Introduction to portfolio management

Portfolio Management, Return, Risk & Beta(β)

- An Introduction

B yV i n ay S i n g h a n i a

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.

What is Portfolio

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.

Portfolio Management

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.

Need for Portfolio Management

Types of Portfolio Management

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.

Types of Portfolio Management

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

Two Basic Principles of Portfolio Management

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.

Two Basic Principles of Portfolio Management

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).

Return of a Portfolio

1 1 01 011

0 0 0

Rate of return Dividend yield Capital gain yield

DIVDIV

P PP PR

P P P

Return of a Portfolio- ExamplePortfolio value = Rs 2,00,000 + Rs 5,00,000 = Rs 7,00,000rA = 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:-

%288.8%284.4%004.4

) %6(.714)%14(.286)( n

1i

iip ERwER

Expected Portfolio ReturnAffect on Portfolio Return of Changing Relative Weights in A and B

Exp

ecte

d R

etu

rn %

Portfolio Weight

10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%

ERB= 10%

Assume ERA = 8% and ERB = 10%


Exp

ecte

d R

etu

rn %

Portfolio Weight

10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%

ERB= 10%

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)


Exp

ecte

d R

etu

rn %

Portfolio Weight

10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%

ERB= 10%

The potential returns of the portfolio are bounded by the highest and lowest returns of the individual assets that make up the portfolio.


Exp

ecte

d R

etu

rn %

Portfolio Weight

10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%

ERB= 10%

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

%8%)10)(0(%)8)(0.1( BBAAp ERwERwER


Exp

ecte

d R

etu

rn %

Portfolio Weight

10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2ERERA=8%

ERB= 10%

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

%10%)10)(0.1(%)8)(0( BBAAp ERwERwER


ERExp

ecte

d R

etu

rn %

Portfolio Weight

10.50

10.00

9.50

9.00

8.50

8.00

7.50

7.00

0 0.2 0.4 0.6 0.8 1.0 1.2

ERA=8%

ERB= 10%

The expected return on the portfolio if 50% is invested in Asset A and 50% in B is 9%.

%9%5%4

%)10)(5.0(%)8)(5.0(

BBAAp ERwERwER

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

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.

Correlation and its importance

BA

ABAB

COV

Portfolio Risk(Standard Deviation)

Portfolio Risk(Standard Deviation):-

Portfolio Return Variance:-

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

Standard Deviation of a Two-Asset Portfolio

))()((2)()()()( ,2222

BABABBAAp COVwwww

Risk of Asset A adjusted for weight in the

portfolio

Factor to take into account co-movement

of returns.

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 portfolio2.the relative weights of the assets in the portfolio3.the degree of co-movement of returns of the assets making up the portfolio

Risk of Asset B adjusted for weight in the

portfolio

Graphical explanation

Possible Returns on the Stock

Probability

-30% -20% -10% 0% 10% 20% 30% 40%

Outcomes that produce harm

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 10%, then those outcomes less than 10% represent risk to the investor.

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:-

What is Beta(β) of a Portfolio?

Interpretation of Beta(β)Value of

Beta Interpretation Example

β < 0 Asset generally moves in the opposite direction as compared to the index

Gold, which often moves opposite to the movements of t he stock market

β = 0 Movement of the asset is uncorrelated with the movement of the benchmark

Fixed-yield asset, whose growth is unrelated to the movement of the stock market

0 < β < 1Movement of the asset is generally in the same direction as, but less than the movement of the benchmark

Stable, "staple" stock such as a company that makes soap. Moves in the same direction as the market at large, but less susceptible to day-to-day fluctuation.

β = 1Movement of the asset is generally in the same direction as, and about the same amount as the movement of the benchmark

A representative stock, or a stock that is a strong contributor to the index itself.

β > 1Movement of the asset is generally in the same direction as, but more than the movement of the benchmark

Volatile stock, such as a tech stock, or stocks which are very strongly influenced by day-to-day market news.

http://en.wikipedia.org/wiki/Beta_(finance)

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

Beta Estimation

2

Covar =

σ

σ σ Cor σ= = Cor

σ σ σ

j, mj

m

j m j, m jj, m

m m m

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

Beta Estimation

j jj mR R e

Determinants of Beta


Nature of Business

Operating Leverage

Financial 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.

Some Facts of Beta(β)

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:

Asset Beta and Equity Beta

Debt1

EquityE A

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.

Industry Beta and Company Beta

Thank You

Introduction to portfolio management

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