Two approaches of portfolio PORTFOLIO MANAGEMENT Portfolio 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.

Traditional approach Determining the objective of the portfolio. Selection of securities to be included in the portfolio.

Analysis of constraints TRADITIONAL APPROACH Determination of objectives Selection of portfolio Common stock Bond and common stock Bond Assessment of risk and return analysis 1. Selection of industries 2. Selection of companies in the industry 3. Determining the size of participation Diversification Portfolio Revision Performance evaluation

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 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

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

7. Performance evaluation 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. T

PORTFOLIO MANAGEMENT

What is 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.

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.

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.

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: Security Analysis. Portfolio Analysis. Portfolio Selection. Portfolio revision. Portfolio evaluation. Each phase is essential and the success of each phase is depend on the efficiency in carrying out each phase.

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.

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.

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.

Portfolio Revision Due to dynamic changes in the economy and financial markets, the attractive securities may cease to provide profitable returns.

Portfolio Evaluation This phase involves the regular analysis and assessment of portfolio performances in terms of risk and returns over a period of time.

Conclusion SECURITY ANALYSIS: Classification of securities( shares, debentures, bonds etc..), examining the risk-return characteristics of individual securities, fundamental and technical analysis. PORTFOLIO ANALYSIS: Identification of range of possible portfolio from a different set and ascertaining risk and return. PORTFOLIO SELECTION: Efficient portfolio is identified and optimal portfolio is selected. PORTFOLIO REVISION: Addition or deletion of securities due to change in availability of additional funds, change in risk, need for cash etc. PORTFOLIO EVALUATION : Comparison of objective norms with relative performance. Provides feedback mechanism for improving the entire portfolio management process.

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.

Mean return i.e. expected return 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.

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.

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

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

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.

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

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.

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. Portfolio average return – Risk free rate of interest Sharpe Index = --------------------------------------------------------------- Standard deviation of the portfolio return

R p - R f S t = ------------- σ p

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.

R p - R f T n = ------------------------- Β p   Portfolio average return – riskless rate of interest T n = --------------------------------------------------------------------------------------------- Beta co-efficient of portfolio

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