Portfolio Management

CHAPTER 8
 Portfolio Management

Portfolio management is the process of selecting a bunch of

securities that provides a maximum return for a given level of risk or
alternatively ensures minimum risk for a given level of return.

Portfolio management is an integrated set of steps

undertaken in a consistent manner to create and
maintain appropriate combination of investment
assets.
 Portfolio Management
Portfolio Management implies:
➢Tactically managing an investment
portfolio
➢By selecting the best investment mix in
the right proportion and
➢Continuously shifting them in the
portfolio
➢To increase the return on investment
and maximize the wealth of the investor.
Portfolio Management as process
Planning Step

•Investor’s Objectives and Constraints

•Investment Policy Statement (IPS)
•Creating Strategic Asset Allocation

Execution Step

•Portfolio Construction and Revision

•Portfolio Optimization
•Tactical Asset Allocation

The Feedback Step

•Monitoring and Rebalancing

•Performance Evaluation
Process of Portfolio
Management

SECURITY PORTFOLIO PORTFOLIO PORTFOLIO

ANALYSIS CONSTRUCTION REVISION EVALUATION
Portfolio Management Process
Security Analysis
➢It is the first stage of portfolio creation process
➢Involves assessing the risk and return factors of individual
securities, along with their correlation.
➢Include technical analysis and fundamental analysis
Portfolio Management Process
Portfolio Construction
➢After determining the securities for investment, a portfolios can
be created
➢Requires understanding how different asset classes and their
weights affect the performance and risk
➢Create a portfolio comprised of diverse assets
➢Diversification can increase returns or decrease risks
Portfolio Management Process
Portfolio Revision
➢The art of changing the mix of securities in a portfolio is called as
portfolio revision.
➢Is the process of adjusting the existing portfolio in accordance
with the changes in financial markets and the investor's position
➢To make sure that the portfolio remains optimal and to earn
good returns.
Portfolio Management Process
Portfolio evaluation
➢Assessing the performance of the portfolio over the stipulated
period
➢Focuses on the quantitative measurement of the return obtained
and risk involved in the portfolio
➢Involves comparing the return earned on a portfolio with the
return earned on a benchmark portfolio.
 Portfolio Theory
➢Any asset of a portfolio may be described by two characteristics:
◦ The expected rate of return
◦ The expected standard deviations of returns
➢The correlation, measured by covariance, affects the portfolio
standard deviation
✓Low correlation reduces portfolio risk while not affecting the expected
return
✓A hedge asset has negative correlation with the other assets in the
portfolio

Copyright ©
2000 by
Harcourt, Inc.
All rights
Measuring Portfolio Risk
n n n

𝜎p = ෍ wi2 𝜎i2 + ෍ ෍ wi wj Covij

i=1 i=1 i=1

where:
𝜎p = the standard deviation of the portfolio
Wi = the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
𝜎i2 = the variance of rates of return for asset i
Covij = the covariance between the rates of return for assets i and j,
where Covij = rij 𝜎𝑖 𝜎𝑗
Copyright ©
2000 by
Harcourt, Inc.
All rights
 Measuring Portfolio Risk
➢ Even if the covariance term is positive, the portfolio standard deviation still
is less than the weighted average of the individual security standard
deviations, unless the two securities are perfectly positively correlated.
✓The standard deviation of the portfolio with perfect positive correlation is just the
weighted average of the component standard deviations
✓In all other cases, making the portfolio standard deviation less than the
weighted average of the component standard deviations
 Estimation Issues
Under the preceding formula:
➢We must estimate expected returns and standard deviation for every asset
being considered for inclusion in the portfolio.
➢We must also estimate the correlation coefficient among the entire set of
assets.
➢The number of correlation estimates can be significant (for a portfolio of 100
securities, the number correlation estimates is 4,950)
➢The potential source of error that arises from these approximations is referred to
as estimation risk.
 Estimation Issues
➢We can reduce the number of correlation coefficients that must be
estimated
➢Assuming that stock returns can be described by the relationship of each
stock to a market index (single index market model) as follows:

𝑅𝑖 = 𝑎𝑖 + 𝑏𝑖 𝑅𝑚 + 𝑒𝑖
Where
• bi = the slope coefficient that relates the returns for Security i to the returns for the aggregate
stock market
• Rm = the returns for the aggregate stock market
 Estimation Issues
➢If all the securities are similarly related to the market and a
slope coefficient bi is derived for each one:
➢The correlation coefficient between two securities i and j is:
2
𝛿𝑚
𝑟𝑖𝑗 = 𝑏𝑖 𝑏𝑗
𝛿𝑖 𝛿𝑗
Where :
2 = the variance of returns for the aggregate stock market
◦ 𝛿𝑚
Assumptions of Portfolio Theory
Basic assumption:
➢Investors are risk averse
➢Given two assets with equal rates of return, investors prefer the asset
with the lower level of risk
➢Investors want to maximize the returns from the total set of
investments for a given level of risk..
➢The relationship among the returns for assets in the portfolio is
important.
➢Hence, a good portfolio is not simply a collection of individually good investments
Portfolio construction
➢It is preferred to add to our portfolios assets with low or negative
correlation with our existing position
✓FINDING FUNDS THAT ZIG WHEN THE BLUE CHIPS ZAG

➢Portfolios of less than perfectly correlated assets always offer better

risk–return opportunities than the individual securities on their own.
➢The lower the correlation between the assets, the greater the gain in
efficiency
Portfolio Theory : The Harry Markowitz Model

➢The theory is found in an article presented by Harry Markowitz in

1952 in Journal of Finance.
➢This model shows as to how an investor can construct portfolio of
investments.
➢As the HM Model is based on the expected returns (means) and
the standard deviation (variance) of different portfolios, it is also
called Mean-Variance Model.
Markowitz idea about an Optimal
Portfolio Selection
➢ Historical Stock Exchange Data as a
source of information.
➢ An optimal portfolio can be built if we
know 3 measure
1. Expected risk : approximated by Standard
Deviation.
2. Correlation : dependencies between the
securities, risk factor.
3. Expected Return: calculated as a Mean.

➢ Return has lognormal distribution in

long time period.
Assumptions of the HM Model
1. Investors are rational 2. Investors have free 3. The markets are
and wants to maximise access to fair and efficient and absorb
their return correct information the information

5. Investors prefer
4. Investors are risk
higher returns to lower
averse and try to
returns for a given level
minimise the risk
of risk
 Markowitz Model
➢In Markowitz model, risk is measured by standard
deviation of the return.
➢There are two types of risks: Unsystematic Risk
and Systematic Risk
➢Utility of a portfolio is risk adjusted return which is
equal to portfolio return minus risk penalty.
➢Risk penalty is portfolio risk, relative to the
investor’s risk tolerance
➢Where,
Risk penalty = (Risk Squared ÷ Risk Tolerance)
 Markowitz Model …
➢The optimal portfolio is one on the efficient frontier that maximises
utility.
➢To generate efficient portfolios the Markowitz Model requires :
(a) expected return on each assets
(b) Standard deviation of returns as a measure risk of each asset, and
(c) the covariance or correlation coefficient as a measure of inter-
relationship between the returns on assets considered.
 Portfolio Opportunity set
➢Portfolio opportunity set indicates
➢All combinations of expected return and standard deviation
➢Constructed from the available assets.
➢When the correlation is perfect negative (-1), the portfolio
opportunity set is linear
✓This offers a perfect hedging opportunity and the maximum advantage
from diversification.
Portfolio Opportunity set …
➢Suppose now an investor wishes to select the optimal
portfolio from the opportunity set.
✓The best portfolio will depend on risk aversion.
✓Portfolios to the northeast in the Figure provide higher rates
of return but impose greater risk.
✓Investors with greater risk aversion will prefer portfolios to
the southwest, with lower expected return but lower risk
 Efficient Frontier
➢From all the possible weights for the assets included in the portfolio, we can
draw a graph (curves) as shown in the next slides
➢The envelope curve that contains the best of all these possible combinations
is referred to as the efficient frontier.
➢The efficient frontier represents that set of portfolios that has the maximum rate of return
for every given level of risk or the minimum risk for every level of return.

➢Every portfolio that lies on the efficient frontier has either:

▪ A higher rate of return for equal risk or
▪ Lower risk for an equal rate of return than some portfolio beneath the frontier.
Determining the Efficient Portfolio
➢To choose the best portfolio from a number of possible portfolios,
two separate decisions are to be made
1. Determination of a set of efficient portfolios.
2. Selection of the best portfolio out of the efficient set.
➢A portfolio that gives maximum return for a given risk, or minimum
risk for given return is an efficient portfolio.
 Determining the Efficient
Portfolio…
➢Generally, Portfolios are selected as follows:
(a) From the portfolios that have the same return, the investor will
prefer the portfolio with lower risk, and
(b) From the portfolios that have the same risk level, an investor will
prefer the portfolio with higher rate of return.
Determining Efficient Frontier…
Determining Efficient Frontier …
Efficient Frontier for Alternative Portfolios
 Determining Efficient Frontier …
➢Portfolio A in preceding graph dominates Portfolio C because it has an equal
rate of return but substantially less risk.
➢Similarly, Portfolio B dominates Portfolio C because it has equal risk but a
higher expected rate of return.
➢Because of the benefits of diversification, we would expect the efficient frontier
to be made up of portfolios of investments rather than individual securities.
➢Once we identified efficient two possible exceptions arise.
▪ Should we choose the portfolio with the highest return or that with the lowest
risk?
 Determining Efficient Frontier …
➢Investors will target a point along the efficient frontier based on
their utility function.
▪Utility function reflects investors attitude toward risk.
➢No portfolio on the efficient frontier can dominate any other
portfolio on the efficient frontier.
➢All of these portfolios have different return and risk measures,
with expected rates of return that increase with higher risk.
 Utility Curve
➢Utility curves specify the trade-offs the investor is willing to make
between expected return and risk.
➢In conjunction with the efficient frontier, the utility curves determine
which particular portfolio on the efficient frontier best suits an
individual investor.
➢Two investors will choose the same portfolio from the efficient set
only if their utility curves are identical
Utility Curve …
 Utility Curve …
On the graph shown in previous slide:
1) The curves labelled U1, U2, and U3 are for a strongly risk-averse
investor.
▪These utility curves are quite steep, indicating that the investor will
not tolerate much additional risk to obtain additional returns.
2) The curves labelled (U3′ , U2′ , U1′) characterize a less risk-averse
investor.
▪ Such an investor is willing to tolerate a bit more risk to get a higher
expected return.
3) The optimal portfolio is the efficient portfolio that has the highest
utility for a given investor.
 Utility Curve …
➢Optimal portfolio lies at the point of tangency between the
efficient frontier and the curve with the highest possible
utility.
✓A conservative investor’s highest utility is at Point X, where the U2
curve just touches the efficient frontier.
✓A less risk-averse investor’s highest utility occurs at Point Y
▪Which represents a portfolio on the efficient frontier with higher
expected returns and higher risk than the portfolio at X.
 Two Assets Portfolio : Example

Portfolio formed Asset E 𝐑𝐢 δ𝒊 𝑪𝒐𝒓𝒓𝑩,𝑬

by two assets Bond 8% 12% 0.30
Stock 13% 20%

The rate of return on this portfolio, rp, will be:

rp = WDRD + WERE
rp = 8Wd + 13WE
 Portfolio Construction
Various Correlation Coefficients
 Optimal Risky Portfolio with Two Risky Assets
➢Suppose our portfolio consists of the bond and stock funds, and
now we can also invest in risk-free T-bills yielding 5%.
➢Figure in next slide shows the opportunity set based on the
properties of the bond and stock funds.
➢Two possible capital allocation lines (CALs) are drawn from the
risk-free rate (rf = 5%) to two feasible portfolios.
✓The first possible CAL is drawn through the minimum-variance portfolio A,
which is invested 82% in bonds and 18%
✓Portfolio A’s expected return is 8.90%, and its standard deviation is
11.45%.
The opportunity set
of the debt and
equity funds and
two feasible CALs.
 Optimal Risky Portfolio with Two Risky Assets…
➢With a T-bill rate of 5%, the reward-to-variability ratio, which
is the slope of the CAL combining T-bills and the minimum-
variance portfolio, is:
𝐸(𝑅𝐴 )−𝑅𝑓
𝑆𝐴 =
δ𝐴
8.9 − 5
𝑆𝐴 =
11.45
=0.34
 Optimal Risky Portfolio with Two Risky Assets…
➢Now consider the CAL that uses portfolio B instead of A.
➢Portfolio B invests 70% in bonds and 30% in stocks.
➢Its expected return is 9.5% (a risk premium of 4.5%), and its standard
deviation is 11.70%.
➢Thus the reward-to-variability ratio on the CAL that is supported by
Portfolio B is:
𝐸(𝑅𝐵 )−𝑅𝑓
𝑆𝐵 =
δ𝐵
9.5 − 5
𝑆𝐴 =
11.70
=0.38
Optimal Risky Portfolio with Two
Risky Assets…
The reward-to-variability ratio of portfolio B is greater than that of
portfolio A.
• Thus ,Portfolio B dominates A. But why stop at Portfolio B?

We can continue to ratchet the CAL upward until it ultimately reaches the
point of tangency with the investment opportunity set.
• This must yield the CAL with the highest feasible reward-to-variability ratio.

Therefore, the tangency portfolio, labelled P in Figure 7.5, is the optimal

risky portfolio to mix with T-bills.
The opportunity set
with the optimal CAL
and the optimal risky
portfolio
Portfolio Optimization
➢The objective of portfolio optimization is to
find the weights that result in the highest 𝐸(𝑅𝑝 ) −𝑅𝑓
slope of the CAL 𝑆𝑝 =
δ𝑝
➢i.e., the weights that result in the risky
portfolio with the highest reward-to-
variability ratio.
➢ Therefore, the objective is to maximize the
slope of the CAL for any possible portfolio, p.
➢ Thus our objective function is the slope
that we have called Sp:
Portfolio Optimization…
➢In the case of two risky assets,
the solution for the weights of the
optimal risky portfolio, P, can be
shown to be as follows.

Substituting our original data, the solution is:

(8 −5)400 (13 − 5)72
𝑊𝐷 = 8 − 5 400+ 13 −5 144 −(8 −5+ 13−5)72 = 0.4

WE = 1 – 0.4 = 0.6
Two-Security Portfolios with
Various Correlations

return
100%
 = -1.0
stocks

 = 1.0

 = 0.3
100%
bonds

The Efficient Set for Many Securities

return
Individual Assets

P
Consider a world with many risky assets; we can still identify
the opportunity set of risk-return combinations of various
portfolios.
The Efficient Set for Many Securities
• All the portfolios that lie on the minimum-variance frontier and
upward provide the best risk–return combinations
– Thus, they are candidates for the optimal portfolio
• The part of the frontier that lies above the minimum-variance portfolio,
therefore, is called the efficient frontier of risky assets.
• For any portfolio on the lower portion of the minimum-variance
frontier, there is a portfolio with the same standard deviation and a
greater expected return positioned directly above it.
– Hence the bottom part of the minimum-variance frontier is
inefficient.
The Efficient Set for Many Securities

return
minimum
variance
portfolio

Individual Assets

P

Given the opportunity set we can identify the minimum

variance portfolio.
The Efficient Set for Many Securities

return
minimum
variance
portfolio

Individual Assets

P

The section of the opportunity set above the minimum variance

portfolio is the efficient frontier.
Optimal Risky Portfolio with a Risk-Free Asset

return
100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world that also has

risk-free securities like T-bills
Optimal Risky Portfolio with a Risk-Free Asset

• To get the optimal portfolio, find the capital allocation line

with the highest reward-to-variability ratio (that is, the
steepest slope)
• The CAL that is supported by the optimal portfolio, P, is
tangent to the efficient frontier.
– This CAL dominates all alternative feasible lines (the
broken lines that are drawn through the frontier).
– Portfolio P, therefore, is the optimal risky portfolio.
Optimal Risky Portfolio with a Risk-Free Asset

return
100%
stocks
Balanced
fund

rf
100%
bonds

Now investors can allocate their money across the T-bills and a
balanced mutual fund
Optimal Risky Portfolio with a Risk-Free Asset

return
rf

P
With a risk-free asset available and the efficient
frontier identified, we choose the capital allocation
line with the steepest slope
Chapter End