• Art and science of making decisions about

investment mix and policy

• Matching investments to objectives
• Asset allocation for individuals and institutions
• Balancing risk against performance
• Deciding on what securities to include in your
portfolio
• Deciding the contents of their portfolio, prudent
investors strive to be diversified to get rid of
PORTFOLIO RISK
unsystematic or diversified risk
- Diversification – allows risk to be reduced • Total Risk = Systematic + Unsystematic Risk
• An extension on “Risk and Rates of Return”
SYSTEMATIC RISK

• Also known as non-diversifiable risk or market

risk
• Risk that cannot be diversified away
• Risk that is inherent/fundamental to the firm –
the RELEVANT risk
- Relevant because already embedded to the
market as a whole and is caused by external
factors such as macro-economic and geo
factors that are uncontrollable that is why
this risk cannot be eliminated
- Example of systematic risk – country is
experiencing war, then the risk of the stock
price is falling because it cannot be avoided
• Measured by Beta (Beta Coefficient)

UNSYSTEMATIC RISK

• Also known as unique, diversifiable, company-

related or firm-specific risk
• Disappears when a portfolio is diversified

Note: when you add more stocks in your portfolio and vary
your investments, that is called diversification

Example: investing both stocks in Ayala and Bayer


THINGS TO NOTE ON THE 2 MEASURE OF CORRELATION
WHEN ADDING A RISK-FREE ASSET TO A PORTFOLIO OF
RISKY ASSETS
• Expected return will be lowered, because a risk-
free asset will generate lower returns
• Standard deviation will have been more
diversified than before, when the portfolio
consists of only risky assets
VOLATILITY VS. RISK
1. Earnings Volatility
• May be due to seasonal fluctuations
• Does not necessarily imply risk
If a company’s earnings are net income
fluctuates, this is due to seasonal fluctuations and
not risk
2. Stock Price Volatility
• Necessarily imply risk as it signifies
investors’ notion that the future of such
stock is unpredictable
If stock price keeps changing or unpredictable,
that means that investors are not confident about
the stock. The future of a company become
questionable
MEASURE OF CORRELATION
▪ Measures of how the returns on a pair of
investment vary together
1. Covariance (COV𝑟1 , 𝑟2) – combines the variance
of the investment’s returns with the tendency of
those returns to move up or down at the same
time other investments move up or down
2. Correlation Coefficient (P 𝑟1 , 𝑟2 ) – standardizes
the covariance. A p of +1 means that 2 variables
move up and down in perfect synchronization
while -1 means the variables always move in
opposite directions perfectly. A p of 0 means that
the 2 variables are independent and not related
to one another
1. Regarding Covariance
• There is no range for Covariance. Hence
it is not standardized measure of
correlation (-infinity to +infinity)
• If COVA,B < 0, then stocks A and B move in
opposite direction
• If COVA,B >0, then stocks A and B move in
the same direction
• If COVA,B = 0, then stocks A and B have no
systematic co-movement
2. Regarding Correlation Coefficient
• A portfolio’s correlation coefficient
ranges from -1 to +1. It is a standardized
measure of correlation
• Correlation coefficient of +1 = perfect
positive correlation. The portfolio is not
diversified
• Correlation coefficient of -1 = perfect
negative correlation. The portfolio is
perfectly diversified
0 = no systematic co-movement
 • Nominal rate of return that an investor needs in
order to make an investment worthwhile
• RRR comprises of:
1. Real risk-free rate
2. Inflation premium
3. Risk premium
a. Business Risk – risk that businesses are
exposed to in the course of its
operations. Concern with the company’s
ability to generate sufficient revenues to
cover its operational expenses.
b. Financial Risk – associated with financing
and concern with the company’s ability
to manage its debt. With it, the lesser risk
that the company may default its debt
payments.
c. Liquidity Risk – risk that the company
may not be able to convert its short-term
assets to pay off its short-term
obligations.
d. Exchange-Rate Risk – risk that changes in
the currency exchange rates may affect
CAPM – CAPITAL ASSET PRICING MODEL the value of assets and financial
transactions
• A model based on the proposition that any
e. Political Risk – risk that political decisions,
stock’s required rate of return is equal to the risk-
events, or conditions are significantly
free rate of return + a risk premium that reflects
affect business operations
only the risk remaining after diversification
• SML (Security Market Line) – shows the
relationship between an expected return on an
asset to its systematic risk
Also the representation of CAPM

FORMULA: ri = rRF + bi (rM – rRF)

Note: Y axis may be label as E(return) since all other things

held constant, we may assume that the market is in
equilibrium. So, the require rate of return is equal to
expected returns

REQUIRE RATE OF RETURN

BETA

• The beta measures the market risk of the stock.

Some benchmark betas follow:
a. b = 0.5 – stock is only half as volatile or risky
as an average stock
b. b = 1.0 – stick is of average risk
c. b = 2.0 – stick is twice as risky as an average
stock
• Stock’s Beta = COV (stock vs. market) / Variance
(market)
• Portfolio Beta – the weighted average of the
betas of individual securities in the portfolio

EXPECTED RATE OF RETURN AND REQUIRED RATE OF

RETURN

Generally, E® = RRR, but the following may cause the RRR

to deviate from the E(r), such as:

1. The risk free rate can change because of the

changes in either real rates or anticipated
inflation
2. A stock’s beta can change
3. Investors’ aversion to risk can change

Movement along SML indicates a change in the

systematic risk of a particular investment
• Parallel shift in the SML = change in the nominal
risk free rate of return
• Indicates increase in nominal risk free rate of
return. It is either due to increase in real risk free
rate or an increase inflation rate
• Change in the slope of SML = indicates change in
investors’ risk appetite
• Changing of slope of SML indicates change in risk
taking capacity of investors.
• Steeper slope - indicates that investors are more
risk averse now, hence they require more
premium for bearing same risk.
• Flatter slope - indicates that investors are
becoming risk seekers since the require less
premium for bearing the same risk
LIMITATIONS OF CAPM
1. Assumptions of CAPM
• Al investors can borrow and lend an
unlimited amount at a given risk free rate
of interest
• No transaction costs
• No taxes
2. Beta Stability
• Past Betas for individual stocks are
historically unstable
• Past Betas are not food proxies for future
estimates of Beta
• Beta is still useful when measuring risk
associated with a portfolio of stocks
Some Concerns about Beta and CAPM
1. Fama and French
• Found no historical relationship between
stocks’ returns and their market betas
• Concludes that variables related to stock
returns below give a much better
estimate of returns
a. Firm’s Size – small firms have
provided relatively high returns
b. Market/Book Ratio – firms with low
market/book ratios have higher
returns
2. Multi-beta Model
• Market risk is measure relative to a set of
risk factors that determine the behavior
of asset returns
• CAPM gauges risk only relative to the
market return
Although CAPM has its limitations, it is still a widely
accepted tool in today’s business world
PORTFOLIO MANAGEMENT PROCESS 3. Current Income – goal is to generate income from
investments
1. Create a Policy Statement – contains the
4. Total Return – goal is to grow the capital base
investor’s goals and constraints relating to his
through both capital appreciation and
investments
reinvestment of that appreciation
2. Develop an Investment Strategy – entails creating
a strategy that combines the investor’s goals and INVESTMENT CONSTRAINTS
objectives with current financial, market, and
1. Liquidity Constraints – see if the investor has
economic conditions
need for cash for their pressing needs as such
3. Implement the Plan Created – putting the
cannot be used for investment
investment strategy to work, investing in a
2. Time Horizons – investors with long time horizons
portfolio that meets the client’s goals and
may have higher risk tolerance as he has the time
constraint requirements
to recoup losses
4. Monitor and Update the Plan – both markets and
3. Tax concerns – investor belonging in high tax
investors’ needs change as time changes. As
bracket – focus on investments that are tax-
such, it is important to monitor for these changes
deferred so that taxes paid won’t be excessive
as they occur and to update the plan to adjust for
4. Legal and Regulatory Factors – EG: Requirements
the changes that have occurred
of trust could require than no more than 10% of
FACTORS AFFECTING RISK TOLERANCE the trust be distributed each year. Thus, the
beneficiaries won’t have so much cash to invest
1. Age
in
• Most Older People: Risk-averse – lower
5. Unique Circumstances – EG: Investors might put
risk tolerance (tend to have less
constraints on certain securities, or companies
opportunities)
• Most Younger People: Risk takers – ASSET ALLOCATION
higher risk tolerance (still have a lot of
1. Ideal Asset Allocation – depends on the investors’
opportunities)
risk tolerance
2. Family Situation
2. Risk-Averse – invest in more debt than equity
• Single: Higher risk tolerance (Lower
securities (eg: probably 80% debt, 20% equity)
income needs)
3. Risk-Taker – invest in more equity than debt
• Supporting a family: Lower risk tolerance
securities (eg: probably 80% equity, 20% debt)
(higher income needs)
3. Wealth and Income Notes: Priorities: Debt, Preferred, Common
• Higher Wealth and Income – may be
PORTFOLIO MANAGEMENT THEORIES
more diversified, can invest in more
securities and can grow his portfolio 1. Risk Aversion – an investor’s general desire to
more avoid participation in “risky” behavior or risky
4. Psychological investments.
• High or low risk tolerance based on - Example: insurance
personality, personal feelings and beliefs. 2. Markowitz Portfolio Theory – Harry Markowitz
developed the “Portfolio Model”, where in
RETURN OBJECTIVES
making a decision, investors should be consider
1. Capital Preservation – goal is to preserve or keep not only expected return but also the level of risk
existing capital, thus nominal return must at least 3. Efficient Frontier – a plot of efficient portfolios. It
= inflation rate consists of the set of all efficient portfolios that
2. Capital Appreciation – goal is not only to yield the highest return for each level of risk
preserve, but to grow capital. Nominal Return
must > expected inflation
MARKOWITZ PORTFOLIO THEORY

Assumptions on individual investment behavior:

1. Given same level of expected return, an investor

will choose the investment with the lowest
amount of risk
2. Risk is measured in terms of an investment’s
variance or standard deviation
3. For each investment, the investor can quantify
the investment’s expected return and the
probability of those returns over a specified time
horizon
4. Investors seek to maximize their utility or CAPITAL MARKET THEORY
satisfaction
Builds upon the Markowitz Portfolio Model
5. Investors make decision based on an
investment’s risk and return. Thus, an investor’s Assumptions:
utility curve is based on risk and return.
1. All investors are efficient investors
2. Investors borrow/lend money at the risk-free rate
3. The time horizon is equal for all investors
4. All assets are infinitely divisible
5. No taxes and transaction costs
6. All investors have the same probability for
outcomes
7. No inflation exists
8. There is no mispricing within the capital markets