Portfolio Management

Portfolio is a collection of different financial investments held by a person at a point of time. These financial investments might include equity shares, debentures, preference shares, fixed deposit schemes of companies, etc.

 Portfolio creation is done on the basis of certain fundamental principles which are applicable universally and followed by the portfolio managers for either maximization of the return or minimization of risk. These principles are also called as notion of portfolio. These are as follows: Notion of Diversification Notion of Negative Correlation

 Notion of Diversification The fundamental of portfolio creation emphasizes that a portfolio should contain large number of securities, which is manageable easily. Generally 15- 20 securities are considered as manageable. The moment more than one security is included in a portfolio the non- systematic risk of the portfolio gets reduced. This happens because of the likely opposite performance of the securities, if one performs poor, then its negative effects can be eliminated by the better performance of another. Therefore, a welldiversified portfolio always has less risk as compared to a less diversified portfolio.

 Notion of Negative Correlation While selecting securities for the construction of a portfolio, the securities to be included in a portfolio should be correlated negatively as far as possible. This will help in minimizing the overall risk of the portfolio. If a portfolio contains two securities which are negatively correlated, then the variability of portfolio returns will minimize automatically, because of the nullifying effect of these securities. The risk will minimize to zero, if securities have perfect negative correlation, whereas, it will multiply many fold, if these have a positive correlation.

Returns and Risk

Returns- Returns of a portfolio is the weighted average of the individual returns of shares included in the portfolio. This means a portfolio will generate the returns according to the returns of individual shares included in the portfolio.

 Risk- Risk can be subdivided into the following two: Systematic Non- systematic

Systematic Risk- This is such a component of return and risk, which is on account of the market- wide factors. Systematic risk factors: Major changes in tax rates War and other calamities A change in economic policy Industrial recession An increase in international oil prices Central Banks restrictive credit policy

Non- systematic
This is such a component of return and risk, which is on account of the performance of the company. This can either be minimized or eliminated by adopting risk management techniques or by not investing in such share, therefore it is called diversifiable risk. Non- systematic risk factors: Company strike Bankruptcy of a major supplier Unexpected entry of a new competitor into the market Increase in excise duty Increase in custom duty on the raw material used by the company.

Objectives of Portfolio Management

Safety of the investment Stable current returns Appreciation in the value of capital Marketability Liquidity Tax Planning

 Safety of the investment- Investment safety or minimisation of risks is one of the most important objectives of portfolio management. There are many types of risks which are associated with investment in equity stocks, including super stocks. There is no such thing as a zero- risk investment. Low- risk investments give correspondingly lower returns. To minimize the overall risk or to bring it to an acceptable level by developing a balanced and efficient portfolio.

 Stable Current Returns- Once investment safety is guaranteed, the portfolio should yield a steady current income. The current returns should at least match the opportunity cost of the funds of the investor.

 Appreciation in the value of capital- A good portfolio should appreciate in value in

Deciding about investment objectives

Safety Regularity of income Capital gain Tax saving Liquidity Speculation Hedging Arbitrage

Constraints
Liquidity Taxes Time horizon Unique Preferences and Circumstances

Traditional Approach to Portfolio Management

Deciding about investment objectives Deciding about investment constraints Asset mix decision Formulation of portfolio strategy Selection of securities Portfolio execution Alignment of portfolio Performance evaluation

 Risk Aversion Risk aversion is an investor's general desire to avoid participation in "risky" behavior or, in this case, risky investments. Investors typically wish to maximize their return with the least amount of risk possible. When faced with two investment opportunities with similar returns, good investor will always choose the investment with the least risk as there is no benefit to choosing a higher level of risk unless there is also an increased level of return.

Formulation of Portfolio Strategy

Active Portfolio Strategy Passive Portfolio Strategy

 Active Portfolio Strategy- A strategy in which, portfolio manager keeps on changing his action plan according to the fluctuations in the market. It can be done in the following ways: Riding the market swings Switching the sectors Combining fundamental and technical analysis

 Riding the market swings- A market is divided into equity, debt and derivatives market. All these markets do not move in the same direction at a time. The diverse movement of these markets can be used as a tool to generate better returns for the portfolio. If equity market is more favorable as compared to the debt market, then the portfolio manager might decide to deviate from the strategic asset allocation. This means, allocating more funds to equity in contrast to the strategic asset allocation. Such deviation from strategic asset allocation is called tactical asset allocation.

 Switching the sectors- Under this, a portfolio manager keeps on switching from one sector to another, depending on the performance of different sectors of the economy.

 Combining fundamental and technical analysis-

Realignment of portfolio
Realignment of portfolio means making a review of portfolio value at a regular interval and reallocation the funds for different avenues depending upon the plan of realignment and risk perception of portfolio manager.

Following are the prominent plans for realignment: Plan of ignorance (buy and hold) Plan of maintenance (constant ratio plan) Plan of switching (ensuring targets through minimum risk)

 Markowitz Portfolio Theory Harry Markowitz developed the portfolio model. This model includes not only expected return, but also includes the level of risk for a particular return. Markowitz assumed the following about an individual's investment behavior: Given the same level of expected return, an investor will choose the investment with the lowest amount of risk. Investors measure risk in terms of an investment's variance or standard deviation. For each investment, the investor can quantify the investment's expected return and the probability of those returns over a specified time horizon. Investors seek to maximize their utility. Investors make decision based on an investment's risk and return, therefore, an investor's utility curve is based on risk and return.

Modern Portfolio Theory

MPT was first time given by Harry Markowitz. This theory stresses upon the fundamentals that creation of portfolio depend upon the relationship between the returns expected represented by mean and the variability of these returns represented by standard deviation/variance. MPT advocates the existence of an efficient frontier. An efficient frontier is a line representing all the efficient portfolios plotted on risk return graph. An efficient portfolio is the one which provides better return for a given level of risk, i.e. minimum risk for a given level of returns as compared to other portfolios, or it might provide maximum returns for a given level of risk as compared to other portfolio. MPT believes that investors possess utility curve, with the help of which portfolio selection can be done by tracing the efficient frontier.

Sharpes Model Single Index Model

In this model it is favoured that returns and risk of a security can be represented in the form of characteristic line which implies the bifurcation of risk and returns into two : systematic factors and non- systematic factors. The model is called as Single Index Model because it advocates that individual shares do not hold any kind of direct relationship with each other instead these have a relationship with one common parameter, i.e. market portfolio representing whole of the market. The model also advocates that an individual security is desirable only when its return are in excess of the risk- free returns. The excess returns of an individual security hold a relationship with the excess relationship on the market portfolio. In the absence of a market portfolio a representative index can be used to show this relationship. Returns and risk of individual securities fluctuate depending upon the fluctuation in the market portfolio/ market index. This relationship can be used to create portfolio.

Portfolio Management- Performance Index

Sharpes Portfolio Performance Measure Treynor Portfolio Performance Measure Jensen Portfolio Performance Measure

 Portfolio revision involves changing the existing mix of securities. This may be effected either by changing the securities currently included in the portfolio or by altering the proportion of funds invested in the securities. New securities may be added to the portfolio or some of the existing securities may be removed from the portfolio. Portfolio revision thus leads to purchase and sales of securities. The objective of portfolio revision is the same as the objective of portfolio selection, i.e. maximising the return for a given level of risk or minimising the risk for a given level of return. The ultimate aim of portfolio revision is maximisation of returns and minimisation of risk.

Need for Portfolio Revision

Availability of additional funds for investment Change in risk tolerance Change in the investment goals Need to liquidate a part of the portfolio to provide funds for some alternative use

Portfolio Revision Strategies

Passive Management Active Management The Formula Plans

Portfolio Revision
Rupee Cost Averaging Constant Rupee Plan Constant Ratio Plan Variable Ratio Plan

Rupee Cost Averaging

Advantages Reduces the average cost per share and improves the possibility of gain over a long period. Takes away the pressure of timing the stock purchase from investors Makes the investors to plan the investment programme thoroughly on the commitment of funds that has to be done periodically Applicable to both falling and rising market, although it works best if the stocks are acquired in a declining market.

Limitations
Extra transaction costs are involved with small and frequent purchase of shares. The plan does not indicate when to sell. It is strictly a strategy for buying. It does not eliminate the necessity for selecting the individual stocks that are to be purchased There is no indication of the appropriate interval between purchases The averaging advantage does not yield profit if the stock price is in downward trend The plan seems to work better when stock prices have cyclical patterns.

Portfolio Evaluation
Portfolio Evaluation refers to the evaluation of the performance of the portfolio. It is essentially the process of comparing the return earned on a portfolio with the return earned on one or more other portfolios or on a benchmark portfolio. Portfolio Evaluation essentially comprises two functions, performance measurement and performance evaluation. Performance measurement is an accounting function which measure the return earned on a portfolio during the holding period or investment period. Performance evaluation, on the other hand, addresses such issues as whether the performance was superior or inferior, whether the performance was due to skill or luck, etc.

 While evaluating the performance of a portfolio, the return earned on the portfolio has to be evaluated in the context of the risk associated with that portfolio. One approach would be to group portfolios into equivalent risk classes and then compare returns of portfolios within each risk category. An alternative approach would be to specifically adjust the return for the riskiness of the portfolio be developing risk adjusted return measures and use these for evaluating portfolios across differing risk levels.