1. Portfolio Management Unit – 1 Session No.4 Topic: Investment Objectives Unit – 1 Session No.4 Topic: Investment Objectives

2. Session Plan Recap the Previous Session Investment Objectives ═ What is Portfolio Risk? ═ How to Measure risk? ═ What is the investor’s willingness to take risk? ═ What is a Specific risk objective(s)?

3. What is Portfolio Selection & Optimization? What is Explicit and Implicit Costs? What is monitoring in Portfolio management Process? How to rebalance? What are the three components used in assessment of portfolio management? Why investment decisions are important in selection of portfolio? Recap

4. Investment Objectives The two objectives in this framework, – Risk and Return The risk objective limits how high the investor can set the return objective.

5. What is Portfolio Risk? Risk is the uncertainty that an investment will earn its expected rate of return. Chance that combination of assets or units within individual group of investments fail to meet financial objectives. In theory, portfolio risk can be eliminated by successful diversification.

6. What is Risk Objective? It will largely determine the return objective In formulating a risk objective, the investor must address the following six questions: – 1. How do I measure risk? – 2. What is the investor’s willingness to take risk? – 3. What is the investor’s ability to take risk? – 4. How much risk is the investor both willing and able to bear? – 5. What are the specific risk objective(s)? – 6. How should the investor allocate risk?

7. What is Risk Objective? 1. How do I measure risk? Risk measurement is a key issue in investments, and several approaches exist for measuring risk. – Examples of absolute risk objectives are a specified level of standard deviation or variance of total return. The variance of a random variable is the expected value of squared deviations from the random variable’s mean. Variance is often referred to as volatility (unpredictability). Standard deviation is the positive square root of variance. – An example of a relative risk objective is a specified level of tracking risk. Tracking risk is the standard deviation of the differences between a portfolio’s and the benchmark’s total returns.

8. What is Risk Objective? Variance The larger the variance for an expected rate of return, the greater the dispersion of expected returns and the greater the uncertainty, or risk, of the investment. Standard Deviation The standard deviation is the square root of the variance:

9. What is Risk Objective? Probability (Pi)Return (Ri)Expected Return 0.255%15% 0.5015% 0.2525%15% Compute Variance and Standard deviation.

10. What is Risk Objective? Value at Risk (VaR): – Downside risk concept and important to investor – A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. – Value at risk is used by risk managers in order to measure and control the level of risk which the firm undertakes. Example: For example, a financial firm may determine that it has a 5% one month value at risk of $100 million. This means that there is a 5% chance that the firm could lose more than $100 million in any given month.

11. What is Risk Objective? What is the investor’s willingness to take risk? Willingness different for institutional versus individual investors. Managers should try to understand the behavioral and, for individuals, the personality factors behind an investor’s willingness to take risk. Individual investors willingness to take risk is determined by his financial goals. Institutional investors ability is based on its business goals.

12. What is Risk Objective? What is the investor’s ability to take risk? Even if an investor is eager to bear risk, – Practical or financial limitations often limit the amount of risk Risk in terms of the volatility(unpredictability) of asset values – short-term loss scenarios can take more risk. – long-term wealth targets or obligations can take more risk. – An institution may face legally promised future payments to beneficiaries (liabilities) and an individual may face future retirement spending needs The ability to increase the savings/ contribution level if the portfolio can increase the ability.

13. What is Risk Objective? How much risk is the investor both willing and able to bear? Risk tolerance, the capacity to accept risk, is a function of both an investor’s willingness and ability to do so. Risk tolerance can also be described in terms of risk aversion, the degree of an investor’s inability and unwillingness to take risk. The investor’s specific risk objectives are formulated with that investor’s level of risk tolerance in mind

14. What is Risk Objective? What are the specific risk objective(s)? – Absolute risk or Relative risk objectives – Relative risk is the number that tells you how much something you do – Absolute risk is the size of your own risk Investors often find that quantitative risk objectives are easier to specify in relative than in absolute terms.

15. What is Risk Objective? How should the investor allocate risk? – This is how some investors frame capital allocation decisions – Active strategies will play a role in the portfolio decisions The investor has determined the measure of risk (e.g., VaR or tracking risk) and the desired total quantity of risk (the overall risk budget) initially An investor using risk budgeting would allocate the overall risk budget to specific investments for allocation It maximize expected overall risk-adjusted return. It resulting optimal risk budgets for the investments would translate to specific allocations of capital to the investors.

16. Summarizing How to reduce portfolio risk? What is VaR? What is Absolute Risk and Relative Risk? Give example. Why risk budgeting is required?

17. Assignment Probability (Pi)Return (Ri)Expected Return 0.204%4%12% 0.4516%12% 0.2023%12% Compute Variance and Standard deviation. Give your comment about the three scenarios