Introduction to portfolio management

 A Portfolio refers to a collection of investment tools such as
stocks, shares, mutual funds, bonds, cash and so on
depending on the investor’s income, budget and convenient
time frame.

 Portfolio management is the art of selecting the right
investment policy for the individuals in terms of minimum risk
and maximum return.

 It refers to managing an individual’s investments in the form
of bonds, shares, cash, mutual funds etc so that he earns the
maximum profits within the stipulated time frame.

 In plain terms, it is managing money of an individual under
expert guidance of portfolio managers.

1. Portfolio management presents the best investment plan
to the individuals as per their income, budget, age and
ability to undertake risks.

2. Portfolio management minimizes the risks involved in
investing and also increases the chance of making profits.

3. Portfolio management enables the portfolio managers to
provide customized investment solutions to clients as per
their needs and requirements.

TYPES OF PORTFOLIO
MANAGEMENT

Discretionary Non Discretionary Advisory

 Discretionary Portfolio management: An individual
authorizes a portfolio manager to take care of his financial
needs on his behalf. The individual issues money to the
portfolio manager who in turn takes care of all his investment
needs, paper work, etc

 Non-Discretionary Portfolio management: The portfolio
manager suggests investment ideas. Choice and timings of
investment depends with investor. However, execution of
trade is done by the portfolio manager.

 Advisory Portfolio Management: Portfolio manager only
suggests investment ideas. Decision taking and execution is
done by investor himself.

1. Effective investment planning considering following
factor:-

• Fiscal, financial and monetary policies

• 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

2. Constant review of Investment:-
• To assess the quality of the management of the companies in
which investment has been made or proposed to be made

• To assess the financial and trend analysis of companies
financials to identify the optimum capital structure and better
performance for the purpose of withholding the investment
from poor companies.

• To analysis 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.

R a te o f re tu rn D iv id e n d yie ld C a p ita l g a in yie ld

D IV 1 P1 P0 D IV 1 P1 P0
R1
P0 P0 P0
The return of a portfolio is equal to the weighted average of
the returns of individual assets (or securities) in the portfolio
with weights being equal to the proportion of investment
value in each asset.
Expected return:

where is the return on the portfolio, is the return on
asset i and is the weighting of component asset (that is,
the proportion of asset "i" in the portfolio).

Portfolio value = Rs 2,00,000 + Rs 5,00,000 = Rs 7,00,000
rA = 14%, rB = 6%,
wA = weight of security A = Rs 2 lacs / Rs 7 lacs = 28.6%
wB = weight of security B = Rs 5 lacs / Rs 7 lacs=71.4%

Solution:-

n

ER p
( wi ER i ) (.286 14 % ) (.714 6% )
i 1

4 . 004 % 4 . 284 % 8 . 288 %

Assume ERA = 8% and ERB = 10%
10.50

10.00
ERB= 10%

9.50

9.00
Expected Return %

8.50

8.00

7.50 ERA=8%

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

A portfolio manager can select the relative weights of the two assets
in the portfolio to get a desired return between 8% (100% invested in
A) and 10% (100% invested in B)
10.50

10.00
ERB= 10%

9.50

9.00
Expected Return %

8.50

8.00

7.50 ERA=8%

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

10.50

10.00 ERB= 10%

9.50
The potential returns of
9.00 the portfolio are
Expected Return %

bounded by the highest
8.50 and lowest returns of the
individual assets that
8.00 make up the portfolio.

7.50
ERA=8%
7.00

0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

10.50

10.00 ERB= 10%

9.50

9.00
Expected Return %

8.50 The expected return on the
portfolio if 100% is invested in
8.00 Asset A is 8%.

7.50
ER p
w A ER A
w B ER B (1 . 0 )( 8 %) ( 0 )( 10 %) 8%
ERA=8%
7.00

0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

10.50

10.00 ERB= 10%

9.50

9.00
Expected Return %

8.50

8.00
ER p
w A ER A
w B ER B
( 0 )( 8 %) (1 . 0 )( 10 %) 10 %
7.50

ERA=8% The expected return on the
7.00
portfolio if 100% is invested in
Asset B is 10%.

0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

10.50 The expected return on
the portfolio if 50% is
10.00 invested in Asset A and ERB= 10%
50% in B is 9%.
9.50

9.00
Expected Return %

ER p
w A ER A
w B ER B
8.50
( 0 . 5 )( 8 %) ( 0 . 5 )( 10 %)
8.00 4% 5% 9%
7.50
ERA=8%
7.00

0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

The degree to which the returns of two stocks co-movement is
measured by the correlation coefficient (ρ).
COV AB
AB
A B

Correlation is important because it affects the degree to which
diversification can be achieved using various assets.

Theoretically, if two assets returns are perfectly positively
correlated, it is possible to build a riskless portfolio with a return
that is greater than the risk-free rate.

Portfolio Risk(Standard Deviation):-

Portfolio Return Variance:-

Where is the correlation coefficient between the returns on
assets i and j

The riskiness of a portfolio that is made of different risky assets
is a function of three different factors:
1. the riskiness of the individual assets that make up the
portfolio
2. the relative weights of the assets in the portfolio
3. the degree of co-movement of returns of the assets making
up the portfolio

2 2 2 2
p
(wA ) ( A
) (wB ) ( B
) 2 ( w A )( w B )( COV A,B
)

Risk of Asset A
adjusted for Risk of Asset B
weight in the Factor to take into
adjusted for account co-movement
portfolio weight in the of returns.
portfolio

Probability The range of total possible
returns on the stock A runs from
-30% to more than +40%. If the
required return on the stock is
Outcomes that produce harm 10%, then those outcomes less
than 10% represent risk to the
investor.

-30% -20% -10% 0% 10% 20% 30% 40%
Possible Returns on the Stock

 Beta is a measure of the volatility or systematic risk of a
security or a portfolio in comparison to the market as a
whole.
 It is the tendency of a security’s return to respond to swings
in the market.
 The Beta of a portfolio is the weighted sum of the individual
asset betas i.e. according to the proportion of the
investments in the portfolio.
 The formula for beta of an asset is:-

Value of
Interpretation Example
Beta

Asset generally moves in the opposite direction Gold, which often moves opposite to the movements of
β<0
as compared to the index t he stock market

Movement of the asset is uncorrelated with the Fixed-yield asset, whose growth is unrelated to the
β=0
movement of the benchmark movement of the stock market

Movement of the asset is generally in the same Stable, "staple" stock such as a company that makes
0 < β < 1 direction as, but less than the movement of the soap. Moves in the same direction as the market at
benchmark large, but less susceptible to day-to-day fluctuation.

Movement of the asset is generally in the same
A representative stock, or a stock that is a strong
β=1 direction as, and about the same amount as the
contributor to the index itself.
movement of the benchmark

Movement of the asset is generally in the same
Volatile stock, such as a tech stock, or stocks which are
β>1 direction as, but more than the movement of
very strongly influenced by day-to-day market news.
the benchmark

 Direct Method—The ratio of covariance between market
return and the security’s return to the market return variance:

C ovar j, m
j
= 2
σ m

σ j σ m C or j, m σj
= = C or j, m
σm σm σm

 The Market Model—In the market model, we regress returns
on a security against returns of the market index:-

Rj j
Rm ej

Determinants
of Beta

Nature of Operating Financial
Business Leverage Leverage

Nature of Business:
 If we regress a company’s earnings with the aggregate
earnings of all companies in the economy, we would obtain a
sensitivity index, which we can call the company’s accounting
beta.
 The real or the market beta is based on share market returns
rather than earnings.
 The accounting betas are significantly correlated with the
market betas. This implies that if a firm’s earnings are more
sensitive to business conditions, it is likely to have higher
beta.
 We must distinguish between the earnings variability and the
earnings cyclicality.

Operating Leverage:
The degree of operating leverage is defined as the change in a
company’s earnings before interest and tax due to change in
sales. Operating leverage intensifies the effect of cyclicality on a
company’s earnings.

Financial Leverage:
Financial leverage refers to debt in a firm’s capital structure.
Since financial leverage increases the firm’s (financial) risk, it will
increase the equity beta of the firm.

 Beta has no upper or lower bound, and betas as large as 3 or
4 will occur with highly volatile stocks.
 Beta can be zero. Some zero-beta assets are risk-free, such as
treasury bonds and cash.
 A negative beta simply means that the stock is inversely
correlated with the market.
 A negative beta might occur even when both the benchmark
index and the stock under consideration have positive
returns. The slope of the regression line in such a case will be
negative.
 If beta is a result of regression of one stock against the market
where it is quoted, betas from different countries are not
comparable.


 For an unlevered (all-equity) firm, the asset beta and the
equity beta would be the same.
 For a levered firm, the proportion of equity will be less than 1.
Therefore, the beta of asset will be less than the beta of
equity. The beta of equity for a levered firm is given as
follows:

D eb t
E A
1
E q u ity

 Industry Beta: The use of the industry beta is preferable for
those companies whose operations match up with the
industry operations. The industry beta is less affected by
random variations.

 Company Beta:Those companies that have operations quite
different from a large number of companies in the industry,
may stick to the use of their own betas rather than the
industry beta.

Introduction to portfolio management

Introduction to portfolio management

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