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Unit 3

1. Concept of Investment

The term ‘Investment’ refers to the commitment of funds made with the expectation of
generating future benefits.

Investment essentially involves the following characteristics:

 There must be some cash outflow in order to acquire the ownership.

 There must be some expectation of earning future benefits (cash or non-cash). The
benefits are known as returns.
2. Different Types of Assets for Investments

The assets for the purpose of investments can broadly be classified into two groups, namely,
Financial Assets and Real Assets.

Investment in Financial Assets include:

 Compulsory or voluntary contribution to Provident Fund

 Contribution to Public Provident Fund
 Contribution to NPS
 Bank Deposits (including SB A/C, Fixed Deposits and Recurring Deposits)
 Corporate Bonds and Deposits (including Non-Convertible Bonds)
 Treasury Bills (preferably by banks)
 Equity shares (directly from companies through IPO and FPOs or from Stock Market
through de-mat account).
 Preference shares
 Mutual Fund Schemes
 Derivatives

Investment in Real Assets include:

 Real estates
 Precious metals like gold, silver platinum and precious stones like diamond, ruby etc.

Among the two financial assets are often preferred over real assets because they are more
liquid (can be easily sold) and requires low minimum investment.

3. Concept of Portfolio

The dictionary meaning of the term portfolio is a large, thin, flat case for loose sheets of
paper such as drawings or maps. However, in finance literature, the term ‘portfolio’ refers to
a collection of different investment in financial assets or in real assets. Portfolios are held
directly by investors and/or managed by financial professionals and money managers.

Investing in a single asset is never advisable as it would increase the risk of adverse
performance or limit the returns to a moderate level. Thus, allocating the total investible
funds to different assets is always a better idea. When allocated, the collection of different
investment assets is called portfolio.

4. Concept of Portfolio Management

Portfolio management is 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. In other words, it is the art of selecting the right
investment tools in the right proportion to generate optimum returns from the investment and/
or to minimise the returns.

5. Steps in Portfolio Management

Portfolio management involves the following steps.

a) Identification of objectives and constraints: The primary step in portfolio management is

to identify the objectives (income, capital appreciation, minimisation of risk etc.) and
constraints of the investors (fund constraints or other technical difficulties such as not
having a de-mat account etc.)

b) Selection of the asset mix: The next major step in portfolio management process is
identifying different assets that can be included in portfolio in order to spread risk and
minimize loss.

c) Formulation of portfolio strategy: The next step in the portfolio management process is
formulation of an appropriate portfolio strategy. There are two choices for the
formulation of portfolio strategy, namely, an active portfolio strategy; and a passive
portfolio strategy. In case of an active portfolio strategy.

d) Security analysis: In this step various individual securities or assets are analysed to
explore their possible return and risk. The analysis should involve economic analysis,
industry analysis and lastly company analysis (this process is known as fundamental

analysis) for a long-term value investment objective or analysing the past trend in
securities prices in stock market (known as technical analysis).

e) Portfolio execution: In this step actual investment is executed in the selected securities
after all the necessary formalities. The amount of investment is decided based in the
overall plan or objectives of the investor.

f) Portfolio evaluation: In this step, the investor or the financial planner evaluates the
performance of the portfolio by various portfolio performance evaluation tools ranging
from total return to risk adjusted returns, tracking error etc. and thereby identifies the
requirement of any revision in the portfolio in order to better cope up with the economic
scenario or to achieve the short and long term objectives.

g) Portfolio revision: This involves selling out an existing investment and investing the
money realised in another channel or instruments. However, it may sometime also
involve changing the mix of existing constituents in the portfolio already constructed.

6. Objectives of Portfolio Management

The major objectives of portfolio management are:

a) Diversification or Risk Reduction (will be discussed in detail later)

b) Consistency of returns
c) Security of the principal amount
d) Capital growth
e) Liquidity or marketability of investments
f) Favorable tax consideration
7. Return and Risk
While evaluating the performance of any portfolio, the two considerations that play the most
important role are return and risk.

7.1. Concept of Return

Return is the compensation an investor receives from any investment for the uncertainty
involved in such investment and for the deferment of his current consumption. It is the
principal reward from the investment.

Return on any investment comprises of two components namely, income component and
capital gain (or appreciation) component. While income component represents the periodic
payouts of an investment (preferably in cash), capital appreciation component represents the
increase in the value of the initial investment. Investments such as bank deposits offer only
the income component while any market linked instruments (such as shares, bonds traded in
the market and mutual funds) offer both return as well as capital appreciation. Thus, total
return of a security is the sum of income component and capital appreciation.

7.2. Types of Return

Return from an investment can be either Ex-post Return or Ex-ante Return.
7.2.1. Ex-post Return
Ex-post return, also called realized return, refers to the return that has been earned or realized.
Thus, it is historical in nature.

The formula for calculating ex-post return is given by,

Rt = Regular return + capital appreciation = +

Ex-post return for a given period is also known as holding period return (HPR).

The above formula is for Single Period Ex-Post Return. For multi period investments, an
investor can calculate either Total Return or Average Return. Average Return can be
calculated using either simple average (arithmetic mean) or geometric average (geometric

An ‘n’ year multi period total return or holding period return = [(1+R1) (1+R2)…..(1+Rn)] –

Arithmetic Average Return ( ) = where Rt = ex-post return for period t; n = no. of


In case single period ex-post returns are negative, the Arithmetic Average Return produces
somewhat misleading results. This is why Geometric Mean Return is preferred. It is
calculated as follows:

Geometric Mean Return = [(1+R1) (1+R2)…..(1+Rn)] – 1.

It is also known as Compound Annual Rate of Return.

Consider the following example.

The price movement and dividend per share of RIL is given below.

Financial Year Price at the end (Pt) (Rs.) Dividend Received (Dt) (Rs.)
2010-11 600 45
2011-12 650 30
2012-13 720 25
2013-14 760 40
2014-15 800 35
2015-16 850 45
2016-17 830 50
2017-18 870 55
2018-19 900 60
You are required to calculate, for the period 2011-12 to 2018-19:
a) Single period ex-post returns
b) Arithmetic average return
c) 8 year holding period return
d) Compound annual rate of return

Single period ex-post return is given by,

Rt = +

Calculation for single period ex-post returns

Financial Pt Dt Rt (%)
2010-11 600 45 ----- ----- ------
2011-12 650 30 = 0.13

2012-13 720 25 = 0.15

2013-14 760 40 = 0.11

2014-15 800 35 = 0.10

2015-16 850 45 = 0.12

2016-17 830 50 = 0.04

2017-18 870 55 = 0.11

2018-19 900 60 = 0.10

Total 0.86

Arithmetic Average Return ( ) = = 0.86/8 = 0.10 = 10%.

8 year holding period return = [(1+R1) (1+R2)…..(1+Rn)] – 1

= [(1+0.13)(1+0.15)(1+0.11)(1+0.10)(1+0.12)(1+0.04)(1+0.11)(1+0.10)] – 1 = 2.26 -1

= 126%

Compound annual rate of return = (2.26)1/8 – 1 = 1.107 – 1 = 0.107 = 10.7%.

Note: While calculating the return, appropriate adjustment has to be made for bonus and
stock split declaration.

Note: Annualized HPR:

For holding period less than one year, annualized return can be calculated as follows:

Annualized HPR = (1+ HPR)365/52/12 ÷ holding period -1

For example, if 3 month HPR is 6%, then Annualized HPR = (1+0.06)12/3 – 1 = 26%. This is
also known as effective return.

Note: Real Return:

It is inflation adjusted return. It is calculated as follows:

Real Return = ( ) – 1.

For example, if HPR is 12% with inflation rate 2%, then real return = -1= 9.8%.

7.2.2. Ex-ante Return

Ex-post return gives only a historical view. Thus, to evaluate the prospective performance,
we need to calculate ex-ante i.e. anticipated return. Its calculation requires two components –
the possible return (Ri) and the probability associated with that return (Pi).

Ex-ante Return = E(R) = where i = alternative states of nature (scenario).

Consider the following example:

Scenario Ri Pi Ri ˟ Pi
Boom 0.20 0.2 0.04
Moderate 0.15 0.5 0.075
Recession 0.10 0.3 0.03
1.0 0.145

So, ex-ante return is 14.5%.

Ex-ante return is helpful in selecting an investment opportunity, while ex-post return is

helpful in evaluating the performance of an existing investment.

7.3. Concept of Risk

In making an investment decision, assessing the return is not enough. This is because, a
measurement of average historical rate of return does not necessarily mean that in every year
the investor realised the same return and hence, in future also the actual return may not be the
same with expected return. This uncertainty associated with an investment is called risk. Risk
is measured in terms of variability or dispersion of actual return from the average or expected
return. Again, risk can be calculated as ex-post (historical) risk or ex-ante (anticipated) risk.

7.3.1. Ex-post Risk

It refers to the risk that has been realized or experienced. It is generally calculated as the
standard deviation of actual return from the mean return for a given period. It is used to
identify the risk of an investment already made and held for a period of time.

The formula to calculate the ex-post risk is as follows:

Ex-post Risk = Standard Deviation = σ = .

In some literature, however, is used instead of .

Consider the following example:

Calculate historical risk based on the following return data.

Year (t) 1 2 3 4 5
Return (Rt) (%) 5 10 20 10 5

Calculation of historical risk.

Year (t) Rt (%) (%)

1 5 25
2 10 0
3 20 100

4 10 0
5 5 25
Total 50 150
So, Mean return = = 50/5 = 10%

So, risk = S.D = *150 = = 5.48%.

7.3.2. Ex-ante Risk

While ex-post risk measures how variable was our earnings over the time, it is hardly useful
in determining the potential of an investment. Such an analysis requires calculation of
estimated risk or ex-ante risk. Ex-ante risk measures the variability of different possible
returns against the estimated return. It is basically a probabilistic estimation.

Ex-ante or estimated risk calculated by the following formula.

Risk = S D = σ =

Consider the following example.

Calculate the ex-ante return from the following information.

Scenario Boom Moderate Recession

Return (Ri) (%) 20 15 10
Probability (Pi) 0.2 0.5 0.3

Calculation of ex-ante risk

Scenario Return Probability Ri Pi [Ri – E(R)] [Ri – E(R)]2 Pi [ Ri – E(R)]2

(Ri) (%) (Pi)
Boom 20 0.2 10.0 1.0 1 0.2
Moderate 12 0.5 6.0 -7.0 14 7.0
Recession 10 0.3 3.0 -9.0 81 24.3
19.0 96 31.5

Ex-ante Risk = σ = = 5.61%

7.4. Selection of Securities based on Mean-Variance Criteria
Once an investor determines the estimated return and risk of possible investment alternatives,
he or she needs to make a proper selection of investments. Though a large number of
qualitative as well as quantitative factors may play important role in this respect, the
estimated return (i.e. mean return) and the risk or standard deviation (square root of variance)
are considered to be the prime factors for selection. This is also known as mean-variance
criterion for selection of investment alternatives. However, the selection also depends on the
attitude of the investor. Based on his attitude towards risk an investor can be a risk seeker,
risk neutral or risk averse investor.

A risk seeker is a person who is always ready to take more risk in anticipation of higher

A risk neutral is a person who does not consider risk while making investment decision.

A risk averse is a person who wants to avoid risk. However, a risk averse investor will also be
ready to take additional risk if the additional risk is adequately compensated by additional
return as per his expectation.

Accordingly, given the choice between two securities, the selection will be in the following

a) If two alternatives provide the same return, investors of all risk classes will select the
alternative with lower risk.
b) If two alternatives provide the same risk, investors of all risk classes will select the
alternative with higher return.
c) (i) If higher return comes with lower risk, then investors of all risk classes will select the
alternative with higher return (which also has lower risk).
(ii) If higher return comes with higher risk, then
 a risk seeker investor will always select the alternative with higher return (which
also has higher risk).
 a risk neutral investor will ignore the risk and will select the alternative with
higher return.
 a risk averse investor may, however, settle down with the alternative with lower
return just to avoid taking more risk.

Note: In this situation also a risk averse investor may opt for the alternative with higher risk
(and higher return) if the additional risk is adequately compensated by additional return as per
his expectation.

Consider the following example.

Situation 1: Given, E(RA) = E(RB) = 15%, but σA = 12% and σB = 10%.

Since the two alternatives provide the same return, investors of all risk classes will select the
alternative with lower risk i.e. alternative B.

Situation 2: Given, E(RA) = 20% E(RB) = 15%, but σA = σB = 10%.

Since the two alternatives provide the same risk, investors of all risk classes will select the
alternative with higher return i.e. alternative A.

Situation 3: Given, E(RA) = 20% E(RB) = 15% and σA = 10% and σB = 12%.

Here, higher return comes with lower risk. So, investors of all risk classes will select the
alternative with higher return i.e. alternative A.

Situation 4: Given, E(RA) = 20% E(RB) = 15% and σA = 13% and σB = 12%.

Here, higher return comes with lower risk.

 a risk seeker investor will always select the alternative with higher return (which
also has higher risk) i.e. alternative A.
 a risk neutral investor will ignore the risk and will select the alternative with
higher return i.e. alternative A.
 a risk averse investor may, however, settle down with the alternative with lower
return just to avoid taking more risk. So, he may select alternative B.

However, if the risk averse investor is satisfied with say, 4% additional return for every 1%
additional risk, he may select security A as it offers 5% additional return (as compared to B)
for additional 1% risk. Thus, the return to risk ratio plays an important role here.

7.5. Correlation between Two Securities:

Correlation measures the association between the returns of two securities. Portfolio risk
depends on this correlation.

Historical correlation is calculated as =

Ex-ante correlation is calculated as = Covariance (x,y) ÷ σx.σy

= ÷ σx .σy

Consider the following example.

Calculation of expected return
Scenario Rxi (%) Ryi (%) Pi Rxi ˟ Pi Ryi ˟ Pi
A -10 5 0.2 -2 1
B 25 30 0.4 10 12
C 20 20 0.3 6 6
D 10 10 0.1 1 1
1.0 15 20
So, E(Rx) = 15% and E(Ry) = 20%.
Calculation of risk
Scenario [Ri – E(R)]2 Pi [ Ri – E(R)]2 [Ri – E(R)]2 Pi [ Ri – E(R)]2
A 625 125 225 45
B 100 40 100 40
C 25 7.5 0 0
D 25 2.5 100 10
175 95
σx = = 13.2287% and σy = = 9.7468%.
Calculation for correlation
Scenario [Rxi – E(Rx)] [Ryi – E(Ry)] [Rxi – E(Rx)]× [Ryi – Pi[Rxi – E(Rx)]× [Ryi –
E(Ry)] E(Ry)]
A -25 -15 375 75
B 10 10 100 40
C 5 0 0 0
D -5 -10 50 5

Correlation = = ÷ σx .σy

= = 0.9307

7.6. Expected Return and Risk of a Portfolio:
For two securities, portfolio return is calculated as follows.
E(RP) = Wx E(Rx) + Wy E(Ry) where ‘w’ refers to the weight i.e. proportional investment.

σP =

For three securities, the formula will be as follows:

E(RP) = Wx E(Rx) + Wy E(Ry) + Wz E(Rz)

σP =

Consider the following example.

Given, E(Rx) = 20% E(Ry) = 15% and σx = 12% and σy = 10% and = -0.6

Then, for wx = 0.5 and Wy = 0.5,

E(RP) = Wx E(Rx) + Wy E(Ry) = 0.5 20 + 0.5 15 = 17.5%

σP =

= 5%
Consider another example.
Given, E(Rx) = 20% E(Ry) = 15% and E(Rz) = 12% σx = 12%, σy = 10% σz = 8%
and = -0.6 = -0.4 and = -0.2

Then, for wx = 0.5 and Wy = 0.3 Wz = 0.2,

E(RP) = Wx E(Rx) + Wy E(Ry) = 0.5 20 + 0.3 15 + 0.2 12 = 16.9%

σP =

= – –

= 4.27%
 Portfolio Risk Calculation - Some Special Cases:
The formula for calculating portfolio risk can be further simplified under the following
situations (values of correlation coefficient).

Value of Correlation Coefficient Portfolio Risk
= -1 σP =
=0 σP =
= +1 σP =
All other cases σP =

However, in all the cases, the formula for portfolio return remains the same.
7.7. Diversification – The Driving Force behind Portfolio Formation

There is a old saying that do not put all your eggs in one basket. The same is applicable for
investment also. Given the choice between two securities, if any investor selects only one
alternative, his risk and return will simply be the replication of the investment alternative he
has selected. In such a case if the alternative faces adverse market movement, entire
investment may be at a stake. Thus, it is suggested that forming a portfolio would be a better
idea. Though, it may lead to an average return, obviously lower than the better among the two
alternatives, if properly selected, it may lead to reduction of risk. This process of reducing the
portfolio risk by combining appropriate investment alternatives is known as diversification.

7.7.1. Systematic vs. Unsystematic Risk

Systematic risk refers to the volatility in return due to various macroeconomic factors which
are beyond the control of a single firm, for example, interest rate, inflation rate etc. Thus, this
risk is economy specific and uncontrollable. Formation of portfolio can never reduce this
risk. Hence, it is also called non-diversifiable risk. Some of the systematic risk are purchasing
power risk, interest rate risk etc.

On the other hand, unsystematic risk is firm specific and often arises due to the inefficient
management, faulty capital structure of the firm etc. Formation of portfolio can reduce this
risk and hence this is called diversifiable risk.

7.7.2. Types of Diversification Strategies

There are two types of diversification strategy available – Naive Diversification and
Markowitz Diversification.

These are discussed as follows.

A. Naive Diversification

Naïve diversification says that an investor or analyst over the time can identify which
securities can be combined together to form a portfolio. There is no hard and fast rule about
this. As a result, the recommendation is highly subjective and often cannot backed by any
objective argument.

B. Markowitz Diversification

As against Naïve Diversification, Markowitz diversification strategy relies on the mean-

variance principle of portfolio risk and return calculation and objectively shows that portfolio
formation can reduce risk.

 Markowitz Rule for Diversification

According to Markowitz, a portfolio based on securities whose returns have negative or zero
correlation or weakly positive correlation can effectively reduce the diversifiable risk and
hence total risk.

 Proof of Markowitz Rule for Diversification

Suppose, there are two securities A and B with the following return and risk.

E(Rx) = 20%, E(Ry) = 15% and σx = 12%, σy = 10%, Wx = 50% and Wy = 50%.

Portfolio return and risk at different values of correlation coefficient will be as follows:

Value of Portfolio Return Portfolio Risk

= -1 E(RP) = Wx E(Rx) + Wy E(Ry) σP =
= 0.5*20 + 0.5*15 = 17.5% = 1%
= -0.5 17.5% σP =
= 5.57%
=0 17.5% σP =
= 7.81%
= + 0.5 17.5% σP =
= 9.54%
=+1 17.5% 11%
Thus, it can be seen that the more the correlation approaches to -1, the higher is the
diversification benefits.

 When diversification is not beneficial?

Very high positive correlation often hinders diversification benefits. The general rule is, for
diversification to be effective, correlation coefficient must be lower than ‘Lower S.D to
Higher S.D’ ratio.

In the previous example, Lower S.D to Higher S.D ratio = 10/12 = 0.83.

Thus, correlation higher than 0.83 will render diversification ineffective.

For example, if = 0.9, σP = = 10.72%.

It may be noted that the portfolio risk is higher than the risk of security B which is the lower
risky security. Thus, here, portfolio cannot reduce the risk.

7.7.3. Risk Minimization Through Diversification

Formation of portfolio can reduce the diversifiable risk (or unsystematic risk). As a result, the
investor changes his securities weight in such a manner that can reduce portfolio risk to its

 Concept of Minimum Variance Portfolio:

The portfolio which has been constructed in such a way that its risk (measured in terms of
S.D or variance) has become the minimum is known as minimum variance portfolio.

 Determination of Optimum Weights:

The weights of individual securities for which the portfolio variance (i.e. risk) becomes
minimum are known as optimum weights. Mathematically, these can be obtained by setting
the first order derivative of portfolio variance as zero and obtaining values of weights for
which the second order derivative is positive.

The general rule is as follows:

Wx = and Wy = 1 - Wx

Under special cases, when = 0, Wx = and Wy = 1 - Wx.

Similarly, when = - 1, Wx = and Wy = 1 - Wx.

Consider the following example.

Given, E(Rx) = 20%, E(Ry) = 15% and σx = 12%, σy = 10% and = 0.6

The optimal weights are:

Wx = = = 28% and Wy = 1 - Wx = 72%

At these weights σP = = 9.17% which is the minimum

variance portfolio.

If = 0, Wx = = = 41% and Wy = 1 - Wx = 59%.

If = - 1, Wx = = 45% and Wy = 1 - Wx = 55%.

Note: For = - 1, the optimum weights will completely eliminate the portfolio risk (i.e. it
will become zero).
Model MCQs (Answers given in bold)
1. Which of the following is a financial asset?
A. Diamond
B. Real estate
C. Gold
D. Fixed Deposits of Banks
2. Which of the following instruments is not free from default risk?
B. Kishan Vikas Patra
C. Sukanya Samridhi Scheme
D. Deposits in Non-Banking Finance Companies
3. Which of the following is the formula to calculate real return?
A. Nominal return + inflation rate
B. Nominal return – inflation rate


D. -1

4. Which of the following investments provide inflation adjusted return?

A. Investment in LIC
B. Investment in real estate
C. Investment in fixed deposits of banks
D. Investment in corporate bonds

5. If return from an investment in 3 months is 10%, what will be the annualized return or
effective annual return?
A. 21%
B. 20%
C. 46.41%
D. 11%
6. Mr. X invested in the shares of RIL when the price per share was Rs. 100. During the
period of holding he received dividend of Rs. 5. If he sold the investment at Rs. 120, what
will be his holding period return?
A. 25%
B. 20%
C. 18%
D. 10%
7. Under portfolio management, the primary objective behind constructing a portfolio is
A. Maximization of return
B. Minimization of risk
C. Wealth accumulation
D. Regular earning
8. Mr. Y predicts three outcomes of economic scenario viz. Boom, Moderate and Recession
with probabilities 0.1, 0.7 and 0.2. If the possible returns under those scenarios are 20%,
14% and 10% respectively, what will be the expected or ex-ante return?
A. 13.8%
B. 15%
C. 20%
D. 10%
9. If E(RA) = E(RB) and σA < σB, a risk averse investor will prefer
A. Security A
B. Security B
C. Anyone of security A and B
D. Neither of security A and B
10. If E(RA) = 10% and E(RB) = 8% and an investor invests 40% in A and 60% in B, then
expected return of the portfolio will be
A. 17%
B. 8.8%
C. 20%
D. 15%
11. Given, correlation coefficient between the returns of security A and B = -1. If risk of the
securities are given by σA = 15% and σB = 10% with weights of 50% each, then σP will be
A. 18%
B. 10%
C. 8%
D. 2.5%
12. In which of the following cases diversification is not beneficial?
A. When the correlation between returns is negative
B. When the correlation between returns is negative

C. When correlation is positive but less than

D. When correlation is positive but more than

13. Calculate risk minimizing portfolio weights if σA = 20% and σB = 15% and rAB = -1.
A. WA = 0.375 and WB = 0.625
B. WA = 0.43 and WB = 0.57
C. WA = 0.5 and WB = 0.5
D. WA = 0.125 and WB = 0.875
14. A portfolio of two securities can eliminate the risk completely only when the value of
correlation coefficient between their returns is
A. +1
B. 0
C. -1
D. -0.5