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 prespecified 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 (10050)/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 twodimensional 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 isoutility 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 shortfall 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 R f 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. Valueat-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 tstatistic 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 capitalweighted 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 ones 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 investors 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 investors 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

Reserve Bank of India.

of the Govt. of India

and the

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 investors 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 individuals 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 investors
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 ones 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 investors 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 investors 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 investors
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 tradeoff between expected returns and risk which depends upon each investors 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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