and pinpoint the date on which the event was announced.

Collect returns data around the announcement date. In this context two issues have to
beresolved: What should be the period for calculating returns weekly, daily, or some
otherinterval? For how many periods should returns be calculated before and after the
announcementdate?

Calculate the excess returns, by period, around the announcement date for each firm in
thesample. The excess return is calculated by making adjustment for market performance and
risk.

Compute the average and the standard error of excess returns across all firms

Assess whether the excess returns around the announcement date are different from zero.
Todetermine whether the excess returns around the announcement date are different from
zero,estimate the T statistic for each day. The results of event studies are mixed. Most event
studiessupport the semi-strong from efficient market hypothesis. Several event studies,
however, havecast their shadow over the validity of the semi strong form efficient markets
theory.

Portfolio study: In a portfolio study, a portfolio of stocks having the observable

characteristic(low price earnings ratio or whatever) is created and tracked over time see
whether it earnssuperior risk-adjusted returns. Steps involved in a portfolio study are

Define the variable (characteristic) on which firms will be classified. The proposed
investmentstrategy spells out the relevant variable. The variable must be observable, but not
necessarilynumerical.

Classify firms into portfolios based upon the magnitude of the variable. Collect data on
thevariable for every firm in the defined universe at the beginning of the period and use
thatinformation for classifying firms into different portfolios.

Compute the returns for each portfolio on the returns for each firm in each portfolio for
thetesting period and calculate the return for each portfolio, assuming that the stocks included
in theportfolio are equally weighted.

Calculate the excess returns for each portfolio. The calculation of excess returns earned by a
portfolio calls for estimating the portfolio beta and determining the excess returns

Assess whether the average excess returns are different across the portfolios. Several
statisticaltests are available to test whether the average excess returns differ across these
portfolios. Someof these tests are parametric and some nonparametric. Many portfolio studies
suggest that it isnot possible to earn superior riskadjusted returns by trading on some
observable characteristics.However, several portfolio studies have documented inefficiencies
and anomalies.

Strong-Form of Efficient Market Hypothesis

The strong-form efficient market hypothesis holds that all available information, public
orprivate, is reflected in the stock prices. The strong form is concerned with whether or not
certainindividuals or groups of individuals possess inside information which can be used to
make aboveaverage profits. If the strong form of the efficient capital market hypothesis
holds, then and dayis as good as any other day to buy any stock. This the most extreme form
of the efficient markethypothesis. Most of the research work has indicated that the efficient
market hypothesis in thestrongest form does not hold good.
 Unit IV
Portfolio Analysis
Security analysis related to the analysis of individual securities within the framework of return
and risk. Whereas, Portfolio analysis makes an analysis of securities in the combined form.

The portfolio analysis considers the determination of future risk and return in holding various
blends of individual securities. Portfolio expected return is a weighted average of the expected
return of individual securities but portfolio variance can be something less than a weighted
average of security variances.

Returns
The expected return of a portfolio depends on the expected return of each of the security
contained in the portfolio. It also seems logical that the amounts invested in each security
should be important.

Risk
The probability of loss is the essence of risk. A useful measure of risk takes into account both
the probability of various possible bad outcomes and their associated magnitudes. Instead of
measuring the probability of a number of different possible outcomes, the measure of risk
should somehow estimate the extent to which the actual outcome is likely to diverge from the
expected. Two measures used for this purpose are the mean absolute deviation and the
standard deviation.

Portfolio selection

The objective of every rational investor is to maximize his returns and minimize the risk.
Diversification is the method adopted for reducing risk. It essentially results in the
construction of portfolios. The proper goal of portfolio construction would be to generate
a portfolio that provides the highest return and the lowest risk. Such a portfolio would be
known as the optimal portfolio. The process of finding the optimal portfolio is described as
portfolio selection. The conceptual framework and analytical tools for determining the
optimal portfolio in disciplined and objective manner have been provided by Harry
Markowitz in his pioneering work on portfolio analysis described in 1952 Journal of
Finance article and subsequent book in 1959. His method of portfolio selection has come
to be known as the Markowitz model. In fact, Markowitz‘s work marks the beginning of
what is known today as modern portfolio theory.

Feasible set of portfolios:

With a limited number of securities an investor can create a very large number of portfolios
by combining these securities in different proportions. These constitute the feasible set of
portfolios in which the investor can possibly invest. This is also known as the portfolio
opportunity set.

Each portfolio in the opportunity set is characterised by an expected return and a measure
of risk, viz., variance or standard deviation of returns. Not every portfolio in the portfolio
opportunity set is of interest to an investor. In the opportunity set some portfolios will
obviously be dominated by others. A portfolio will dominate another if it has either a lower
standard deviation and the same expected return as the other, or a higher expected return
and the same standard deviation as the other. Portfolios that are dominated by other
portfolios are known as inefficient portfolios. An investor would not be interested in all the
portfolios in the opportunity set. He would be interested only in the efficient portfolios.

Efficient set of portfolios:

Let us consider various combinations of securities and designate them as portfolios 1 to n.
The expected returns of these portfolios may be worked out. The risk of these portfolios
may be estimated by measuring the standard deviation of portfolio returns. The table below
shows illustrative figures for the expected returns and standard deviations of some
portfolios.

Portfolio no. Expected Return Standard deviation

(per cent) (risk)
1 5.6 4.5
2 7.8 5.8
3 9.2 7.6
4 10.5 8.1
5 11.7 8.1
6 12.4 9.3
7 13.5 9.5
8 13.5 11.3
9 15.7 12.7
10 16.8 12.9

If we compute portfolio nos. 4 and 5, for the same standard deviation of 8.1 portfolio no. 5
gives a higher expected return of 11.7, making it more efficient than portfolio no. 4. Again,
if we compare portfolio nos. 7 and 8, for the same expected return of 13.5 per cent, the
standard deviation is lower for portfolio no. 7, making it more efficient than portfolio no.
8. Thus, the selection of portfolio by the investor will be guided by two criteria:
1. Given two portfolios with the same expected return, the investor would prefer
the one with the lower risk.
2. Given two portfolios with the same risk, the investor would prefer the one with
the higher expected return.

These criteria are based on the assumption that investors are rational and also risk-averse.
As they are rational they would prefer more return to less return. As they are risk-averse,
they would prefer less risk to more risk.
The concept of efficient sets can be illustrated with the help of a graph. The expected return
and standard deviation of portfolios can be depicted on an XY graph, measuring the
expected return on the Y axis and the standard deviation on the X axis. Following figure
depicts such a graph.

As each possible portfolio in the opportunity set or feasible set of portfolios has an expected
return and standard deviation associated with it, each portfolio would be represented by a
single point in the risk-return space enclosed within the two axes of the graph. The shaded
area in the graph represents the set of all possible portfolios that can be constructed from a
given set of securities. This opportunity set of portfolios takes a concave shape because it
consists of portfolios containing securities that are less than perfectly correlated with each
other.

Diagram:
Consider portfolios F and E. Both the portfolios have the same expected return but portfolio
E has less risk. Hence, portfolio E would be preferred to portfolio F. Now consider
portfolios C and E. Both have the same risk, but portfolio E offers more return for the same
risk. Hence, portfolio E would be preferred to portfolio C. Thus, for any point of risk-return
space, an investor would like to move as far as possible in the direction of increasing returns
and also as far as possible in the direction of decreasing risk. Effectively, he would be
moving towards the left in search of decreasing risk and upwards in search of increasing
returns.
 Feasible set of portfolios
Let us consider portfolios C and A. Portfolio C would be preferred to portfolio A because
it offers less risk for the same level of return. In the opportunity set of portfolios represented
in the diagram, portfolio C has the lowest risk compared to all other portfolios. Here
portfolio C in this diagram represents the global minimum variance portfolio.

Comparing portfolios A and B, we find that portfolio B is preferable to portfolio A because

it offers higher return for the same level of risk. In this diagram, point B represents the
portfolio with the highest expected return among all the portfolios in the feasible set.

Thus, we find that portfolios lying in the north-west boundary of the shaded area are more
efficient than all the portfolios in the interior of the shaded area. This boundary of the
shaded area is called the efficient frontier because it contains all the efficient portfolios in
the opportunity set. The set of portfolios lying between the global minimum variance
portfolio and the maximum return portfolio on the efficient frontier represents the efficient
set of portfolios. The efficient frontier is shown separately in the following figure:

The efficient frontier

The efficient frontier is a concave curve in the risk-return space that extends from the
minimum variance portfolio to the maximum return portfolio.
Selection of optimal portfolio:
The portfolio selection problem is really the process of delineating the efficient portfolios
and then selecting the best portfolio from the set.
Rational investors will obviously prefer to invest in the efficient portfolios. The particular
portfolio that an individual investor will select from the efficient frontier will depend on
that investor‘s degree of aversion to risk. A highly risk averse investor will hold a portfolio
on the lower left hand segment of the efficient frontier, while an investor who is not too
risk averse will hold one on the upper portion of the efficient frontier.

The selection of the optimal portfolio thus depends on the investor‘s risk aversion, or
conversely on his risk tolerance. This can be graphically represented through a series of
risk return utility curves or indifference curves. The indifference curves of an investor are
shown in the figure below. Each curve represents different combinations of risk and return
all of which are equally satisfactory to the concerned investor. The investor is indifferent
between the successive points in the curve. Each successive curve moving upwards to the
left represents a higher level of satisfaction or utility. The investor‘s goal would be to
maximise his utility by moving upto the higher utility curve. The optimal portfolio for an
investor would be the one at the point of tangency between the efficient frontier and the
risk-return utility or indifference curve.
This is shown in the following figure. The point O‘ represents the optimal portfolio.

Optimal portfolio

Markowitz used the technique of quadratic programming to identify the efficient portfolios.
Using the expected return and risk of each security under consideration and the covariance
estimates for each pair of securities, he calculated risk and return for all possible portfolios.
Then, for any specific value of expected portfolio return, he determined the least risk
portfolio using quadratic programming. With another value of expected portfolio return, a
similar procedure again gives the minimum risk portfolio. The process is repeated with
different values of expected return, the resulting minimum risk portfolios constitute the set
of efficient portfolios.

Limitations of Markowitz model:

1. Large number of input data required for calculations: An investor must
obtain estimates of return and variance of returns for all securities as also
covariances of returns for each pair of securities included in the portfolio. If
there are N securities in the portfolio, he would need N return estimates, N
variance estimates and N (N-1) / 2 covariance estimates, resulting in a total of
2N + [N (N-1) / 2] estimates. For example, analysing a set of 200 securities
would require 200 return estimates, 200 variance estimates and
 19,900 covariance estimates, adding upto a total of 20,300 estimates. For a set
of 500 securities, the estimates would be 1,25,750. Thus, the number of
estimates required becomes large because covariances between each pair of
securities have to be estimated.

2. Complexity of computations required: The computations required are

numerous and complex in nature. With a given set of securities infinite number
of portfolios can be constructed. The expected returns and variances of returns
for each possible portfolio have to be computed. The identification of efficient
portfolios requires the use of quadratic programming which is a complex
procedure.

Because of the difficulties associated with the Markowitz model, it has found little use in
practical applications of portfolio analysis. Much simplification is needed before the theory
can be used for practical applications. Simplification is needed in the amount and type of
input data required to perform portfolio analysis; simplification is also needed in the
computational procedure used to select optimal portfolios.

The simplification is achieved through index models. There are essentially two types of
index models:
Single index model
Multi-index model

The single index model is the simplest and the most widely used simplification and may
be regarded as being at one extreme point of a continuum, with the Markowitz model at
the other extreme point.

Multi-index models may be placed at the mid region of this continuum of portfolio analysis
techniques.

Single index model:

The basic notion underlying the single index model is that all stocks are affected by
movements in the stock market. Casual observation of share prices
reveals that when the market moves up, prices of most shares tend to increase. When the
market goes down, the prices of most shares tend to decline. This suggests that one reason
why security returns might be correlated and there is co-movement between securities, is
because of a common response to market changes. This co- movement of stocks with a
market index may be studied with the help of a simple linear regression analysis, taking the
returns on an individual security as the dependent variable (R i) and the returns on the
market index (Rm) as the independent variable.

The return of an individual security is assumed to depend on the return on the market index.
The return of an individual security may be expressed as:

Where
= Component of security i‘s return that is independent of the market‘s
performance.
= Rate of return on the market index.
= Constant that measures the expected change in given a change in .

= Error term representing the random or residual return.

This equation breaks the return on a stock into two components, one part due to the market
and the other part independent of the market. The beta parameter in the equation, ,
measures how sensitive a stock‘s return is to the return on the market index. It indicates
how extensively the return of a security will vary with changes in the market return.

The alpha parameter indicates what the return of the security would be when the market
return is zero. The positive alpha represents a sort of bonus return and would be a highly
desirable aspect of a security, whereas a negative alpha represents a penalty to the investor
and is an undesirable aspect of a security.

The final term in the equation, , is the unexpected return resulting from
influences not identified by the model. It is referred to as the random or residual return.
It may take on any value, but over a large number of observations it will average out
to zero.
William Sharpe, who tried to simplify the data inputs and data tabulation required for the
Markowitz model of portfolio analysis, suggested that a satisfactory simplification would
be achieved by abandoning the covariance of each security with each other security and
substituting in its place the relationship of each security with a market index as measured
by the single index model. This is known as Sharpe index model.

In the place of [N (N – 1) / 2] covariances required for the Markowitz model, Sharpe model
would requires only N measures of beta coefficients.

Measuring security return and risk under Single Index Model:

Using the single index model, expected return of an individual security may be expressed
as:

The return of the security is a combination of two components:

(a) A specific return component represented by the alpha of the security; and
(b) A market related return component represented by the term .

The residual return disappears from the expression because its average value is zero, i.e. it
has an expected value of zero.

Correspondingly, the risk of a security becomes the sum of a market related

component and a component that is specific to the security. Thus,
Total risk = Market related risk + Specific risk

Where
= Variance of individual security.
= Variance of market index returns.
= Variance of residual returns of individual security.
= Beta coefficient of individual security.
The market related component of risk is referred to as systematic risk as it affects all
securities. The specific risk component is the unique risk or unsystematic risk which can
be reduced through diversification. It is also called diversifiable risk.

The estimates of , , and of a security are often obtained from

regression analysis of historical data of returns of the security as well as returns of a
market index. For any given or expected value of Rm, the expected return and risk of
the security can be calculated. For example, if the estimated values of , , and
of a security are 2 per cent, 1.5 and 300 respectively and if the market index is expected
to provide a return of 20 per cent, with variance of 120, the expected return and risk
of the security can be calculated as shown below:

Measuring Portfolio Return and Risk under Single Index Model:

Portfolio analysis and selection require as inputs the expected portfolio return and risk for
all possible portfolios that can be constructed with a given set of securities. The return and
risk of portfolios can be calculated using the single index model.

The expected return of a portfolio may be taken as portfolio alpha plus portfolio beta times
expected market return. Thus,

The portfolio alpha is the weighted average of the specific returns (alphas) of the individual
securities. Thus,

Where
= Proportion of investment in an individual security.
= Specific return of an individual security.
The portfolio beta is the weighted average of the Beta coefficients of the individual
securities. Thus,

Where
= Proportion of investment in an individual security.
= Beta coefficient of an individual security.

The expected return of the portfolio is the sum of the weighted average of the specific
returns and the weighted average of the market related returns of individual securities.

The risk of a portfolio is measured as the variance of the portfolio returns. The risk of a
portfolio is simply a weighted average of the market related risks of individual securities
plus a weighted average of the specific risks of individual securities in the portfolio. The
portfolio risk may be expressed as:

The first term constitutes the variance of the market index multiplied by the square of
portfolio beta and represents the market related risk (or systematic risk) of the portfolio.
The second term is the weighted average of the variances of residual returns of individual
securities and represents the specific risk or unsystematic risk of the portfolio.

As more and more securities are added to the portfolio, the unsystematic risk
of the portfolio becomes smaller and is negligible for a moderately sized portfolio.
Thus, for a large portfolio, the residual risk or unsystematic risk approaches zero and
the portfolio risk becomes equal to . Hence, the effective measure of portfolio
risk is
Let us consider a hypothetical portfolio of four securities. The table below shows the basic
input data such as weightage, alphas, betas and residual variances of the individual
securities required for calculating portfolio return and variance.

Input Data
Security Weightage Alpha Beta Residual variance
( ) ( ) ( )
A 0.2 2.0 1.7 370
B 0.1 3.5 0.5 240
C 0.4 1.5 0.7 410
D 0.3 0.75 1.3 285
Portfolio value 1.0 1.575 1.06 108.45

The values of portfolio alpha, portfolio beta, and portfolio residual variance can be
calculated as the

Portfolio residual variance

= 108.45

These values are noted in the last row of the table. Using these values, we can calculate the
expected portfolio return for any value of projected market return. For a market return of
15 per cent, the expected portfolio return would be:
 (15)

For calculating the portfolio variance we need the variance of the market returns. Assuming
a market return variance of 320, the portfolio variance can be calculated as:

The single index model provides a simplified method of representing the covariance
relationships among the securities. This simplification has resulted in a substantial
reduction in inputs required for portfolio analysis. In the single index model only three
estimates are needed for each security in the portfolio, namely specific return , measure
of systematic risk and variance of the residual return . In addition to these, two
estimates of the market index, namely the market return and the variance of the market
return are also needed. Thus, for N securities, the number of estimates required would
be 3N+2. For example, for a portfolio of 100 securities, the estimates required would be
302. In contrast to this, for the Markowitz model, a portfolio with 100 securities would
require 5150 estimates of input data (i.e. 2N + [N(N-1) / 2] estimates).

Using the expected portfolio returns and portfolio variances calculated with the single
index model, the set of efficient portfolios is generated by means of the same quadratic
programming routine as used in the Markowitz model.

Multi-Index Model:
The single index model is in fact an oversimplification. It assumes that stocks move
together only because of a common co-movement with the market. Many researchers have
found that there are influences other than the market that cause stocks to move together.
Multi-index models attempt to identify and incorporate these non-market or extra-market
factors that cause securities to move
together also into the model. These extra-market factors are a set of economic factors
that account for common movement in stock prices beyond that accounted for by the
market index itself. Fundamental economic variables such as inflation, real economic
growth, interest rates, exchange rates etc. would have a significant impact in
determining security returns and hence, their co-movement.

A multi-index model augments the single index model by incorporating these

extra market factors as additional independent variables. For example, a multi-index
model incorporating the market effect and three extra-market effects takes the following
form:

The model says that the return of an individual security is a function of four
factors – the general market factor and three extra-market factors .
The beta coefficients attached to the four factors have the same meaning as in the single
index model. They measure the sensitivity of the stock return to these factors. The alpha
parameter and the residual term also have the same meaning as in the single index
model.

Calculation of return and risk of individual securities as well as portfolio return

and variance follows the same pattern as in the single index model. These values can
then be used as inputs for portfolio analysis and selection.

A multi-index model is an alternative to the single index model. However, it is

more complex and requires more data estimates for its application. Both the single
index model and the multi-index model have helped to make portfolio analysis more
practical.