Fi Notes 6

Portfolio construction and evaluation Portfolio construction is a blending together the broad asset classes as to obtain optimum return with minimum risk.A diversification securities gives the assurance of obtaining the anticipated return on the portfolio. Approaches in portfolio construction Basically there are two approaches in portfolio construction viz, 1. Traditional approach 2. Markowitz efficiency frontier approach. In traditional approach, investor’s needs in terms of income and capital appreciation are evaluated and appropriate securities are selected for investment to meet investment needs. Common practice is to evaluate the entire financial plan of the individual and based upon his need and priorities portfolio is selected. Traditinal approach deals with two major decisions Determining objectives of portfolio. Selection of securities to be included in such a portfolio. Normally this is carried out in four to six steps. Before formulating the objectives, the constraints of the investor should be analyzed. Within the given frame work of constraints, objectives are formulated. Then based on the objectives, securities are selected. After that, risk and return of the securities should be studied. The investor has to asses the major risk categories that he is trying to minimize. Compromise on risk and non risk factor has to be carried out. Finally the relative portfolio weights are assigned to securities like bonds, stocks and debentures and then diversification is carried out. 1. Analysis of constraints a. Income needs ( current income and constant income) b. Liquidity c. Safety of principal d. Time horizon e. Tax considerations f. Temperaments of the investors.. 2. Determination of objectives a. Current income b. Growth in income c. Capital appreciation d. Preservation of capital

3 Selection of portfolio. Selection of portfolio depends upon various objectives of investors. A Objective and asset mix. B Growth of income and asset mix. C Capital appreciation and asset mix. D Safety of principal and asset mix. Risk and return analysis. The traditional approach to portfolio building has some basic assumptions. First, the individuals prefers larger to smaller returns from securities. To achieve this goal , investors has to take more risk. The ability to achieve higher returns is dependent upon his ability to judge risk and his ability to take specific risk. These risks may be interest rate risk, purchasing power risk, financial risk and market risk. Diversification. Once the asset mix is determined and risk and return are analysed, the final step is the diversification of portfolio. Financial risk can be minimized by commitments to top quality bonds, but these securities offer poor resistance to inflation. Stocks provide better inflation protection than bond but are more vulnerable to financial risks. Investors has to select industries appropriate to his investment objectives. Each industry corresponds to specific goals of the investors. Likewise investors has to select two or more companies in each industries as a part of diversification.

Markowitz model Modern portfolio theory (MPT)—or portfolio theory—was introduced by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection. Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual securities in constructing their portfolios. Standard investment advice was to identify those securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these. Following this advice, an investor might conclude that railroad stocks all offered good risk-reward characteristics and compile a portfolio entirely from these. Intuitively, this would be foolish. Markowitz formalized this intuition. Detailing a mathematics of diversification, he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that each individually have attractive risk-reward characteristics. In a nutshell, inventors should select portfolios not individual securities.

If we treat single-period returns for various securities as random variables, we can assign them expected values, standard deviations and correlations. Based on these, we can calculate the expected return and volatility of any portfolio constructed with those securities. We may treat volatility and expected return as proxy's for risk and reward. Out of the entire universe of possible portfolios, certain ones will optimally balance risk and reward. These comprise what Markowitz called an efficient frontier of portfolios. An investor should select a portfolio that lies on the efficient frontier.

INVEST TIMINGS AND PORTFOLIO PERFORMANCE EVALUATION Investor must decide about how often portfolio should be revised, as too often or too infrequently is not desirable. If wants to maximise returns – not only buy right shares but buy at right time. FORMULA PLANS THERE are different plans developed to help the investors in deciding about their timing of their investment. These are the Mechanical techniques to beat market through timing Helps more in loss minimization than return maximization. TYPES OF FORMULA PLANS. CONSTANT RUPEE VALUE PLAN This specifies that rupee value of stock portion of portfolio will remain constant. i.e., when value raises – sell some quantity and when value falls– buy some quantity. Portfolio will remain constant in money value. But, this leads to excessive transaction cost and cannot claim full benefit of price movements.

CONSTANT RATIO PLAN This plan establishes a fixed % relationship between aggressive and defensive components. Balance can be adjusted at a fixed interval or when portfolio moves away from desired ratio by a fixed %. But may miss intermediate price movements. VARIABLE RATIO PLAN In case of this plan it is advised to steadily increase aggressive stock portion and decrease defensive stock. Buy more of a stock group when price falls and Sell more of a stock group when price raises. FREE COST AVERAGE Making periodical investment of equal rupee value is the crux of this plan. Such programme leads to purchase of more stocks when price is cheap and buy less when it is costly.

RISK ADJUSTED MEASURE OF PERFORMANCE While evaluating a portfolio two major factors must be established, 1 ability to above avg returns for a given risk 2 ability to diversify ( reduce risk) In portfolio evaluation there is a need to consider rate of return achieved but also level of risk investor is subjected to. How to combine risk and return into index for evaluation of portfolio ? Sharpe, Treynor and Tensen have developed model / index for portfolio measurement consider both risk and return . SHARPE’S – REWARD TO VARIABILITY Involves deducting risk free return from portfolios net avg return, difference is risk premium or reward for investing in risky asset, then it is divided by standard deviation of annual returns. TREYNOR’S REWARD TO VOLATILITY RATIO This plan is similar to sharpes plan but here it considers portfolios beta to measure its risk.

JENSEN’S DIFFERENTIAL RETURM MEASURE. This is based on CAPM concept. Involves two steps, Calculate what return of portfolio should be using CAPM concept Compare it with actual realised return.