Investment and Portfolio

Management
Unit- 1
By : Sapna Kataria
Investment refers to putting money into an asset or business with the
expectation of generating more money in the future. There are different ways to
do this, like buying stocks, bonds, or mutual funds. The main goal is to make your
money grow over time.
Following are the types of investment available in India:
Stocks.
Certificate of Deposit.
Bonds.
Real Estate.
Fixed Deposits.
Mutual Funds.
Public Provident Fund (PPF)
National Pension System (NPS)
 Types of Investments

Stocks/Equities
A share of stock is a piece of ownership of a public or private company. By owning
stock, the investor may be entitled to dividend distributions generated from the net
profit of the company. As the company becomes more successful and other
investors seek to buy that company's stock, it's value can also appreciate and be
sold for capital gains.
The two primary types of stocks to invest in are common stock and preferred stock.
Common stock often includes voting right and participation eligibility in certain
matters. Preferred stock often have first claim to dividends and must be paid before
common shareholders.
In addition, stocks are often classified as being either growth or value investments.
Investments in growth stocks is the strategy of investing in a company while it is
small and before it achieves market success. Investment in value stocks is the
strategy of investing in a more established company whose stock price may not
appropriate value the company.
Bonds/Fixed-Income Securities
A bond is an investment that often demands an upfront investment, then pays a
reoccurring amount over the life of the bond. Then, when the bond matures, the
investor receives the capital invested into the bond back. Similar to debt, bond
investments are a mechanism for certain entities to raise money. Many
government entities and companies issue bonds; then, investors can contribute
capital to earn a yield.
The recurring payment awarded to bondholders is called a coupon payment.
Because the coupon payment on a bond investment is usually fixed, the price of a
bond will often fluctuate to change the bond's yield. For example, a bond paying 5%
will become cheaper to buy if there are market opportunities to earn 6%; by falling in
price, the bond will naturally earn a higher yield.
Index Funds and Mutual Funds
Instead of selecting each individual company to invest in, index funds, mutual funds,
and other types of funds often aggregate specific investments to craft one
investment vehicle. For example, an investor can buy shares of a single mutual fund
that holds ownership of small cap, emerging market companies instead of having to
research and select each company on its own.
Mutual funds are actively managed by a firm, while index funds are often passively-
managed. This means that the investment professionals overseeing the mutual
fund is trying to beat a specific benchmark, while index funds often attempt to
simply copy or imitate a benchmark. For this reason, mutual funds may be a more
expense fund to invest in compared to more passive-style funds.
Real Estate
Real estate investments are often broadly defined as investments in physical,
tangible spaces that can be utilized. Land can be built on, office buildings can be
occupied, warehouses can store inventory, and residential properties can house
families. Real estate investments may encompass acquiring sites, developing
sites for specific uses, or purchasing ready-to-occupy operating sites.
In some contexts, real estate may broadly encompass certain types of
investments that may yield commodities. For example, an investor can invest in
farmland; in addition to reaping the reward of land value appreciation, the
investment earns a return based on the crop yield and operating income.
Commodities
Commodities are often raw materials such as agriculture, energy, or metals.
Investors can choose to invest in actual tangible commodities (i.e. owning a bar of
gold) or can choose alternative investment products that represent digital
ownership (i.e. a gold ETF).
Commodities can be an investment because they are often used as inputs to
society. Consider oil, gas, or other forms of energy. During periods of economic
growth, companies often have greater energy needs to ship more products or
manufacture additional goods. In addition, consumers may have greater demand
for energy due to travel. In this example, the price of commodities fluctuates and
may yield a profit for an investor.
•Facilitates informed decision-making
A comprehensive understanding of the Investment Process equips individuals with
the ability to analyse various Investment options critically. It enables them to make
decisions based on in-depth knowledge, market trends, and historical data.
Informed decisions lead to Investments that are not only profitable but also aligned
with personal financial goals.
•Ensures proper Risk Management
Knowledge of the Investment Process empowers individuals to assess risks
associated with different Investment avenues. It helps in distinguishing between
high-risk, high-reward Investments and more stable, low-risk options. By
understanding the risks involved, Investors can create a diversified portfolio that
balances any potential returns with acceptable levels of risk, ensuring financial
security even in fluctuating market conditions.
Guarantees alignment with goals
Each person's financial goals are unique, ranging from buying a house to funding a
child's education or planning for retirement. Understanding the Investment Process
enables individuals to match their goals with the right Investment products.
Whether it's stocks for long-term growth or bonds for stable income, a sound
understanding ensures that Investments align with specific objectives. This
alignment enhances the likelihood of achieving these goals within the desired
timeframe.
Ensures market adaptability
Financial markets are subject to constant change. Those who comprehend the
Investment Process are better equipped to adapt to these changes. Whether it's
a shift in economic conditions, regulatory alterations, or technological
advancements affecting Investment options, a deep understanding allows
Investors to adjust their strategies accordingly. This adaptability ensures that
Investments remain relevant and optimised, maximising potential returns and
minimising losses.
Instils confidence in Investment decisions
Understanding the Investment Process instils confidence. It eradicates the fear
of the unknown, allowing Investors to approach their financial ventures with
assurance. Confidence encourages proactive decision-making and prevents
impulsive actions driven by market volatility. As a result, Investors can maintain
a steady course even when faced with market fluctuations, ensuring a
disciplined and resilient Investment approach.
Helps in wealth preservation and growth
Investments are not just about earning money; they're also about preserving and
growing wealth over time. A solid understanding of the Investment Process aids
in wealth preservation by preventing common pitfalls and unnecessary risks.
Moreover, it facilitates wealth growth by identifying opportunities that align with
an individual's risk tolerance and financial objectives. This combination of
preservation and growth is vital for creating a robust financial legacy that can
benefit not only the Investor but also future generations.
•Evaluation of investment goals




Evaluation of investment goals is the first crucial step of the investment process. The
purpose of your investment can be wealth creation, income generation or safety. Also,
your goals may vary according to age and income.




Usually, young people invest with the aim of accumulating wealth and have a risky
appetite. But income generation and retirement planning are the purposes of
investment when you reach midlife and later midlife. So, chalking out your investment
goals help you hit the right investment asset to generate adequate returns.
•Evaluation of the present financial situation




You cannot implement an effective investment decision process without
disciplined savings. So, after evaluating your long and short-term financial goals,
it is necessary to know about your current financial situation. It helps you decide
how much to save according to the time horizon of your investment goal. So,
before picking an asset, assess your monthly expenses, assets, liabilities, risk-
taking ability, etc.

•Asset allocation




After an analysis of goals and financial situation, the next step is asset
allocation. You can choose between equity, bonds, money market instruments,
gold, real estate, etc according to your risk appetite and needs.
•Diversification of assets is also an essential step to minimise risks. Asset
allocation usually depends on your present financial condition. But you can
change it according to your risk appetite and needs which might change with
income and age. Also, ensure to include liquid and fixed income assets in your
portfolio. This helps to meet your urgent financial needs and long-term goals.
Depending on your needs and risk tolerance, you can choose between the
following portfolios:

Aggressive: The portfolio consists of riskier assets that generate apt returns.
Defensive: The portfolio has assets that are less sensitive to market movements.
Income: Income Portfolio helps provide regular profit distributions and dividends
for the investor.
Hybrid: The portfolio has several assets including equity, bonds, real estate, etc.

•Choose the right investment strategy

An appropriate investment strategy is another crucial step for better and stable
returns. The strategies of investment are as follows:

Short term: A short-term investment strategy offers returns in a short duration.

It may include short-term bonds, cash funds, money market instruments, etc.
Long term: This strategy includes investments in stocks, mutual funds, real
estate, gold, etc. Long-term investments generate returns over many years
and usually offer lesser risk and more returns. While investing in long-term
assets remember that the capital is locked in for a longer duration.
Active: An active investment strategy involves the active participation of the
investor in fund management.
Passive: Passive investment strategy doesn’t need day-to-day involvement. It
allows the investor to sit back while their investment generates returns.
•Track and manage your portfolio

After following the above investment process steps, it is time to track and
manage your portfolio. This step involves reviewing the performance of assets
at regular intervals. It ensures that your investments are in line with your financial
goals and needs. Apart from this, it is important to change your fund allocation
according to performance, market volatility and risk tolerance. You must know
when to sell and buy specific assets to generate more returns or avoid losses.
Step 1: Setting financial goals
Setting clear financial goals is the cornerstone of any successful Investment
journey. Short-term goals like purchasing a car and long-term objectives such as
retirement planning must be defined and prioritised. These goals act as guiding
stars, shaping your Investment strategies and providing direction.
Through meticulous goal-setting, individuals create a roadmap, ensuring that their
Investments align with their aspirations, whether it's funding a dream holiday or
securing a comfortable retirement. Clear goals provide the purpose and motivation
needed to navigate the intricate world of Investments, turning dreams into tangible
financial achievements.
Step 2: Assessing risk tolerance
Understanding your risk tolerance is pivotal in making Investment decisions. It
refers to your ability to endure fluctuations in the value of your Investments.
Assessing your risk tolerance involves evaluating your comfort level with market
uncertainties.
Are you conservative, moderate, or aggressive in your risk appetite? By gauging
your psychological and financial resilience, you can tailor your Investment portfolio
accordingly. Conservative Investors prefer stability, while aggressive ones seek high
returns despite higher risks. This step ensures that your Investments align with your
temperament, making your financial journey not just profitable but also emotionally
secure.
Step 3: Creating a budget and emergency fund
A strong financial foundation starts with disciplined budgeting and building an
emergency fund. Budgeting helps in tracking income and expenses, ensuring
surplus funds for Investments. Simultaneously, having an emergency fund
safeguards Investments from unexpected events such as medical emergencies or
sudden job loss.
The emergency fund acts as a safety net, preventing the need to liquidate
Investments during crises, thus preserving long-term goals. Creating a budget
cultivates financial discipline, enabling systematic Investments, while an
emergency fund provides:
1) Financial security
2) Reinforcement in your ability to stay invested during market fluctuations
3) Surety that your Investments stay on course to meet your goals
Step 4: Diversifying Investment portfolio
Diversification is the golden rule of Investments. It refers to spreading Investments
across different asset classes, such as stocks, bonds, mutual funds, and real
estate. This strategy mitigates risks by reducing the impact of poor performance in
any single Investment. Diversifying ensures that a downturn in one sector doesn’t
devastate your entire portfolio, balancing potential losses.
For instance, when stocks underperform, bonds might flourish, maintaining overall
stability. Diversification aligns Investments with risk tolerance and financial goals,
ensuring a resilient portfolio.
Step 5: Conducting research and analysis
Informed decisions are the bedrock of successful investing. Conducting thorough
research and analysis is imperative before making Investment choices. Fundamental
analysis delves into a company's financial health, while technical analysis studies
market trends. Staying updated on economic indicators and market dynamics enables
anticipation of trends.
Informed Investors can identify promising opportunities, avoiding impulsive decisions.
Research ensures an understanding of potential risks and rewards, leading to prudent
choices. Continuous analysis aids in tracking Investments, ensuring they align with
goals. With comprehensive knowledge, Investors can navigate the ever-changing
market landscape, making well-informed decisions that pave the way for sustainable
financial growth.
Step 6: Making informed Investment decisions
Professional guidance and continuous monitoring are pivotal in making informed
Investment decisions. Seeking advice from financial experts provides nuanced insights
tailored to your specific needs. Regularly monitoring Investment performance is
essential, ensuring they align with your goals. Adapting strategies to market changes
and evolving life goals is critical.
Whether it’s seeking expert advice or using online tools, informed decisions are the
result of meticulous evaluation and adaptation. By staying vigilant and flexible,
Investors can respond to market dynamics, ensuring that their Investments remain
aligned with their objectives, even amidst economic fluctuations, securing their
financial future.
Step 7: Regularly reviewing and rebalancing the portfolio
Investment strategies need periodic review and adjustment. Regular portfolio
reviews help gauge performance against goals. Rebalancing involves adjusting
asset allocation to maintain the desired risk and return levels. Life events like
marriage or nearing retirement may necessitate changes in the Investment
approach.
Adapting the portfolio ensures it remains effective in fulfilling objectives. By
responding to changing circumstances, Investors maximise opportunities and
minimise risks. Regular reviews and rebalancing not only safeguard Investments
against market volatility but also optimise their potential. This step ensures that
Investments remain relevant, aligning with evolving goals, ultimately securing a
stable and prosperous financial future.
Here’s an example of alpha:
•If a mutual fund has underperformed by 1% against its benchmark, it will have an
alpha of -1.0.
•If a mutual fund has neither underperformed nor outperformed, it will have an alpha
of zero because it will not have lost or gained value compared to the benchmark
index.
•If a mutual fund has outperformed by 1%, it will have an alpha of +1.0.
Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) postulates that market prices
incorporate all available information at all times, and so securities are always
properly priced (the market is efficient.) Therefore, according to the EMH, there
is no way to systematically identify and take advantage of mispricings in the
market because they do not exist.
If mispricings are identified, they are quickly arbitraged away and so persistent
patterns of market anomalies that can be taken advantage of tend to be few and
far between.
Empirical evidence comparing historical returns of active mutual funds relative to
their passive benchmarks indicates that fewer than 10% of all active funds are
able to earn a positive alpha over a 10-plus year time period, and this percentage
falls once taxes and fees are taken into consideration. In other words, alpha is
hard to come by, especially after taxes and fees.
Because beta risk can be isolated by diversifying and hedging various risks
(which comes with various transaction costs), some have proposed that alpha
does not really exist, but that it simply represents the compensation for taking
some un-hedged risk that hadn't been identified or was overlooked.
What Does the Treynor Ratio Reveal?
In essence, the Treynor ratio is a risk-adjusted measurement of return based on
systematic risk. It indicates how much return an investment, such as a portfolio of
stocks, a mutual fund, or exchange-traded fund, earned for the amount of risk the
investment assumed.
If a portfolio has a negative beta, however, the ratio result is not meaningful. A higher
ratio result is more desirable and means that a given portfolio is likely a more suitable
investment. Since the Treynor ratio is based on historical data, however, it's important
to note this does not necessarily indicate future performance, and one ratio should not
be the only factor relied upon for investing decisions.
The Slope of the CAL
The slope of the CAL measures the trade-off between risk and return. A steeper slope
means you would receive a higher expected return for taking on more risk. The value
of this calculation is known as the Sharpe ratio.
Types of Risk and Return
1. Systematic
Risks that can influence a complete economic market or at minimum a significant portion of it are
known as systematic risks. They are the dangers of losing assets as a result of various
macroeconomic or political risks which impact the general market performance. There are many
types of systematic risks; a few of those are:
•Political risk - Political risk arises largely as a result of political insecurity in a nation or area. For
example, if a country goes to war, the firms that operate there are deemed unsafe, and therefore risky.
•Market risk - Market risk is the byproduct of investors' overall inclination to follow the market. So it is
essentially the inclination of security values to shift together.
•Exchange rate risk - This type of risk arises from the unpredictability of currency value fluctuations.
As a result, it impacts enterprises that conduct foreign exchange operations, such as export and
import firms, or firms that do business in a foreign country.
•Interest rate risk - A shift in the market's rate of interest causes this type of risk. It mostly affects
fixed-income assets since bond costs are connected to interest rates, but it also affects the valuation
of stocks.

2. Unsystematic
Unsystematic risk is a type of risk that impacts only one sector or one business. It is the danger of
losing money on an investment because of a business or sector-specific hazard. A shift in leadership,
a safety recall on a good, a legislative reform that might reduce firm sales, or a new rival in the
market are all examples of unsystematic risk.
Systematic vs Unsystematic
In order to help you better understand, let's review a few of the main differences
between systematic and unsystematic risks:
1. Systematic risks can't be controlled but unsystematic risks can be controlled.
2. Systematic risks are caused by external factors while unsystematic risks are
caused by internal factors.
3. Systematic risks can cause chaos within an entire economy while unsystematic
risks can only cause issues to a specific organization or sector.

Return
There are two types of return that are most focused on: realized return and
expected return.
Realized
Realized return refers to the actual return on an investment over a specific time
frame. It is critical to recognize that nothing can alter a realized return. It's really a
post-fact number that no action can alter. It merely provides information to
investors to help them make wiser financial choices in the future.
Expected
An expected return is the estimate of profits or losses that an investor may expect
from an investment. The expected return is a metric used to estimate if an
investment will have a positive or negative net outcome on average. The expected
return is often founded on previous data and so cannot be guaranteed in the
foreseeable future; yet, it frequently establishes acceptable expectations.
Common Methods of Measurement for Investment
Risk Management
Risk management is a crucial process used to make investment decisions. Risk
management involves identifying and analyzing risk in an investment and deciding whether
or not to accept that risk given the expected returns for the investment. Some common
measurements of risk include standard deviation, Sharpe ratio, beta, value at risk (VaR),
conditional value at risk (CVaR), and R-squared.
Risk management is the analysis of an investment's returns compared to its risk with the
expectation that a greater degree of risk is supposed to be compensated by a higher
expected return.
Risk—or the probability of a loss—can be measured using statistical methods that are
historical predictors of investment risk and volatility.
Commonly used risk management techniques include standard deviation, Sharpe ratio, and
beta.
Value at Risk and other variations not only quantify a potential dollar impact but assess a
confidence interval of the likelihood of an outcome.
Risk management also oversees systematic risk and unsystematic risk, the two broad types
of risk impacting all investments.
Value at Risk (VaR)
Value at Risk (VaR) is a statistical measurement used to assess the level of risk
associated with a portfolio or company. The VaR measures the maximum potential loss
with a degree of confidence for a specified period. For example, suppose a portfolio of
investments has a one-year 10% VaR of $5 million. Therefore, the portfolio has a 10%
chance of losing $5 million over a

one-year period.
There are several different methods for calculating Value at Risk, each of which with its
own formula:
1. The historical simulation method is the simplest as it takes prior market data over a
defined period and applies those outcomes to the current state of an investment.
2. The parametric method or variance-covariance method is more useful when dealing
with larger data sets.
3. The Monte Carlo method is best suited for the most complicated simulations and
assumes the probability of risk for each risk factor is known.
Conditional Value at Risk (CVaR)
1. Conditional Value at Risk (CVaR) is another risk measurement used to assess the tail
risk of an investment. Used as an extension to the VaR, the CVaR assesses the
likelihood, with a certain degree of confidence, that there will be a break in the VaR. It
seeks to assess what happens to investment beyond its maximum loss threshold.
This measurement is more sensitive to events that happen at the tail end of a
distribution.
R-squared
R-squared is a statistical measure that represents the percentage of a fund
portfolio or a security's movements that can be explained by movements in a
benchmark index. For fixed-income securities and bond funds, the benchmark is
the U.S. Treasury Bill. The S&P 500 Index is the benchmark for equities and equity
funds.
Basis Risk Measurement Risk Assessment
It is the process of employing various
Risk assessment is a comprehensive process
statistical and mathematical techniques
involving identifying, analyzing, and
and tools to assign numerical values to
Definition evaluating risks. It includes understanding
uncertainties, enabling organizations to
the context, vulnerabilities, threats, and
understand the magnitude of possible
existing controls.
losses.

Here, it facilitates risk management by They aim to provide a comprehensive view of

Purpose
covering a wide range of risks, considering the risks faced by an organization, including
internal and external factors influencing the its nature, origins, and potential
organization. consequences.
Understanding the overall risk landscape,
Assigning numerical values to risks for
Key Focus including qualitative and quantitative
quantitative analysis
aspects
Various statistical and mathematical
Different qualitative and quantitative
techniques such as VaR, Beta Coefficient,
Methods methods, such as interviews, surveys, and
Alpha, Sharpe Ratio, R-squared, and
scenario analysis
Standard Deviation
Moreover, it helps in risk assessment as it Here, it facilitates risk management by
gauges individual uncertainty, providing covering a wide range of risks considering
Scope
detailed insights into their potential impact internal and external factors influencing the
and likelihood. organization.
Provides a complete understanding of
Results include numerical values or scores
overall uncertainties, enabling organizations
Outcome representing the quantified impact and
to develop effective risk management
probability of loss.
strategies
Basis Risk Measurement Risk Management
Risk management is a
systematic process of identifying,
It refers to evaluating and
assessing, and prioritizing risks,
quantifying potential losses or
Definition followed by the coordinated
uncertainties an organization or
application of resources to
project faces.
minimize, control, or mitigate the
impact of these risks.

These aims to provide a

quantitative understanding of They strive to minimize the
Purpose risks, helping organizations unfavorable impact of risks and
understand the potential loss maximize potential opportunities.
and make informed decisions.

Primarily focuses on quantifying Involves a broader approach,

and analyzing risks, often using incorporating strategies and
Key Focus
tools like risk models, statistical actions to mitigate and respond
analysis, and historical data. to identified risks effectively

Results in the implementation of

strategies and actions to either
Provides numerical or qualitative
prevent the occurrence of
data indicating the level of risk,
Outcome adversities or minimize their
often in the form of risk scores or
impact, leading to enhanced
probabilities
decision-making and
organizational resilience
Risk Management Process
In this section we will cover the processes of managing specific portfolio risks. The
Portfolio Manager plays a critical role in setting up and establishing portfolio risk
management processes. According to PMI’s Standard for Portfolio Management,
there are four primary portfolio risk management processes:
1. Identify portfolio risks—Portfolio risks may come from several directions. Major
project risks are one component of portfolio risks and should be identified during
the Work Intake process or during project planning and reviewed on a regular
basis during portfolio review meetings. Other portfolio risks will be identified by
the Portfolio Governance Team.
2. Analyze portfolio risks—The most serious project risks are communicated to the
Portfolio Governance Team at a portfolio governance meeting or portfolio review
meeting. The Portfolio Governance Team decides which risks are elevated to the
portfolio level (see the figure below). The Portfolio Governance Team will also
assess the severity and probability of other major portfolio risks.
3. Develop portfolio risk responses—Selected Portfolio Governance Team
representatives (or delegate) will be assigned as risk owner(s) to develop options
and actions to mitigate threats to portfolio performance. Portfolio level risks
should also be prioritized.
4. Monitor and control portfolio risks—Portfolio risks and mitigation plans should be
tracked at Portfolio Governance Team meetings.
Asset allocation is how investors divide their portfolios among different assets that
might include equities, fixed-income assets, and cash and its equivalents. Investors
ordinarily aim to balance risks and rewards based on financial goals, risk tolerance,
and the investment horizon.
KEY TAKEAWAYS
1. Asset allocation is how investors split up their portfolios among different kinds of
assets.
2. The three main asset classes are equities, fixed income, and cash and cash
equivalents.
3. Each asset class has different risks and return potential, so each will behave
differently over time.
4. No simple formula can find the right asset allocation for every individual investor.
Rupee Cost Averaging (RCA) is an investment technique where an individual invests a fixed
amount of money at regular intervals, regardless of the market's ups and down. In simple
terms, it is a Systematic Investment Plan (SIP) which has the potential to help investors build
wealth.
The idea of rupee cost averaging is averaging out the price at which you purchase units of a
mutual fund. The main factor of equity investments is market volatility, reflecting the
unpredictability of the economy. The demand of law says that the commodity is purchased at
a higher quantity when it is less expensive and when the price increases the demand reduces.
When the market is rough the rupee cost averaging works the best. It benefits the investors
to purchase less when the markets are high-priced and more when it’s cheap. A Systematic
Investment Plan (SIP) is an easy investment plan of doing this with the advantage of rupee
cost averaging.
Dematerialisation is the process by which a client can get physical certificates converted into
electronic balances. An investor intending to dematerialise its securities needs to have an
account with a DP. The client has to deface and surrender the certificates registered in its
name to the DP.
Through dematerialization, so-called DEMAT accounts allow for electronic transactions
when shares of stock are bought and sold. Within a DEMAT account, the certificates for stocks
and other securities of the user are held as a means for seamless trades to be made.
The introduction of dematerialization served to eliminate such a paper-oriented process.
Furthermore, by adopting electronic bookkeeping, this allowed for accounts to be updated
automatically and swiftly.
Types of Portfolio Management : Portfolio Management is further of the following
types –
a) Active Portfolio Management: As the name suggests, in an active portfolio
management service, the portfolio managers are actively involved in buying
and selling of securities to ensure maximum profits to individuals. The aim of
active portfolio management is to outperform the benchmark. (For example,
BSESENSEX, NSE-NIFTY50, etc.).
b) Passive Portfolio Management: In a passive portfolio management, the
portfolio manager deals with a fixed portfolio designed to match the current
market scenario. Discretionary Portfolio management services an individual
authorizes a portfolio manager to take care of his/her financial needs on
his/her behalf. The individual issues money to the portfolio manager who in
turn takes care of all his investment needs, paper work, documentation, filing
and so on. In discretionary portfolio management, theportfolio manager has
full rights to take decisions on his client’s behalf. In nondiscretionary portfolio
management services, the portfolio manager can merely advise the client
what is good and bad for him but the client reserves full right to take his own
decisions.
Elements of Portfolio Management :
a) Proper Asset Allocation: The key to effective portfolio management is the long-term mix
of assets. Asset allocation is based on the understanding that different types of assets
do not move in concert, and some are more volatile than others. Asset allocation seeks
to optimize the risk/return profile of an investor by investing in a mix of assets that have
low correlation to each other. Investors with a more aggressive profile can weight their
portfolio toward more volatile investments. Investors with a more conservative profile
can weight their portfolio toward more stable investments.
b) Diversification: The only certainty in investing it is impossible to consistently predict the
winners and losers, so the prudent approach is to create a basket of investments that
provide broad exposure within an asset class. Diversification is the spreading of risk and
reward within an asset class. Because it is difficult to know which particular subset of an
asset class or sector is likely to outperform another, diversification seeks to capture the
returns of all of the sectors over time but with less volatility at any one time. Proper
diversification takes place across different classes of securities, sectors of the economy
and geographical regions.
c) Rebalancing and Restructuring: It is used to return a portfolio to its original target
allocation at annual intervals. It is important for retaining the asset mix that best reflects
an investor’s risk/return profile. Otherwise, the movements of the markets could expose
the portfolio to greater risk or reduced return opportunities. For example, a portfolio that
starts out with a 70% equity and 30% fixed-income allocation could, through an extended
market rally, shift to an 80/20 allocation that exposes the portfolio to more risk than the
investor can tolerate.
 Rebalancing almost always results in the sale of high-priced/low-value
securities and the redeployment of the proceeds into low-priced/highvalue or
out-of-favor securities. This annual exercise enables investors to capture gains
and expand the opportunity for growth in high potential sectors while keeping
the portfolio aligned with the investor’s risk/return profile.
 Portfolio Selection : Portfolio Selection is the process of finding out the optimal
portfolio which would be one generating highest return with the lowest risk.
This is done with the objective of maximizing the investor’s return.
Diversification is done for reducing the risk in a portfolio. The investor usually
combines a limited number of securities thereby creating a large number of
portfolios and in different proportions. This is known as portfolio opportunity
set. Every portfolio in the opportunity set is characterized by an expected
return and some risk in terms of variance or standard deviation. Some
portfolios in a portfolio opportunity set are of interest to an investor depending
upon the risk and return as measured by standard deviation. A portfolio will
dominate over others if it has a lower standard deviation. These portfolios
which are dominated by other portfolios are known as inefficient portfolios.
Efficient portfolios are the ones in which the investor is interested to invest.
 Efficient Portfolio : An Efficient portfolio is the one which yields maximum
return at minimum risk at a given level of return. The Dominance Principle is
used as a base to identify the efficient portfolio.
A portfolio having maximum return for a specific level of risk is preferred over other
portfolios having similar risk. Investors maximize their terminal wealth by going for
high yielding securities at a given risk level. Only efficient portfolios are feasible in the
long run which fulfills this need of the investors. The expected returns and risk
measured by standard deviation of portfolio returns can be estimated as done in the
table below.

By comparing the portfolios at the given risk and return, if we compare portfolio No. 5 and 6
with the same return at 13%, an investor would select Portfolio No. 5 since the risk is low at
11.3 as compared to portfolio No. 6. Similarly, if we compare portfolio No. 3 and 4, having
similar risk depicted by standard deviation of 7.8 an investor would choose portfolio No. 4
since it yield at higher return at 11% compared to portfolio No. 3. Thus we can lay down
general criteria for portfolio selection as - 1. Between two portfolios having the same risk,
an investor would choose the one with higher expected return. 2. Between two portfolios
having the same return, an investor would choose the one with lower risk. This is because
of the rational natures of the investors who is risk averse and want more returns
What Is the Modern Portfolio Theory (MPT)?
•The modern portfolio theory (MPT) is a practical method for selecting investments
in order to maximize their overall returns within an acceptable level of risk. This
mathematical framework is used to build a portfolio of investments that maximize
the amount of expected return for the collective given level of risk.
•American economist Harry Markowitz pioneered this theory in his paper "Portfolio
Selection," which was published in the Journal of Finance in 1952.1 He was later
awarded a Nobel Prize for his work on modern portfolio theory.2
•A key component of the MPT theory is diversification. Most investments are either
high risk and high return or low risk and low return. Markowitz argued that investors
could achieve their best results by choosing an optimal mix of the two based on an
assessment of their individual tolerance to risk.
The modern portfolio theory (MPT) is a method that can be used by risk-averse
investors to construct diversified portfolios that maximize their returns without
unacceptable levels of risk.
The modern portfolio theory can be useful to investors trying to construct efficient
and diversified portfolios using ETFs.
Investors who are more concerned with downside risk might prefer the post-modern
portfolio theory (PMPT) to MPT.
The diversification plays a very important role in the modern portfolio theory. The
theory also focuses on the benefits of diversifying the portfolio i.e. investing in
different asset classes like stocks, bonds, real estate, gold etc. It is based on the
underlying fact of ‘Do not put all your eggs in one basket’. Markowitz approach is
viewed as a single period approach. At the beginning of the period the investor must
make a decision in what particular securities to invest and hold these securities until
the end of the period. Because a portfolio is a collection of securities, this decision is
equivalent to selecting an optimal portfolio from a set of possible portfolios.
Markowitz approach is viewed as a single period approach. At the beginning of the
period the investor must make a decision in what particular securities to invest and
hold these securities until the end of the period. Because a portfolio is a collection of
securities, this decision is equivalent to selecting an optimal portfolio from a set of
possible portfolios. Essentiality of the Markowitz portfolio theory is the problem of
optimal portfolio selection.
Markowitz Efficient Frontier : The concept of Efficient Frontier was also introduced by
Markowitz and is easier to understand than it sounds. It is a graphical representation
of all the possible mixtures of risky assets for an optimal level of Return given any
level of risk, as measured by standard deviation.
Essentiality of the Markowitz portfolio theory is the problem of optimal portfolio
selection. Markowitz Efficient Frontier :
The concept of Efficient Frontier was also introduced by Markowitz and is easier to
understand than it sounds. It is a graphical representation of all the possible mixtures of
risky assets for an optimal level of Return given any level of risk, as measured by
standard deviation.
The chart above shows a hyperbola showing all the outcomes for various portfolio
combinations of risky assets, where Standard Deviation is plotted on the X-axis
and Return is plotted on the Y-axis. The Straight Line (Capital Allocation Line)
represents a portfolio of all risky assets and the risk-free asset, which is usually a
triple-A rated government bond. Tangency Portfolio is the point where the portfolio
of only risky assets meets the combination of risky and risk-free assets. This
portfolio maximizes return for the given level of risk. Portfolio along the lower part
of the hyperbola will have lower return and eventually higher risk. Portfolios to the
right will have higher returns but also higher risk. Markowitz Portfolio Theory
(Modern Portfolio Theory or Passive Investment Approach) is the base idea of the
ways to wealth concept.
Assumption of the Markowitz Theory : Markowitz theory is based on the modern
portfolio theory under several assumptions.
i) The market is efficient and all investors have in their knowledge all the facts
about the stock market and so an investor can continuously make superior returns
either by predicting past behavior of stocks through technical analysis or by
fundamental analysis of internal company management or by finding out the
intrinsic value of shares. Thus, all investors are in equal category.
ii) All investors before making any investments have a common goal. This is the
avoidance of risk because they are risk averse.
iii) All investors would like to earn the maximum rate of return that they can achieve
from their investments.
iv) The investors base their decisions on the expected rate of return of an
investment. The expected rate of return can be found out by finding out the
purchase price of a security dividend by the income per year and by adding annual
capital gains. It is also necessary to know the standard deviation of the rate of
return expected by an investor and the rate of return which is being offered on the
investment. The rate of return and standard deviation are important parameters for
finding out whether the investment is worthwhile for a person.
v) Markowitz brought out the theory that it was a useful insight to find out how the
security returns are correlated to each other. By combining the assets in such a way
that they give the lowest risk maximum return could be brought out by the investor.
vi) From the above, it is clear that every investor assumes that while making an
investment he will combine his investments in such a way that he gets a maximum
return and is surrounded by minimum risk.
vii) The investor assumes that greater or larger the return that he achieves on his
investments, the higher the risk factor surround him. On the contrary, when risks are
low the return can also be expected to below.
viii) The investor can reduce his risk if he adds investment to his portfolio.
ix) An investor should be able to get higher return for each level of risk ‘by
determining the efficient set of securities’.
Total Risk of Stock = General Risk + Specific Risk
= Market Risk + Issuer Risk
= Systemic Risk + Non Systemic Risk
Measurement of Risk and Return : Risk is the uncertainty of future returns. Risk can be
measured as the difference between expected return and actual return. Expected
returns are the anticipated returns for a future period. Risk is measured as the
difference between expected return and actual realized return. There are different
techniques/tools of measuring risk –
1. Volatility : Volatility is the range of price fluctuations as compared to the expected
level of return. The more the changes in price the more volatile a stock is. Volatility
brings uncertainty and hence greater risk. The past volatility data provides an insight
into the risk of a stock.
2. Standard Deviation : This is the most common measure of risk in investments in
terms of variance or standard deviation. Standard Deviation indicates the likely
volatility in the returns from the mean value of returns. It can be either in the form of
an increase or a decrease from the mean.
3. Probability Distribution : Probabilities indicate the likelihood of different outcomes
and are in the form of decimals. Past occurrences are taken to estimate the
probability with consideration for any changes expected in the future. To determine
the single most outcomes from a specific probability distribution, the expected value
is computed. Expected return or Ex-ante return is the mean return found by using
probability distribution of expected return.
The value of Beta determines the risk-return relationship as follows:
If Beta = 1; there is a balance of risk and return, i.e. the value of the securities
decreases or increases proportionately to the stock market, denoting average
risk involved.
If Beta > 1; then we can say that the stocks are overvalued and are highly
volatile to the fluctuations in the stock market holding high risk.
If Beta < 1; the stocks are undervalued and are less volatile to the market
fluctuations, in other words, such securities are less risky.
Formula
Portfolio Analysis : At some time in the future, the actual return will be one of many
possible outcomes. The various outcomes have some probability of occurring. The
expected return is just the average of these possible returns weighted (multiplied)
by the respective probabilities of occurring. Standard deviation of annual returns is
most useful for measuring risk over shorter time periods. For measuring risk over
longer time periods, the dispersion of possible cumulative returns is a better
measure of risk. This is because over many years, a relatively small difference in
annualized rate of return can result in a large difference in cumulative returns. The
cumulative return on your investments at a specified future time is referred to as
terminal wealth. The dispersion of possible terminal wealth is referred to as
terminal wealth dispersion.
The collection of multiple investments is referred to as portfolio. Mostly large size
organizations and also some individuals maintain a portfolio of their different
investments and hence the risk and return is considered as the entire portfolio risk
and return. Portfolio may be composed of two or more bonds, stocks, securities
and investments or combination of all.
i) This is because trading individual securities creates costs - brokerage costs,
bid-ask spreads and price impact
ii) There is a critical mass value, below which it does not pay to actively manage a
portfolio - it is far better to invest in funds
iii) The larger a portfolio, the more choices become available in terms of assets -
this is largely because some components of trading costs - the brokerage costs
and the spread - may get smaller for larger portfolios.
iv) If a portfolio becomes too large, it might start creating a price impact which
might cause trading costs to start increasing again.