Investment Planning and review

Overview

Suppose you find a great investment opportunity, but you lack the cash to take advantage of it. This is the classic problem of financing. The short answer is that you borrow -- either privately from a bank, or publicly by issuing securities. Securities are nothing more than promises of future payment. They are initially issued through financial intermediaries such as investment banks, which underwrite the offering and work to sell the securities to the public. Once they are sold, securities can often be re-sold. There is a secondary market for many corporate securities. If they meet certain regulatory requirements, they may be traded through brokers on the stock exchanges, such as the NYSE, the AMEX and NASDAQ, or on options exchanges and bond trading desks.

Securities come in a bewildering variety of forms - there are more types of securities than there are breeds of cats and dogs, for instance. They range from relatively straightforward to incredibly complex. A straight bond promises to repay a loan over a fixed amount of interest over time and the principal at maturity. A share of stock, on the other hand, represents a fraction of ownership in a corporation, and a claim to future dividends. Today, much of the innovation in finance is in the development of sophisticated securities: structured notes, reverse floaters, IO's and PO's -- these are today's specialized breeds. Sources of information about securities are numerous on the world-wide web. For a start, begin with the Ohio State Financial Data Finder. All securities, from the simplest to the most complex, share some basic similarities that allow us to evaluate their usefulness from the investor's perspective. All of them are economic claims against future benefits. No one borrows money that they intend to repay immediately; the dimension of time is always present in financial instruments. Thus, a bond represents claims to a future stream of pre-specified coupon payments, while a stock represents claims to uncertain future dividends and division of the corporate assets. In addition, all financial securities can be characterized by two important features: risk and return. These two key measures will be the focus of this second module.

I. Finance from the Investor's Perspective

Most financial decisions you have addressed up to this point in the term have been from the perspective of the firm. Should the company undertake the construction of a new processing plant? Is it more profitable to replace an old boiler now, or wait? In this module, we will examine financial decisions from the perspective of the purchaser of corporate securities: shareholders and bondholders who are free to buy or sell financial assets. Investors, whether they are individuals or institutions such as pension funds, mutual funds, or college endowments, hold portfolios, that is, they hold a collection of different securities. Much of the innovation in investment research over the past 40 years has been the development of a theory of portfolio management, and this module is principally an introduction to these new methods. It will answer the basic question, What rate of return

will investors demand to hold a risky security in their portfolio? To answer this question, we first must consider what investors want, how we define return, and what we mean by risk.

II. Why Investors Invest

What motivates a person or an organization to buy securities, rather than spending their money immediately? The most common answer is savings -- the desire to pass money from the present into the future. People and organizations anticipate future cash needs, and expect that their earnings in the future will not meet those needs. Another motivation is the desire to increase wealth, i.e. make money grow. Sometimes, the desire to become wealthy in the future can make you willing to take big risks. The purchase of a lottery ticket, for instance only increases the probability of becoming very wealthy, but sometimes a small chance at a big payoff, even if it costs a dollar or two, is better than none at all. There are other motives for investment, of course. Charity, for instance. You may be willing to invest to make something happen that might not, otherwise -- you could invest to build a museum, to finance low-income housing, or to re-claim urban neighborhoods. The dividends from these kinds of investments may not be economic, and thus they are difficult to compare and evaluate. For most investors, charitable goals aside, the key measure of benefit derived from a security is the rate of return.

III. Definition of Rates of Return

The investor return is a measure of the growth in wealth resulting from that investment. This growth measure is expressed in percentage terms to make it comparable across large and small investors. We often express the percent return over a specific time interval, say, one year. For instance, the purchase of a share of stock at time t, represented as Pt will yield P t+1 in one year's time, assuming no dividends are paid. This return is calculated as: R t = [ Pt+1 - Pt]/ Pt. Notice that this is algebraically the same as: Rt= [P t+1/ Pt]-1. When dividends are paid, we adjust the calculation to include the intermediate dividend payment: Rt=[ P t+1 - Pt+Dt]/ Pt. While this takes care of all the explicit payments, there are other benefits that may derive from holding a stock, including the right to vote on corporate governance, tax treatment, rights offerings, and many other things. These are typically reflected in the price fluctuation of the shares.

IV. Arithmetic vs. Geometric Rates of Return

There are two commonly quoted measures of average return: the geometric and the arithmetic mean. These rarely agree with each other. Consider a two period example: P0 = $100, R1 = -50% and R2 = +100%. In this case, the arithmetic average is calculated as (100-50)/2 = 25%, while the geometric average is calculated as: [(1+R1)(1+R2)]1/2-1=0%. Well, did you make money over the two periods, or not? No, you didn't, so the geometric average is closer to investment experience. On the other hand, suppose R1 and R2 were statistically representative of future returns. Then next year, you have a 50% shot at getting $200 or a

50% shot at $50. Your expected one year return is (1/2)[(200/100)-1] + (1/2)[(50/100)-1] = 25%. Since most investors have a multiple year horizon, the geometric return is useful for evaluating how much their investment will grow over the long-term. However, in many statistical models, the arithmetic rate of return is employed. For mathematical tractability, we assume a single period investor horizon.

Chapter II: Preferences and Investor Choice

The last chapter presented the Markowitz model of portfolio selection, but with one key element missing -- individual portfolio choice. The efficient frontier dominates all combinations of assets, however it still has infinitely many assets. How do you pick one portfolio out of all the rest as the perfect one for you? This turns out to be a big challenge, because it requires investors to express their preferences in risk-return space. Investors choose portfolios for a myriad of reasons, very few of which can be reduced to a two-dimensional space. In fact, investors are used to having the ability the CHANGE their investment decision if it is not developing as planned. The simple Markowitz model does not allow this freedom. It is a single period model, now used widely in practice for decision-making in a multi-period world. In this chapter, we will address some of the ways that one may approximate investor preferences in mean-variance space, however these methods are only approximations.

I. Choosing A Single Portfolio

How might you choose a single portfolio among all of those on the efficient frontier? One approach is to model investor preferences mathematically, using iso-utility curves. These curves express the risk-return trade-off for investors in two-dimensional space. They work exactly like lines on a topological map. They are nested lines that show the highest and lowest altitudes in the region -- except they measure altitude in units of utility (whatever that is!) instead of feet or meters. Typically, a convenient mathematical function is chosen as the basis for iso-utility curves. For instance, one could use a logarithmic function, or even part of a quadratic function to capture the essence of investor preferences. The essential feature of the function is that it must allow people to demand ever-increasing levels of return for assuming more risk.

Although the mathematics of utility functions is beyond the scope of this course, if you are interested in further investigation, I recommend visiting Campbell Harvey's Pages on Optimal Portfolios.

One way to characterize differences in investor risk aversion is by the curvature of the iso-utility lines. Below are representative curves for four different types of investors: A more risk-averse, a moderately risk-averse, a less risk-averse, and a risk-loving investor. The whole set of nested curves is omitted to keep the picture simple.

Notice that the risk-lover demands lower expected return as risk increases in order to maintain the same utility level. On the other hand, for the more risk-averse investor, as volatility increase, he or she will demand sharply higher expected returns to hold the portfolio. These different curves will result in different portfolio choices for investors. The optimization procedure simply takes the efficient frontier and finds its point of tangency with the highest iso-utility curve in the investor set. In other words, it identifies the single point that provides the investor with the highest level of utility. For risk-averse individuals, this point is unique.

The problem with applying this methodology to identifying optimal portfolios is that it is difficult to figure out the risk-aversion of individuals or institutions. Just like mapping an unknown terrain, the asset allocator must try to map the clients preference structure -- never knowing whether it is even consistent from one day to the next!

II. Another Approach: Preferences about Distributions

The Markowitz model is an elegant way to describe differences in distributions of returns among portfolios. One approach to the portfolio selection problem is to choose investment policies based upon the probability mass in the lower left-hand tail. This is called the short-fall criterion. It's simplicity has great appeal. It does not require a complete topological mapping of investor preferences. Instead it only requires the investor to specify a floor return, below which he or she wants to avoid falling. The short-fall approach chooses a portfolio on the efficient frontier that minimizes the probability of the return dropping below that floor. Suppose, for instance, your specify a floor return level equal to the riskless rate, Rf. For every portfolio on the frontier, you calculate the ratio:

Notice that the shortfall criterion is like a t-statistic, where the higher the value, the greater the probability. The portfolio that has the highest probability of exceeding R f is the one for which this value is maximized. In fact, the similarity to a t-statistic extends even further, as we will see.

Another useful thing is that it turns out that it is quite simple to find the portfolio that maximizes the probability of exceeding the floor. You can do it graphically!

Identify the floor return level on the Y axis. Then find the point of tangency to the efficient frontier. In the figure, for instance, the tangency point minimizes the probability of having a return that drops below R floor. One particular floor value is of interest -- that is the floor given by the riskless rate, Rf. The slope of the short-fall line when Rf is the floor is called the Sharpe Ratio. The portfolio with the maximum Sharpe Ratio is the one portfolio in the economy that minimizes the probability of dropping below treasury bills. By the same token, it is the one portfolio in the economy that has the maximum probability of providing an equity premium! That is, if you must bet on one portfolio to beat t-bills in the future, the tangency portfolio found via the Sharpe Ratio would be it.

The "safety-first" approach is a versatile one. In the above example, we maximized probability of exceeding a floor by maximizing the slope, identifying a point of tangency. You can also find portfolios by other methods. For instance, you can check the feasibility of a desired floor and probability of exceeding that floor by fixing the Y intercept and fixing the slope. Either the ray will pass through the feasible set, or it will not. If it does not, then there is no portfolio that meets the criteria you specified. If it does, then there are a number of such portfolios, and typically the one with the highest expected return is the one to choose.

Another approach is to find a floor that meets your probability needs. In other words, you

ask "Which floor return may I specify that will give me a 90% confidence level that I will exceed it?" This is equivalent to setting the slope equal to the t-statistic value matching that probability level. Since this is equivalent to a one-tailed test, you would set the slope to 1.28 (i.e. the quantile of the normal distribution that gives you 90% to the left, or 10% in the right side of the distribution. For a 95% chance, you would choose a slope of 1.644. For a 99% chance you would choose a slope of 2.32.

Once you choose the slope, then move the line vertically until it becomes a tangent. This will give you both a floor and a portfolio choice.

III. A Note on Value at Risk

The safety first approach can be used to calculate the value-at-risk of the portfolio. Value-at-risk is an increasingly popular measure of the potential for loss over a given time horizon. It is applied in the banking industry to calculate capital requirements, and it is applied in the investment industry as a risk control for portfolios of securities.

Consider the problem of estimating how big a loss your portfolio could experience over the next month. If the distribution of portfolio returns is normal, then a three standard deviation drop is possible, but not very likely. Typically, the estimate of the maximum expected loss is defined for a given time horizon and a given confidence interval. Consider the type of loss that occurs once in twenty months. If you know the mean and standard deviation of the portfolio, and you specify the confidence interval as a 5% event (1 in twenty months) or a 1% event (1 in a hundred months) it is straightforward to calculate the "Value at Risk."

Let Rp be the portfolio return and STDp be the portfolio standard deviation. Let T be the t-statistic associated with the confidence interval. T of 1.64 corresponds to a one in 20 month event. Let Rvar be the unknown negative return portfolio return that we expect to occur one in twenty times.

The equation for the line is: Rp = Rvar + T*STDp and thus, Rvar = Rp - T*STDp. Rvar multiplied times the value of the assets in the portfolio is the Value at Risk.

Suppose you are considering the VAR of a $100 million pension portfolio over the monthly horizon. It is composed of 60% stocks and 40% bonds, and you are interested in the 95% confidence interval.

Let us assume that the monthly expected stock return is 1% and the expected bond return is .7%, and their standard deviations are 5% and 3% respectively. Assume that the correlation between the two asset classes is .5. First we calculate the mean and standard deviation of the portfolio:

Rp = (.6)*(.01) + (.4)(.007) = .0088

STDp = sqrt[ .6^2*.05^2 + .4^2*.03^2 + 2*.5*.6*.4*.05*.03] = .038

Then, Rvar = .0088 - 1.64*.038 = -.054

Thus, the monthly value-at-risk of the portfolio is ($100 million)(.054) = $5.4 million.

Note that, despite the terminology, this does not really mean that $94.6 is not at risk. The analysis only means that you expect a loss at least as large as $5.4 million one month out of 20.

This approach to calculating value-at-risk depends on key assumptions. First, returns must be close to normally distributed. This condition is often violated when derivatives are in the portfolio. Second, historically estimated return distributions and correlations must be

representative of future return distributions and correlations. Estimation error can be a big problem when you have statistics on a large number of separate asset classes to consider. Third, returns are not assumed to be auto-correlated. When there are positive trends in the data, losses should be expected to mount up from month to month.

In summary, value at risk is becoming pervasive in the financial industry as a summary measure of risk. While it has certain drawbacks, its major advantage is that it is a probability-based approach that can be viewed as a simple extension of safety-first portfolio selection models.

IV. Epilogue

Notice that the introduction of a genuine risk-free security simplifies the portfolio problem for all investors in the world. Their optimal choice is reduced to the problem of choosing proportions of the riskless asset and the risky portfolio T (tangency). MRA (More Risk Averse) investors will hold a mix of tangency portfolio and T-bills, LRA (Less Risk Averse) investors will borrow at the riskless rate and invest the proceeds in the tangency portfolio.

If we could only figure out what the tangency portfolio is composed of, we could solve everyone's investment decision with the same product! What do you think T is composed of? The answer is in the next chapter.

For more information about the utility approach to risk, see the excellent write-up by Campbell Harvey on Optimal Portfolios.. For a comprehensive hyper-text book on investment decision-making, see William Sharpe's Macro-Investment Analysis

Chapter IV: The Portfolio Approach to Risk

I. The Quest For the Tangency Portfolio

In the 1960's financial researchers working with Harry Markowitz's mean-variance model of portfolio construction made a remarkable discovery that would change investment theory and practice in the United States and the world. The discovery was based upon an idealized model of the markets, in which all the world's risky assets were included in the investor opportunity set and one riskless asset existed, allowing both more and less risk averse investors to find their optimal portfolio along the tangency ray.

Assuming that investors could borrow and lend at the riskless rate, this simple diagram

suggested that everyone in the world would want to hold precisely the same portfolio of risky assets! That portfolio, identified at the point of tangency, represents some portfolio mix of the world's assets. Identify it, and the world will beat a path to your door. The tangency portfolio soon became the centerpiece of a classical model in finance. The associated argument about investor choice is called the "Two Fund Separation Theorem" because it argues that all investors will make their choice between two funds: the risky tangency portfolio and the riskless "fund".

Identifying this tangency portfolio is harder than it looks. Recall that a major difficulty in estimating an efficient frontier accurately is that errors grow as the number of assets increase. You cannot just dump all the means, std's and correlations for the world's assets into an optimizer and turn the crank. If you did, you would get a nonsensical answer. Sadly enough, empirical research was not the answer, due to statistical estimation problems.

The answer to the question came from theory. Financial economist William Sharpe is one of the creators of the "Capital Asset Pricing Model," a theory which began as a quest to identify the tangency portfolio. Since that time, it has developed into much, much more. In fact, the CAPM, as it is called, is the predominant model used for estimating equity risk and return.

II. The Capital Asset Pricing Model

Because the CAPM is a theory, we must assume for argument that ...

1. All assets in the world are traded 2. All assets are infinitely divisible 3. All investors in the world collectively hold all assets 4. For every borrower, there is a lender 5. There is a riskless security in the world 6. All investors borrow and lend at the riskless rate 7. Everyone agrees on the inputs to the Mean-STD picture 8. Preferences are well-described by simple utility functions 9. Security distributions are normal, or at least well described by two parameters 10. There are only two periods of time in our world

This is a long list of requirements, and together they describe the capitalist's ideal world. Everything may be bought and sold in perfectly liquid fractional amounts -- even human capital! There is a perfect, safe haven for risk-averse investors i.e. the riskless asset. This means that everyone is an equally good credit risk! No one has any informational advantage in the CAPM world. Everyone has already generously shared all of their knowledge about the future risk and return of the securities, so no one disagrees about expected returns. All customer preferences are an open book -- risk attitudes are well described by a simple utility function. There is no mystery about the shape of the future return distributions. Last but not least, decisions are not complicated by the ability to change your mind through time. You invest irrevocably at one point, and reap the rewards of your investment in the

next period -- at which time you and the investment problem cease to exist. Terminal wealth is measured at that time. I.e. he who dies with the most toys wins! The technical name for this setting is "A frictionless one-period, multi-asset economy with no asymmetric information."

The CAPM argues that these assumptions imply that the tangency portfolio will be a value-weighted mix of all the assets in the world

The proof is actually an elegant equilibrium argument. It begins with the assertion that all risky assets in the world may be regarded as "slices" of a global wealth portfolio. We may graphically represent this as a large, square "cake," sliced horizontally in varying widths. The widths are proportional to the size of each company. Size in this case is determined by the number of shares times the price per share.

Here is the equilibrium part of the argument: Assume that all investors in the world collectively hold all the assets in the world, and that, for every borrower at the riskless rate there is a lender. This last condition is needed so that we can claim that the positions in the riskless asset "net-out" across all investors.

From the two-fund separation picture above, we already know that all investors will hold the same portfolio of risky assets, i.e. that the weights for each risky asset j will be the same across all investor portfolios. This knowledge allows us to cut the cake in another direction: vertically. As with companies, we vary the width of the slice according to the wealth of the individual.

Notice that each vertical "slice" is a portfolio, and the weights are given by the relative asset values of the companies. We can calculate what the weights are exactly:

Weight on asset i = [price i x shares i] / world wealth

Each investor's portfolio weight is exactly proportional to the percentage that the firm represents of the world's assets. There you have it: the tangency portfolio is a capital-weighted portfolio of all the world's assets.

III. Investment Implications

The CAPM tells us that all investors will want to hold "capital-weighted" portfolios of global wealth. In the 1960's when the CAPM was developed, this solution looked a lot like a portfolio that was already familiar to many people: the S&P 500. The S&P 500 is a capital-weighted portfolio of most of the U.S.'s largest stocks. At that time, the U.S. was the world's largest market, and thus, it seemed to be a fair approximation to the "cake." Amazingly, the answer was right under our noses -- the tangency portfolio must be something like the S&P 500! Not co-incidentally, widespread use of index funds began about this time. Index funds are mutual funds and/or money managers who simply match the performance of the S&P. Many institutions and individuals discovered the virtues of indexing. Trading costs were minimal in this strategy: capital-weighted portfolios automatically adjust to changes in value when stocks grow, so that investors need not change their weights all the time -- it is a "buy-and-hold" portfolio. There was also little evidence at the time that active portfolio management beat the S&P index -- so why not?

IV. Is the CAPM true?

Any theory is only strictly valid if its assumptions are true. There are a few nettlesome issues that call into question the validity of the CAPM:

Is the world in equilibrium? Do you hold the value-weighted world wealth portfolio? Can you even come close? What about "human capital?"

While these problems may violate the letter of the law, perhaps the spirit of the CAPM is correct. That is, the theory may me a good prescription for investment policy. It tells investors to choose a very reasonable, diversified and low cost portfolio. It also moves them into global assets, i.e. towards investments that are not too correlated with their personal human capital. In fact, even if the CAPM is approximately correct, it will have a major impact upon how investors regard individual securities. Why?

V. Portfolio Risk

Suppose you were a CAPM-style investor holding the world wealth portfolio, and someone offered you another stock to invest in. What rate of return would you demand to hold this stock? The answer before the CAPM might have depended upon the standard deviation of a stock's returns. After the CAPM, it is clear that you care about the effect of this stock on the TANGENCY portfolio. The diagram shows that the introduction of asset A into the portfolio will move the tangency portfolio from T(1) to T(2).

The extent of this movement determines the price you are willing to pay (alternately, the return you demand) for holding asset A. The lower the average correlation A has with the rest of the assets in the portfolio, the more the frontier, and hence T, will move to the left. This is good news for the investor -- if A moves your portfolio left, you will demand lower expected return because it improves your portfolio risk-return profile. This is why the CAPM is called the "Capital Asset Pricing Model." It explains relative security prices in terms of a security's contribution to the risk of the whole portfolio, not its individual standard deviation.

PORTFOLIO

A combination of securities with different risk & return characteristics will constitute the

portfolio of the investor. Thus, a portfolio is the combination of various assets and/or

instruments of investments. The combination may have different features of risk & return,

separate from those of the components. The portfolio is also built up out of the wealth or

income of the investor over a period of time, with a view to suit his risk and return

preference to that of the portfolio that he holds. The portfolio analysis of the risk and return

characteristics of individual securities in the portfolio and changes that may take place in

combination with other securities due to interaction among themselves and impact of each

one of them on others.

What is a Portfolio?

In finance, a portfolio is an appropriate mix of or collection of investments held by an institution or a private individual.

Holding a portfolio is part of an investment and risk-limiting strategy called diversification. By owning several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the portfolio could include stocks, bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities, or any other item that is expected to retain its value.In building up an investment portfolio a financial institution will typically conduct its own investment analysis, whilst a private individual may make use of the services of a financial advisor or a financial institution which offers portfolio management services.

Meaning of Portfolio:

Portfolio means combined holding of many kinds of finanacial securities i.e. shares, debentures, government bonds, units and other financial assets. Making a portfolio means putting one’s eggs in different baskets with varying elements of risks and return. The object of portfolio is to reduce risk by diversification and maximise gains.

The term investment portfolio refers to the various assets of an investor which are to be considered as a unit. Thus, an investment portfolio is not merely a collection of unrelated

assets but a carefully blended asset combination within a unified teamwork. It is necessary for investors to take all decisions regarding their wealth position in a context of portfolio.

What is Portfolio Management?

Portfolio management involves deciding what assets to include in the portfolio, given the goals of the portfolio owner and changing economic conditions. Selection involves deciding what assets to purchase, how many to purchase, when to purchase them, and what assets to divest. These decisions always involve some sort of performance measurement, most typically expected return on the portfolio, and the risk associated with this return (i.e. the standard deviation of the return). Typically the expected returns from portfolios of different asset bundles are compared.

Portfolio management means selection of securities and constant shifting of portfolio in the light of varying attractiveness of the constituents of portfolio. It is a choice of selecting and revising spectrum of securities to it in with the characteristics of an investor. Management means utilisation of resources in the best possible manner. Portfolio management involves maintainng a proper combination of securities which comprise the investor’s portfolio in such a manner that they give maximum return with minimum risk. This requires forming of a proper investment policy which is a policy of formation of guidelines for allocation of available funds among the various types of securities.

Markowitz analyzed the implications of the fact that the investors, although seeking high expected returns, generally wish to avoid risk. It is the basis of all scientific portfolio management. Although the expected return on portfolio is directly related to the expected return on component securities, it is not possible to deduce portfolio riskiness simply by knowing the riskiness of individual securities. The riskiness of portfolio depends upon the attributes of individual securities as well as the interrelationships among the securities.

A professional who manages other people or institutions investment portfolio with the object of profitability, growth and risk minimization is known as a Portfolio Manager. He is expected to manage the investor’s assets prudently and choose particular investment avenues appropriate for particular times aiming at maximization of profit. Portfolio management includes portfolio planning, selection and construction, review and evaluation of securities. The skill in portfolio management lies in achieving a sound balance between the objectives of safety, liquidity and profitability.

Timing is an important factor of portfolio revision. Ideally, investors should sell at market tops and sell at market bottoms. They should be guarded against buying at high prices and selling at low prices. Timing is a crucial factor while switching between shares and bonds.

Investors may switch from bonds to shares in a bullish market and vice-versa in a bearish market.

PORTFOLIO MANAGEMENT

Portfolio management is the professional management of various securities (shares, bonds

and other securities) and assets (e.g., real estate) in order to meet specified investment goals

for the benefit of the investors.

The art and science of making decisions about investment mix and policy, matching

investments to objectives, asset allocation for individuals and institutions, and balancing

risk against performance.

Portfolio management is all about strengths, weaknesses, opportunities and threats in the

choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other

tradeoffs encountered in the attempt to maximize return at a given appetite for risk.

BASIC PRINCIPLES OF PORTFOLIO MANAGEMENT:

There are two basic principles for effective portfolio management which are given below:-

I. Effective investment planning for the investment in securities by considering the

following factors:

a) Fiscal, financial and monetary policies of the Govt. of India and the

Reserve Bank of India.

b) Industrial and economic environment and its impact on industry.

Prospect in terms of prospective technological changes, competition in the market,

capacity utilization with industry and demand prospects etc.

II. Constant Review of Investment:

It requires to review the investment in securities and to continue the selling and

purchasing of investment in more profitable manner. For this purpose they have to carry

the following analysis:

a) To assess the quality of the management of the companies in which investment has

been made or proposed to be made.

b) To assess the financial and trend analysis of companies Balance Sheet and Profit and

Loss Accounts to identify the optimum capital structure and better performance for the

purpose of withholding the investment from poor companies.

c) To analyze the security market and its trend in continuous basis to arrive at a conclusion

as to whether the securities already in possession should be disinvested and new

securities be purchased. If so the timing for investment or disinvestment is also

revealed.

OBJECTIVES OF PORTFOLIO MANAGEMENT:

The major objectives of portfolio management are summarized as below:-

The basic objective of portfolio management is to maximmise yield and minimise risk. The other objectives are as follows:

a) Stability of Income: An investor considers stability of income from his investment. He also considers the stability of purchasing power of income.

b) Capital Growth: Capital appreciation has become an important investment principle. Investors seek growth stocks which provide a very large capital appreciation by way of rights, bonus and appreciation in the market price of a share.

c) Liquidity: An investment is a liquid asset. It can be converted into cash with the help of stock exchange. Investment should be liquid as well as marketable. The portfolio should contain a planned proportion of high-grade and readily salable investment.

d) Safety: Safety means protection for investment against loss under reasonably variations. In order to provide safety, a careful review of economic and industry trends is necessary. In other words, errors in portfolio are unavoidable and it requires extensive diversification. Even investor wants that his basic amount of investment should remain safe.

e) Tax incentives: investors try to minimise their tax liabilities from the investments. The portfolio manager has to keep a list of such investment avenues along with the return risk, profile, tax implications, yields and other returns. An investment programme without considering tax implications may be costly to the investor.

1. SECURITY/SAFETY OF PRINCIPAL : Security not only involves keeping the

principal sum intact but also keeping intact its purchasing power intact.

2. STABILITY OF INCOME : So as to facilitate planning more accurately and

systematically the reinvestment consumption of income.

3. CAPITAL GROWTH : This can be attained by reinvesting in growth securities or

through purchase of growth securities.

4. MARKETABILITY : It is the case with which a security can be bought or sold. This is

essential for providing flexibility to investment portfolio.

5. LIQUIDITY I.E. NEARNESS TO MONEY : It is desirable to investor so as to take

advantage of attractive opportunities upcoming in the market.

6. DIVERSIFICATION : The basic objective of building a portfolio is to reduce risk of

loss of capital and / or income by investing in various types of securities and over a wide

range of industries.

7. FAVORABLE TAX STATUS : The effective yield an investor gets form his investment

depends on tax to which it is subject. By minimizing the tax burden, yield can be

effectively improved.

THE PORTFOLIO MANAGEMENT PROCESS:

The portfolio management process is the process an investor takes to aid him in meeting his

investment goals. 

The procedure is as follows:

1. CREATE A POLICY STATEMENT  -A policy statement is the statement that

contains the investor's goals and constraints as it relates to his investments.

2. DEVELOP AN INVESTMENT STRATEGY  -This entails creating a strategy that

combines the investor's goals and objectives with current financial market and

economic conditions.

3. IMPLEMENT THE PLAN CREATED  -This entails putting the investment strategy

to work, investing in a portfolio that meets the client's goals and constraint

requirements.

4. MONITOR AND UPDATE THE PLAN  -Both markets and investors' needs change

as time changes. As such, it is important to monitor for these changes as they occur and

to update the plan to adjust for the changes that have occurred.

SCOPE OF PORTFOLIO MANAGEMENT:

Portfolio management is a continuous process. It is a dynamic activity. The following are

the basic operations of a portfolio management.

1. Monitoring the performance of portfolio by incorporating the latest market conditions.

2. Identification of the investor’s objective, constraints and preferences.

3. Making an evaluation of portfolio income (comparison with targets and achievement).

4. Making revision in the portfolio.

5. Implementation of the strategies in tune with investment objectives.

ELEMENTS OF PORTFOLIO MANAGEMENT

Portfolio management is a dynamic process whch involves the following basic tasks:

a) Identification of the objectives, constraints and preferences of investors for formulation of investment policy.

b) Develop and implement strategies in tune with investment policy formulated. It will help the selection of asset classes and securities in each class depending upon their risk return attributes.

c) Review and monitoring of the perfomance of the portfolio by continuous overview of the market conditions and perfomance of the companies.

d) Evaluation of the portfolio for the results to compare with targets and make some adjustments for the future

CONSTRUCTION OF PORTFOLIO:

PORTFOLIO CONSTRUCTION means determining the actual composition of portfolio. It refers to the allocation of funds among variety of financial assets open forinvestment. Portfolio theory concerns itself with the principles governing such allocation. Therefore, the objective of the theory is to elaborate the principles in which the risk can be minimised subject to desired level of return on the portfolio or maximise the return subject to the constraints of a certain level of risk. The portfolio manager has to set out all the alternative investments along with their projected return or risk and choose investments which satify the requirements of the investor and cater to his preferences.

It is a critical stage because mix is the single most determinant of portfolio performance. Portfolio construction requires knowledge of different aspects of securities. The componenrs of portfolio construction are (a) Asset location (b) Security location (c) Portfolio structure. Asset location means setting the asset mix. Security selection involves choosing the appropriate security to meet the portfolio target and portfolio structure involves setting the amount of each security to be included in the portfolio.

Investing in securities presupposes risk. a common way of reducing risk is to follow the principle of diversification. Diversification is investing in number of different securities rather than concentrating in one or two securities. The diversification assures the benefit of

obtaining the anticipated return on the portfolio of securities. In a diversification portfolio, some securities may exceed expectatins with the effect that the actual result of the portfolio will be reasonably close to the anticipated results.

APPROACHES TO CONSTRUCTION OF PORTFOLI

There are two approaches to constructing portfolio of securities:

(a) Interior Decorating Appraoch (b) Markowitz Approach.

Interior Decorating Approach: interior decorating approach is tailor made to the investment objectives and constraints of each investor. In case of exterior building or room structure, the furnishing and intrior decoration to be carried out inside the structure will depend on the purpose for which it is to be used. Similarly, the portfolio will consist of securities which will suit the individual’s investment objectives and constraints. An individual investor has to carefully develop his portfolio over aperiod of years to suit his needs and match his investment objectives. A serious minded investor will have to consider the following important categories of investment oppurtunities.

1) Protective Investments: These investments protect the investors against the uncertainities in life. The life insurance policy is a good example of this type of investment.

2) Tax Oriented Investment: Some investments provide tax incentives to the investors. For example, Public Provident Fund, National Savings Certificate etc.

3) Fixed Income Investment: These investment yield a fixed rate of return on the investments. For example, investment in preference shares, debentures, bank, deposits etc.

4) Emotional Investment: These investments are made for the emotional security and satisfaction. Investors get some satisfaction from these investments made in house property, jewellery, household appliances.

5) Speculative Investments: these investments are made for the purpose of speculation. The motive behind is tomake quick gain out of fluctuations in the market. For example, investment in real estate, shares, comodity trading etc.

6) Growth Investments: these investments are made for the purpose of earning capital gains. These are not made for getting regular income. For example, investment in growth shares, real estates, land, gold etc.

With the help of these varieties of investments, we can attempt to develop a matrixfor matching the indi vidual characteristics of specific investments so that a suitable portfolio

can be developed for each investor. In real life, building a portfolio is a simple thing. A young family which may have a lot of insurance and considerable growth portfolio should add some real estate by the time it reaches the midstream. At the middle-age sets, the investors should avoid making risky and speculative investments. They should make the necessary emotional investments which will provide security and mental peace in the old age. Whn they are on the verge of retirement and even during retirement their portfolio should preferably consist of safe and income generating investments.

(b) Markowitz Approach: Markowitz approach provides a systematic seacrh for optimal portfolio. It enables the investors to locate minimumvariance portfolios i.e. portfolios with the least amount of risk for diferent levels of expected returns. It is more analytical than simple diversification because it considers correlations between asset rturns for lowering risk. There are computer based packages available for determinig efficient portfolios. If we go through this available process for different levels of expected returns, we can locate minimum variance portfolio. Application of the above package will tell us how much we can invest in each security to form an efficient portfolio for a given level of return.

PORTFOLIO COMPOSITION

The principla objective of the traditional approach is to select the portfolio of securities that most appropriately meets the investors needs. The investor will attempt to maximise expected return subject to the level of risk involved. The first step is to obtain thepertinent facts about the individual. This information aids the portfolio manager in determining the constraints on thye portfolio and the most appropriate portfolio objectives. If the major objective is income , the portfolio will be made up of high-quality long-term bonds. If safety principle is the objective, the portfolo will be made up of high-quality short-term debt instruments. Objectives for common stock portfolios are more complex and range from income to rapid appreciation.

SCOPE OF PORTFOLIO MANAGEMENT

Portfolio management is the art of putting money in fairly safe, quite profitable and reasonably in liquid form. An investors attempt to find the best combination of risk and return is the first and usually the foremost goal. In choosing among different investment opportunities the following aspects of risk management should be considered.

a) The selection of a level of risk and return that reflects the investor’s tolerance for risk and desire for return, i.e. personal preferences.

b) The management of investment alternatives to expand the set of opportunities available at the investors acceptable risk levels.

The very averse investor might choose to invest in mutual funds. The more risk –tolerant investor might choose shares, if they offer higher returns. Much more can be done to help the investor to secure most desirable opportunities. Investment opportunities can be packaged together by forming portfolios. This will increase the number of investment opportunities available at any specified risk level. Thus, the potential for creating portfolios changes the whole problem of investment choice. Risk adverse investors may be unable to find a way to invest in shares and debentures to earn the higher returns from the opportunities through portfolios.

Portfolio management in India is still in its infancy. An investor has to choose a portfolio according to his preferences normally goes to necessities and comforts like purchasing a house or domestic appliances. His second preference goes to contractual obligations such as life insurance or provident funds. The third preference goes to make some a provision for savings required for cash transactions in the form of cash or bank deposits which are required to make day to day payments. The next preference goes to short-term investments like UTI units and post office deposits which provide liquidity. The last choice goes to investment in company shares and debentures. The final decision is taken on the basis of alternatives, attributes and investor preferences.

For most investors it is not possible to choose between managing one’s own portfolio. They can hire a professional manager to do it. The professional manager provides a variety of services including diversification, active portfolio management, liquid securities and performance of duties associated with keeping track of investor’s money. Professionally managed funds include open-ended mutual funds, money market funds and close-ended mutual funds. A great variety of investment objectives, portfolio management styles and management expense levels are present in the professional fund management industry. Investors are often able to select a fund ideally suited to their personal needs, wealth levels and objectives.

EFFICIENT PORTFOLIO

Portfolio management involves construction of portfolio based upon investor’s objectives, constraints, preferences for his risk and returns and his tax liability. It is reviewed and adjusted from time to time in tune with the market conditions. The evaluation is to be done in terms of targets set for risk and return changes in the portfolio are to be made in order to meet the changing conditions.

In order to construct an efficient portfolio, we have to conceptualize various combinations of investments in a basket and designate them as expected portfolios. Then expected returns from these portfolios have to be worked out. The risk on these portfolios is to be estimated by measuring the standard deviation of different portfolio returns. We can diversify into a number of securities whose risk return profiles vary in order to reduce the risk.

The shaded region represents all possible portfolios that can be obtained from a given set of securities. The portfolios lying on the curve ABC are efficient portfolios because they offer a maximum return for a given level of risk and minimum risk for a given level of return. The portfolio at point D is on the boundary of the feasible region but it is not efficient, because the portfolio on curve ABC offering the same expected return is less risky. The Markowitz assumes that any rational investor will prefer efficient portfolios to all other portfolios. The choice of a particular efficient portfolio depends on the investor’s preferences or utility function.

SELECTING THE APPROPRIATE PORTFOLIO:

The investor has to select the most appropriate portfolio from among the many portfolios. He has the option (a) maximizing expected returns for a given level of risk or (b) minimizing risk for a given level of expected return. The Markowitz model allows a trade-off between expected returns and risk which depends upon each investor’s risk preferences. The investor can select the risk combination that best satisfies unique personal preferences.

Portfolios differ from one another not just in number and type of securities held but also in combination of risk and return they offer. Therefore, everyone will not choose the same portfolio. If they choose from among alternative portfolios on the basis of expected return and variance they will pick up efficient portfolios.

Conclusion

The CAPM is a theoretical solution to the identity of the tangency portfolio. It uses some ideal assumptions about the economy to argue that the capital weighted world wealth

portfolio is the tangency portfolio, and that every investor will hold this same portfolio of

risky assets. Even though it is clear they do not, the CAPM is still a very useful tool. It has been taken as a prescription for the investment portfolio, as well as a tool for estimating an expected rate of return. In the next chapter, we will take a look at the second of these two

uses.

Creating an efficient frontier from historical or forecast statistics about asset returns is inherently uncertain due to errors in statistical inputs. This uncertainty is minor when compared to the problem of projecting investor preferences into mean-standard deviation space. Economists know relatively little about human preferences, especially when they are confined to a single-period model. We know people prefer more to less, and we know most people avoid risk when they are not compensated for holding it. Beyond that is guess-work. We don't even know if they are consistent, through time, in their choices. The theoretical approach to the portfolio selection problem relies upon specifying a utility function for the investor, using that to identify indifference curves, and then finding the highest attainable utility level in the feasible set. This turns out to be a tangency point. In practice, it is difficult to estimate a utility function, and even more difficult to explain it back to the investor.

An alternative to utility curve estimation is the "safety-first" technology, which is motivated by a simple question about preferences. What is your "floor" return? If you can pick a floor, you can pick a portfolio. In addition, you can identify a probability of exceeding that floor, by observing the slope of the tangency line. Safety-first also lets you find optimal portfolios by picking a floor and a probability, as well as simply picking a probability.

Value at risk is becoming increasingly popular method of risk measurement and control. It is a simple extension of the safety-first technology, when the assets comprising the portfolio have normally distributed returns.

Chapter

BIBLIOGRAPHY

Bibliography:

BOOKS:

INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

- PRASANNA CHANDRA.

INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

-N.G. KALE.

- P.K. BANGAR.

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