UNIT 4 - PORTFOLIO CONSTRUCTION AND SELECTION

Portfolio Analysis
● Security analysis related to the analysis of individual securities within the framework of return and risk.
● Whereas, Portfolio analysis makes an analysis of securities in the combined form.
● The portfolio analysis considers the determination of future risk and return in holding various blends of
individual securities.
● Portfolio expected return is a weighted average of the expected return of individual securities but
portfolio variance can be something less than a weighted average of security variances.

Portfolio Returns
● The expected return of a portfolio depends on the expected return of each of the security contained in
the portfolio.
● It also seems logical that the amounts invested in each security should be important. Indeed, this is the
case.
● The example of a portfolio with three securities is shown here.
● The expected holding period value-relative for the portfolio is:
● Value of Portfolio = Rs.23,100/- & Value of Investment = 20,000/-
● Return = VP / VI = (3100 / 20000) x 100 = 15.50%

Steps in Portfolio Analysis

● Understanding investor expectation and market
characteristics
● Defining an asset allocation and deployment strategy
● Evaluating performance and making changes, if
required

Advantages of Portfolio Analysis

● It helps investors to assess the performance periodically and make changes to their Investment
strategies.
● This helps in comparing not just portfolio against a benchmark for return perspective but also to
understand the risk undertaken to earn such return which enables investors to derive the risk-adjusted
return.
● It helps in realigning the investment strategies with the changing investment objective of the investor.
● It helps in separating underperformance and outperformance and accordingly, investments can be
allocated.

Portfolio Risk
● The probability of loss is the essence of risk.
● A useful measure of risk takes into account both the probability of various possible bad outcomes and
their associated magnitudes.
● Instead of measuring the probability of no. of different possible outcomes, the measure of risk should
estimate the extent to which the actual outcome is likely to diverge from the expected.
● Two measures used for this purpose are the mean absolute deviation and the standard deviation.
Risk Reduction Through Diversification
● Diversification is a technique that reduces risk by allocating investments across various financial
instruments, industries, and other categories.
● It aims to minimize losses by investing in different areas that would each react differently to the same
event.
● Most investment professionals agree that, although it does not guarantee against loss, diversification is
the most important component of reaching long-range financial goals while minimizing risk.
● Diversification reduces risk by investing in vehicles that span different financial instruments, industries,
and other categories.
● Unsystematic risk can be mitigated through diversification while systematic or market risk is generally
unavoidable.
● Investors can choose to pick their own assets to invest in.
● Otherwise, they can select an index fund that is comprised of a variety of companies and holdings.
● Balancing a diversified portfolio may be complicated and expensive, and it may come with lower
rewards because the risk is mitigated.
● A diversified portfolio may lead to better opportunities, enjoyment in researching new assets, and
higher risk-adjusted returns.
● For example, you have a portfolio that only has airline stocks.
● Share prices will drop following any bad news, such as an indefinite pilot strike that will ultimately
cancel flights.
● This means your portfolio will experience a noticeable drop in value.
● You can counterbalance these stocks with a few railway stocks, so only part of your portfolio will be
affected.
● In fact, there is a very good chance that the railroad stock prices will rise, as passengers look for
alternative modes of transportation.
● This action of proactively balancing your portfolio across different investments is at the heart of
diversification.
● Instead of attempting to maximize your returns by investing in the most profitable companies, you enact
a defensive position when diversifying.

Main Aspects of Diversification

● Diversifying Across Sectors and Industries
● Diversifying Across Companies
● Diversifying Across Asset Classes
● Diversifying Across Borders
● Diversifying Across Time Frames

Portfolio Selection
● The selection of portfolio depends on the various objectives of the investor.
● The selections of portfolio under different objectives are dealt subsequently.
○ Objectives and Asset Mix
○ Growth, Income and Asset Mix
○ Capital Appreciation and Asset Mix
○ Safety of Principal and Asset Mix
○ Risk and Return Analysis
○ Diversification
Objectives & Asset Mix
● If the main objective is getting adequate amount of current income, sixty per cent of the investment is
made on debts and 40 per cent on equities.
● The proportions of investments on debt and equity differ according to the individual’s preferences.
● Money is invested in short term debt and fixed income securities.
● Here the growth of income becomes the secondary objective and stability of principal amount may
become the third.
● Even within the debt portfolio, the funds invested in short term bonds depends on the need for stability
of principal amount in comparison with the stability of income.
● If the appreciation of capital is given third priority, instead of short term debt the investor opts for long
term debt.
● The maturity period may not be a constraint.

Growth, Income & Asset Mix

● Here the investor requires a certain percentage of growth in the earnings received from his investment.
● The investor’s portfolio may consist of 60 to 100 percent equities and 0 to 40 percent debt instrument.
● The debt portion of the portfolio may consist of concession regarding tax exemption.
● Appreciation of principal amount is given third priority.
● Computer software, hardware and non-conventional energy producing company shares provide good
possibility of growth in dividend.

Capital Appreciation & Asset Mix

● Capital appreciation and asset mix means that the value of the original investment increases over the
years.
● Investment in real estate’s like land and house may provide a faster rate of capital appreciation but they
lack liquidity.
● In the capital market, the values of the shares are much higher than their original issue prices.
● For example Satyam Computers, share value was Rs.306 in April, 1998 but in October, 1999 the value
was Rs.1658.
● The market capitalization also has increased.
● Next to real assets, the stock markets provide best opportunity for capital appreciation.
● If the investor’s objective is capital appreciation, 90 to 100 per cent of his portfolio may consist of
equities and 0-10% of debts.
● The growth of income becomes the secondary objective.

Safety of Principal & Asset Mix

● Usually, the risk averse investors are very particular about the stability of principal.
● According to the life cycle theory, people in the third stage of life also give more importance to the
safety of the principal.
● All the investors have this objective in their mind.
● No one likes to lose his money invested in different assets.
● But, the degree may differ.
● The investor’s portfolio may consist more of debt instruments & within the debt portfolio more would be
on short term debts.
Risk & Return Analysis
● The traditional approach to portfolio building has some basic assumptions.
● First, the individual prefers larger to smaller returns from securities.
● To achieve this goal, the investor has to take more risk.
● The ability to achieve higher returns is dependent upon his ability to judge risk and his ability to take
specific risks.
● The risks are namely interest rate risk, purchasing power risk, financial risk and market risk.
● The investor analyses the varying degrees of risk and constructs his portfolio.
● At first, he establishes the minimum income that he must have to avoid hardships under most adverse
economic condition and then he decides risk of loss of income that can be tolerated.
● The investor makes a series of compromises on risk and non-risk factors like taxation and marketability
after he has assessed the major risk categories, which he is trying to minimize.

Diversification
● Once the asset mix is determined and the risk and return are analyzed, the final step is the
diversification of portfolio.
● Financial risk can be minimized by commitments to top-quality bonds, but these securities offer poor
resistance to inflation.
● Stocks provide better inflation protection than bonds but are more vulnerable to financial risks.
● Good quality convertibles may balance the financial risk and purchasing power risk.
● According to the investor’s need for income and risk tolerance level portfolio is diversified.
● In the bond portfolio, the investor has to strike a balance between the short term and long term bonds.
● Short term fixed income securities offer more risk to income and long term fixed income securities offer
more risk to principal.
● In the stock portfolio, he has to adopt the following steps:
○ Selection of Industries
○ Selection of Companies in the Industry
○ Determining the Size of Participation

Selection of Industries
● The investor has to select the industries appropriate to his investment objectives.
● Each industry corresponds to specific goals of the investor.
● The sales of some industries like two wheelers and steel tend to move in tandem with the business
cycle, the housing industry sales move counter cyclically.
● If regular income is the criterion then industries, which resist the trade cycle should be selected.

Selection of Companies
● Likewise, the investor has to select one or two companies from each industry.
● The selection of the company depends upon its growth, yield, expected earnings, past earnings,
expected price earning ratio, dividend and the amount spent on research and development.
● Selecting the best company is widely followed by all the investors but this depends upon the investors’
knowledge and perceptions regarding the company.
Size of Participation
● The final step in this process is to determine the number of shares of each stock to be purchased.
● This involves determining the number of different stocks that is required to give adequate
diversification.
● Depending upon the size of the portfolio, equal amount is allocated to each stock.
● The investor has to purchase round lots to avoid transaction costs.

Other Important Factors for PS

● Earnings of the firm
● Movements of the market
● Continuous valuation of the stock
● Survey of stock (large / small / old / new / established firms)
● Historical growth of firms
● Capital structure of the firm

Feasible Set of Portfolios

● A feasible portfolio is a group of investments picked from the available alternatives within an investor's
capital resources limits, investment goals, and tolerance for risk.
● Put simply, it is a portfolio an investor can build up, given the assets he or she has available.
● Each feasible portfolio is not always an efficient portfolio and has its own risk and reward profile.
● Investors have the option to choose between a range of feasible portfolios.
● Managing a portfolio is about strengths, weaknesses, and opportunities, so there are downsides in no
matter what type of portfolio investors decide to manage.
● It all comes down to risk balancing and allocation.
● According to nasdaq.com, a feasible portfolio is: “A portfolio that an investor can construct, given the
assets available”.
● A portfolio is a range of investments held by an individual or organization.

Efficient Set / Frontier

● An efficient frontier is a set of investment portfolios that are expected to provide the highest returns at a
given level of risk.
● A portfolio is said to be efficient if there is no other portfolio that offers higher returns for a lower or
equal amount of risk.
● Where portfolios are located on the efficient frontier depends on the investor’s degree of risk tolerance.
● The efficient frontier is a curved line.
● It is because every increase in risk results in a relatively smaller amount of returns.
● In other words, there is a diminishing marginal return to risk, and it results in a curvature.
● Diversifying the assets in your portfolio leads to increased returns and decreased risks, which leads to
a portfolio that is located on the efficient frontier.
● Therefore, diversification can create an efficient portfolio that is located on a curved line.
Markowitz Model
● In finance, the Markowitz model ─ put forward by Harry Markowitz in 1952 ─ is a portfolio optimization
model.
● It assists in the selection of the most efficient portfolio by analyzing various possible portfolios of the
given securities.
● Here, by choosing securities that do not 'move' exactly together, the HM model shows investors how to
reduce their risk.
● The HM model is also called mean-variance model due to the fact that it is based on expected returns
(mean) and the standard deviation (variance) of the various portfolios.
● It is foundational to Modern portfolio theory.

Assumptions of Markowitz Model

● Risk of a portfolio is based on the variability of returns from said portfolio.
● An investor is risk averse.
● An investor prefers to increase consumption.
● The investor's utility function is concave and increasing, due to their risk aversion and consumption
preference.
● Analysis is based on single period model of investment.
● An investor either maximizes their portfolio return for a given level of risk or minimizes their risk for a
given return.
● An investor is rational in nature.

Methodology of Markowitz Model

● Determining the Efficient Set
● Choosing the Best Portfolio

Single Index Model

● The single-index model (SIM) is a simple asset pricing model to measure both the risk and the return of
a stock.
● The model has been developed by William Sharpe in 1963 and is commonly used in the finance
industry.
● The equations show that the stock return is influenced by the market (beta), has a firm specific
expected value (alpha) and firm-specific unexpected component (residual).
● Each stock's performance is in relation to the performance of a market index.
● Security analysts often use the SIM for such functions as computing stock betas, evaluating stock
selection skills, and conducting event studies.
Construction of Optimum Portfolio
● An optimal portfolio is one designed with a perfect balance of risk and return.
● The optimal portfolio looks to balance securities that offer the greatest possible returns with acceptable
risk or the securities with the lowest risk given a certain return.
● Portfolio construction is the process of understanding how different asset classes, funds and weightings
impact each other, their performance and risk and how decisions ladder up to an investor's objectives.

Multi-Index Model
● The multi-index model (MIM) is an extension of the single index model (SIM).
● The relation between the SIM and the MIM is similar to the relation between a single and multi-variable
regression.
● The MIM introduces the thought that there are a few sources of risk, identified by the model, and thus
risk is no longer captured only by the variance of a security or the beta of a security.
● The idea behind the MIM stems from the premise that there are few common factors (indices) that
affect the prices of securities in the market.