Colombo Stock Exchange (CSE) Workshop Portfolio Management Dr.

P D Nimal

6/26/2012

Prepared by P D Nimal

Objectives
This discussion consists of:

Introduction to PM Investor Behavior and Investor Objective Nature of Risk and Return Portfolio Risk and Portfolio Return Efficient Frontier Capital Market Line (CML) Components of Risk Characteristic Line (CL) Security Market Line (SML) Lessons for Investors

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Introduction to Portfolio Management

Investment Environment

Available Instruments Treasury Bills & Bonds Deposits Corporate Bonds Stocks Security Markets Money and Capital Primary & secondary Institutions Regulators Financial Intermediaries Colombo Stock Exchange Brokering Firms
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Investments
Financial Assets

Direct investing

Indirect investing
Ex. mutual fund

Money market ins.

Capital market ins.

Derivative ins.

Fixed income ins.

Equity ins. 4

Risk and Return

More Risk = More Return Do you Agree?

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Investor Behavior & Objective

Do you satisfy with a certain amount of return? Nonsatiation If the Stock Market Return is same as T-Bills, do you like to Invest in Stocks? Risk Aversion
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Investor Behavior & Objective

Do you take risk without a reward?

No

To take risk investors expect high return

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Risk and Return

Measure of Return

Average Return

Holding period return Measure of Risk

Standard Deviation (STDEV)

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Risk and Return of Assets CSE

CSE-WS.xlsx

Nature of Risk and Return of Data from the CSE

See Table-1
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Risk and Return -Individual asset CSE-WS.xlsx

Price Year 1 2 3 4 5 AssetA 100 125 110 165 99 Average STDEV 25.00 12.00 50.00 40.00 5.75 39.74 Return AssetA

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Portfolio Investment

Is it better to invest in one or two selected stocks or in a portfolio of assets? Portfolio is better Why? Diversification advantage What is Diversification Advantage?
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Risk and Return Portfolio CSE-WS.xlsx

Report (75:25) 8.25 8.25 19.75 10.50 3.75 5.30 11.29 RePort (50:50) 1.5 1.5 21.5 3 2.5 5.40 9.17 RePort (25:75) 5.25 5.25 23.25 4.5 8.75 5.50 11.63
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Year 1 2 3 4 5 Average STDEV

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ReA 15.00 15.00 18.00 18.00 10.00 5.20 16.30

ReB 12.00 12.00 25.00 12.00 15.00 5.60 16.77

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Risk and Return Portfolio CSE-WS.xlsx

Return & Risk Wa 100 75 50 25 0 Wb STDEV Average 0 25 50 75 100 16.30 11.29 9.17 11.63 16.77 5.20 5.30 5.40 5.50 5.60
5.65 5.60 5.55 5.50 5.45 5.40 5.35 5.30 5.25 5.20 5.15 8.00

10.00

12.00

14.00

16.00

18.00

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Efficient Frontier
When we draw the efficient frontier of all the stocks in the market, it looks like bellow.
Mean

Mean-Variance EF

EF is From the lowest risk to upwards, because it gives gives The Highest Return at a given level of STD and The lowest STD at a given level of Return
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Inefficient Assets & Portfolios

VAR

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Risk and Return of Assets CSE

CSE-WS.xlsx

Nature of Risk and Return of Data from the CSE

See Table-1 & 2
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Summary-CSE
Stock/Port ReBINN(A) ReBFL(B) ReHNB(C) ReASPI ReMPI ReEWP(AB) ReEWP(ABC) 5.70 9.91 0.47 2.09 1.05 7.81 5.36

from 12/09 to 02/12

STDEV 28.20 26.29 12.82 7.56 7.68 20.21 14.23

Average

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Risk and Return High return can be made only with High Risk

Will High Risk end up with High Return always?

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Bull and Bear Market CSE 12/09 to 02/12

ASPI
9,000.0 8,000.0 7,000.0 6,000.0 5,000.0 4,000.0 3,000.0 2,000.0 1,000.0 0.0 Aug-10 Jun-11 May-10 Sep-11 Nov-10 Feb-11 Dec-11 Apr-12 Oct-09 Jan-10 Jul-12

Bear Bull

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Risk and Return Individual assets and portfolios

Data from the CSE See Table-3 & 4 for the period from Dec. 2009 to Feb. 2011 A Bull Market CSE-WS.xlsx

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Risk and Return Individual assets and portfolios

Data from the CSE See Table-5 & 6 for the period from March 2011 to Feb. 2012 A Bear Market CSE-WS.xlsx

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Bull and Bear Market CSE Summary from 12/09 to 02/12

Stock/Port TBRate ReBINN(A) ReBFL(B) ReHNB(C) ReASPI ReMPI ReEWPAB ReEWPABC
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Total 12/09 02/12 0.66 5.70 9.91 0.47 2.09 1.05 7.81 5.36

BullM 12/09 02/11 0.67 7.13 24.85 6.71 6.38 4.81 15.99 12.90

BearM 03/11 02/12 0.64 4.03 7.52 6.81 2.91 3.35 1.74 3.43
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Risk & Return Importance of T-Bills and T-Bonds

Thus, It is not advisable to invest all your funds in the share market, you should invest some of the funds in T-bills and T-bonds where the return is guaranteed either it is a bull or a bear market Average Return of the T-bill were about 0.6% (about 8% pa) regardless of the state of the economy.
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Capital Market Line (CML) EF with Risk free Assets

With risk-free lending and borrowing, the CML is as follows (Rf-M-Z). The tangency portfolio would be the market portfolio.

Expected Return, rp ^ rM Rrf A

Z M

.
M

The Capital Market Line (CML): Rrf-M-Z Risk, p

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Adding Stocks to a Portfolio

What would happen to the risk of a portfolio as more randomly selected stocks were added? p would decrease because the unsystematic risk is diversified

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Risk vs. Number of Stock in Portfolio

p
35%

Company Specific (Diversifiable) Risk

20%

Systematic or market Risk, p

0 10 20 30 40 2,000 stocks 25

Market risk & Diversifiable risk

Market risk is that part of a securitys risk that cannot be eliminated by diversification. Firm-specific, or diversifiable, risk is that part of a securitys risk that can be eliminated by diversification. As more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio. p falls very slowly after about 40 stocks are included. The lower limit for p is M

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Component of Risk
Total Risk = Systematic Risk + Unsystematic Risk

When you add more and more stocks to the portfolio, the unsystematic risk gets reduced and The risk that you bear is the Systematic Risk (SR) of individual stocks What is the measure of SR of return of a stock It is the beta of the stock.
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Relevant measure of risk Portfolio

The relevant measure of risk of a stock in a well diversified portfolio is its Beta and Not the STDEV of the returns of the stock.

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Characteristic Line (Beta estimation) CSE-WS.xlsx

ReASPI 7.41 4.72 2.19 12.47 1.15 8.86 11.90 9.63 23.67 4.56 3.64 3.12 8.12 8.68 7.33 1.81 0.83 7.98 0.28 0.50 1.39 6.84 3.67 0.21 6.26 4.61 ReBFL 19.39 18.80 2.16 44.12 6.63 33.97 1.43 76.76 57.53 9.96 1.24 51.05 44.77 13.16 1.64 9.50 6.70 21.14 1.67 20.40 3.10 16.69 3.36 3.09 10.60 20.85

Characteristic Line for BFL

100.00 80.00 60.00 40.00 20.00 0.00 0.00

Re-BFL = 2.464Rm + 4.748

-10.00

-5.00

5.00

10.00

15.00

20.00

25.00

30.00

-20.00 -40.00

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Relevant measure of risk Portfolio CSE-WS.xlsx

Stock/Port ReBINN ReBFL ReHNB ReASPI ReMPI ReEWPAB ReEWPABC STDEV 28.20 26.29 12.82 7.56 7.68 20.21 14.23 27.24 22.43 WAofSTDev Beta 0.15 2.46 0.95 1.00 0.93 1.30 1.19 1.30 1.19 WAofBeta

Portfolio STDEV is not the weighted average of STDEVs 6/26/2012

Portfolio Beta is the weighted average of Betas 30

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Security Market Line (SML)

E Ri R f i E Rm R f

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Capital Asset Pricing Model (CAPM) cont

Security Market Line (SML)
When the beta risk of securities or portfolio is

Equal to 1, the expected return is equal to the market ER. Less than 1, the expected return is less than the market ER. Greater than 1, the expected return is greater than the market ER.
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Beta and Return-CSE

Stock/Port ReBINN(A) ReBFL(B) ReHNB(c) ReASPI ReMPI ReEWP(AB) ReEWP(ABC)
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Average/Re 5.70 9.91 0.47 2.09 1.05 7.81 5.36

STDEV 28.20 26.29 12.82 7.56 7.68 20.21 14.23

Beta 0.15 2.46 0.95 1.00 0.93 1.30 1.19

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Risk and Return

Does any measure of risk, STDEV or Beta guarantee high return for high risk? No Thus, High risk takers should be prepared to face both high return as well as Low or even Negative Return
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Lessons for Investors

To earn more you have to take high risk and High risk may or may not end up with high return. Thus, risk management is very important Divide the Total funds into two on your risk preference Invest certain amount in T-Bills and T-Bonds or Deposits Invest the Balance in a well diversified portfolio (about 20 to 30 stocks)
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