Unit 5 - Portfolio Management TECHNICAL ANALYSIS Course Materials by K.Rajeswari Asst Professor SNS college of technology Unit 5 - Portfolio Management Portfolio Selection

Portfolio Selection The process of personal portfolio selection The trade-off between expected return and risk Efficient diversification with many risky assets 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Concept of Portfolio A person’s wealth portfolio includes Assets: stocks, bonds, shares in unincorporated business, houses or apartments, pensions benefits, insurance policies, etc. Liabilities: student loans, auto loans, home mortgages, etc. 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Portfolio Selection A study of how people should invest their wealth optimally A process of trading off risk and expected return to find the best portfolio of assets and liabilities Narrow and broad definitions: How much to invest in stocks, bonds, and other securities Whether to buy or rent one’s house What types and amounts of insurance to purchase How to manage one’s liabilities How much to invest in one’s human capital 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Cont… Although there are some general rules for portfolio selection that apply to virtually everyone, there is no single portfolio or portfolio strategy that is best for everyone. 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

The Life Cycle In portfolio selection, the best strategy depends on an individual’s personal circumstances (family status, occupation, income, wealth). Illustrations Young couple: buy a house and take out a mortgage loan / older couple: sell house and invest in assets providing a steady stream of income. Buying insurance policies: Miriam (a parent with dependent children) / Sanjiv (a single person with no dependents). 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Time Horizon In formulating a plan for portfolio selection, you begin by determining your goals and time horizons. Planning horizon: the total length of time for which one plans Decision horizon: the length of time between decisions to revise the portfolio Trading horizon: the minimum time interval over which investors can revise their portfolios / its determination and impacts Investment strategy & trading horizon: portfolio insurance or dynamic portfolio strategy. 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Risk Tolerance A major determinant of portfolio choices It is influenced by such characteristics as age, family status, job status, wealth, and other attributes that affect a person’s ability to maintain his standard of living in the face of adverse movements in the market value of his investment portfolio 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

The Trade-off between Expected Return and Risk The objective is to find the portfolio which offers investors the highest expected rate of return for the degree of risk they are willing to tolerate. Two step process: find the optimal combination of risky assets. mix this optimal risk-asset with the riskless asset. 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Riskless Asset A security that offers a perfectly predictable rate of return in terms of the unit of account selected for the analysis and the length of the investor’s decision horizon. For example, if the U.S dollars is taken as the unit of account and the decision horizon is half a year, the riskless rate is the interest rate on U.S Treasury bills maturing after half a year. 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Rates of Return on Risky Assets Required return depends on the risk of the investment. Greater the risk, greater the return Risk premium 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

minimum-variance portfolio Portfolio of many risky assets Efficient frontier: the set of portfolios offering the highest expected return for any given standard deviation. Standard Deviation (%) Expected Return (%) efficient frontier minimum-variance portfolio 10

Combining the Riskless Asset and a Single Risky Asset: An illustration Let’s suppose that you have $100,000 to invest. You are choosing between a riskless asset with a interest of 6% per year and a risky asset with an expected rate of return of 14% per year and a standard deviation of 20%. How much of your $100,000 should you invest in the risky asset? 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Mean and Standard Deviation 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

The Risk-Return Trade-off Line 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.05 0.15 0.2 0.25 0.3 Standard Deviation Expected Return S J H F G R inefficient

Selecting the Preferred Portfolio It is important to note that in finding the optimal combination of risky assets, we do not need to know anything about investor preferences. There is always a particular optimal portfolio of risky assets that all risk-averse investors who share the same forecasts of rates of return will combine with the riskless asset to reach their most-preferred portfolio.

The Rationale for Portfolio Selection Return Risk Low Risk High Return High Risk Low Return

Portfolio of many risky assets and the riskless asset Standard Deviation (%) Expected Return (%) Short sell rf Efficient frontier Tangent Portfolio 10

Two-Fund Separation Theorem (Tobin, 1958) Efficient Frontier The jelly fish shape contains all possible combinations of risk and return: The feasible set. The red line constitutes the efficient frontier of portfolios of risky assets: Highest return for given risk. The tangent portfolio T is the optimal portfolio of risky assets that all risk-averse investors will combine with the riskless asset. Standard Deviation Expected Return T Two-Fund Separation Theorem (Tobin, 1958)

Thanks… 6/24/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management