Portfolio Management and Wealth Planning - Zell Education 2024

“
Weekday Weekend Sel

f-Paced
1
Required Disclaimer
CFA Institute does not endorse, promote or warrant the accuracy or quality of Zell Notes. CFA®️ and
Chartered Financial Analyst®️ are registered trademarks owned by CFA Institute.
2
Table Of Contents
Portfolio Risk and Return: Part I ............................................................................................................. 4
Portfolio Risk and Return: Part II .......................................................................................................... 25
Portfolio Management: An Overview ................................................................................................... 43
Basics of Portfolio Planning and Construction ...................................................................................... 58
The Behavioural Biases of Individuals ................................................................................................... 66
Introduction to Risk Management ........................................................................................................ 79
Formula ................................................................................................................................................. 87
3
Foreword
Zell's CFA notes have been curated with a clear purpose – To fill the gap for individuals who don't feel
very comfortable studying from extensive study notes that demand special attention. At Zell
Education, we are focused on upskilling a student professionally and personally – To ensure that a
student not only clears a level but clears it with flying colours. With this in mind, we also ensure a
student is upskilled and is in line with the professional demands of the industry.
At Zell, we don't fret about a student's background, prior knowledge, or preferences. The aim is pretty
simple; we focus on ensuring that every student is on the same page as another and with the relevant
knowledge after clearing a level – A student can genuinely be called a professional.
With a state-of-the-art learning management system, we've imbibed the highest quality standards of
teaching coupled with an excellent placement team to ensure a student goes from training to the
application of the skills he's learned. We look at experiential learning at the forefront of our training
to have a 360 based approach for every applicant to be ready to perform at the highest level!
With the aforementioned in context, we bring to you these notes, created by us, for you, to truly help
make the difference and turn your journey with us into a memorable one.
Authored by: Jay Gandani, Mohit Madhiwalla, Shaili Shah, Esha Vora
Illustrated by: Ravi Gupta
Portfolio Risk and Return: Part I 4
Portfolio Risk and Return: Part I

It is important to understand the risk-return profile of assets while building a suitable portfolio for a
mutual fund scheme or for a separately managed account. Ensure that you are familiar with the
calculations of portfolio standard deviation, the effect of correlation on diversification, and the two-
fund separation theorem.
Calculate and interpret major return measures and describe their appropriate uses.
Returns can be measured over a single period or over multiple periods. Single period returns are
straightforward because there is only one way to calculate them. Multiple period returns, however,
can be calculated in various ways and it is important to be aware of these differences to avoid
confusion.
Holding Period return
Holding period return is the most basic method when it comes to calculating returns on a portfolio.
This is the method that most retail investors use to calculate returns.
This is a simple calculation of a percentage increase in the value of an investment over a given period
of time.
Holding Period Return = (End of Period Value ÷ Beginning of Period Value) - 1
and with dividends
Holding Period Return = [(End of Period Value + Dividends) ÷ Beginning of Period Value] - 1
For instance, if an investor purchased 10 shares worth Rs. 2,000 and over the period of one year, the
company paid a dividend of 20 rupees per share, and the sold the shares for 2,300, then the holding
period return is:
[(23,000 + 200) ÷ 20,000] – 1 = 16.00%.
The holding period return can be calculated for multiple periods (more than one year). In which
case, for a 3-year HPR is calculated by compounding the three annual returns.
R = [(1 + R1) × (1 + R2) × (1 + R3)] − 1, where R1, R2, and R3 are the three annual returns.
Average Returns
These may be calculated as a simple average or as a geometric average.
Arithmetic Mean or Mean Return
This is a simple average of all the holding period returns (HPR) for various investments. Note that the
holding period for each security should be common. It is calculated as:
Mean Return = (HPR1 + HPR2 + HPR3 + … + HPRn) ÷ n
For example, if an investor holds HDFC Bank, Reliance and Infosys in their portfolio and the returns
are 16.00%, 12.00%, and 18.00%, respectively, then the average return for the portfolio is:
(16.00% + 12.00% + 18.00%) ÷ 3 = 15.33%

Geometric Mean Return
This is used to calculate the return for an individual security over time. Arithmetic returns may be
overstated when there are periods of high volatility, so geometric returns are preferred in this case.
Additionally, geometric returns account for compounding. When used in time series data, arithmetic
returns assume that the investment amount for each period is the same. However, the investment
value of a portfolio will change every year, so we cannot assume that the beginning values for each
year are the same.
The geometric return is calculated as:
Geometric Mean Return = n√(1 + R1 ) × (1 + R2 ) ×(1 + R3 ) × … × (1 + Rn ) - 1
For instance, if the time series returns for Reliance over the last 3 years is 9.00%, -1.50%, and 5.00%,
then the geometric mean return is:
3 3
√(1 + 9.00%) × (1 - 1.50%) × (1 + 5.00%) - 1 = √1.1273 - 1 = 1.04076 - 1 = 4.08%
Notice that the arithmetic return (4.17%) is overstated.
The geometric return is the compounded annual growth rate (CAGR). This essentially tells us the
average compounded growth rate of an investment over a given period.
Compare the money-weighted and time-weighted rates of return and evaluate the
performance of portfolios based on these measures.
Money-Weighted Return
This method of return calculation applies the concept of internal rate of return (IRR) to the investment
portfolios. This takes into account all cash inflows and cash outflows. Money-weighted return is a
useful performance measure when the investment manager is responsible for the timing of cash flows.
This is often the case for private equity fund managers.
A cash inflow is any item that brings money towards the investor, and a cash outflow is any item that
takes money away from the investor.
Let us consider the following example:
Details (Rs. million) Year 1 Year 2 Year 3

Balance from the 0.00 33.00 33.60
previous year
Additional investment 30.00 15.00 0.00
by the investor
Net balance at the start 30.00 48.00 33.60
of the year
Investment return for 10.00% -5.00% 15.00%
the year
Investment gain/(loss) 3.00 (2.40) 5.04
Withdrawal by the 0.00 (12.00) (5.00)

investor
Balance at the end of 33.00 33.60 33.64

the year
We can draw out the following cash flow streams. Remember that we are looking at the cash flows
from the perspective of the investor.
Time Net Cash Flow

0 -30.00
1 -15.00
2 12.00
3 33.64
The IRR for these cash flows is 0.59%. We can see that the return is the realized cash return that the
investor takes from the investment account. The investment value on the last period is considered the
cash amount that the investor holds.
It is not an accurate representation of the portfolio return because the actual return is higher when
we consider the unrealized portion.
Time-Weighted Rate of Return
Time-weighted rate of return measures compounds growth. It is the rate at which $1 compounds over
a specified performance horizon. Time-weighting is the process of averaging a set of values over time.
Few steps to follow to calculate time-weighted return:
• Value the portfolio before any significant additions or withdrawals and break the evaluation
period into subperiods based on cash inflows and outflows.
• Compute the holding period return.
• Compute the annualized holding period return. For instance, if there are two subperiods, then
we must find the CAGR of these two periods. This is simply the geometric mean return.
Let us see the following example for a comprehensive understanding of time-weighted return:
Mr. Shah purchases some shares for Rs. 500. At the end of the year, he buys another share of the
same company for Rs. 520. At the end of the second year, Mr Shah sells both shares for Rs. 530 each.
At the end of both years 1 and 2, the stock paid a dividend of Rs. 12 per share
Step 1: Break the evaluation into two periods based on the timing of cash flows.
Holding period 1
• Beginning value = Rs. 500

• Dividends paid = Rs. 12
• Ending value = Rs. 520
Holding period 2
• Beginning value = Rs. 1,040 (2 shares)

• Dividends paid = Rs. 24 (Rs. 12 per share)

• Ending value = Rs. 1,060 (2 shares)
Step 2: Calculate the HPR for each holding period.
HPR1 = [(520 + 12) ÷ 500] − 1 = 6.40%
HPR2 = [(Rs. 1,060 + 24) ÷ Rs. 1,040] − 1 = 4.23%
Step 3: Find the CAGR.
(1 + Time-Weighted Return)2 = 1.0640 × 1.0423
Note that we have taken the left-hand side to the power of 2 because there are 2 holding periods that
we have identified based on the cash flows.
Time-Weighted Return = [(1.064) × (1.0423)]1/2- 1 = 5.30%
This is easier to compute compared to the money-weighted return and is the preferred method for
fund managers. Note that the XIRR function in Excel can be used when there are irregular holding
periods.
If funds are invested in a portfolio just before a poor portfolio performance, the money-weighted rate
of return will be lower than the time-weighted rate of return. On the other hand, if funds are invested
in a portfolio just before a period of relatively high returns, the money-weighted rate of return will
tend to be higher than the time-weighted rate of return.
Other Considerations
Annualised Returns
It is common industry practice to display returns in an annualised form. This accounts for the time
value of money and allows comparisons across different time horizons. Let us take the following
example:
The following information has been provided regarding three different stocks:
• Stock 1: Weekly Return = 0.10%
• Stock 2: Quarterly Return = 2.00%
• Stock 3: Return Over 18 months = 9.10%
Which of the following stocks has the highest annualised return?
We can standardise the returns to annualised returns in the following way depending on the time
horizon provided:
• Stock 1: (1 + 0.10%)52 - 1 = 5.33% (since there are 52 weeks in a year)
• Stock 2: (1 + 2.00%)4 - 1 = 8.24% (since there are 4 quarters in a year)
• Stock 3: (1 + 9.10%)12/18 - 1 = 5.98% (since we want to assess the 12-month return from an
18-month period)
Notice that when we increase the periods (from weekly to annual or quarterly to annual), we
extrapolate the returns to the future. This assumes that the same level of return will continue over
the period. However, when we consider a return that exceeds one year, we simply see the
compounded return on a pro-rata basis.
Gross and Net Return
Gross return refers to the total return on a security portfolio before deducting fees for the
management and administration of the investment account. Net return refers to the return after
these fees have been deducted.
Pre-Tax and After-Tax Nominal Return
All forms of income (dividend. Short/long term capital gains) may be taxed differently. Pre-tax
nominal return refers to the return before paying taxes. After-tax nominal returns, as the name
suggests, refers to the return after tax liability is deducted.
For instance, consider a portfolio with an investment of Rs. 10 million. The end of period value is Rs.
13 million. The gross return is Rs. 3 million. Now assume that the fund manager charges an expense
ratio that costs the investor Rs. 500,000 from the gross return. The net return after the fee is deducted
is Rs. 2.5 million. Also, assume that the dividends received were Rs. 100,000 over the holding period.
Hence the pre-tax nominal returns are Rs. 2.6 million. If the tax rate is 20%, then the after-tax nominal
return will be $2.08 million.
Real Return
Real return is the inflation-adjusted return. This form of return depicts the true return on investment
and gives an insight into the increase in purchasing power of the investor.
If:
(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation)
Then:
(1 + Real Rate) = (1 + Nominal Rate) ÷ (1 + Inflation)
For example, if the return earned on the investment is 12.00% and inflation over the same period is
3.00%, then the real return earned by the investor is:
(1 + Real Rate) = (1 + 12.00%) ÷ (1 + 3.00%)
(1 + Real Rate) = 1.0874
Real Rate = 0.0874 or 8.74%
How is this related to purchasing power?
Consider a Rs. 10,000 investments in an index fund which earns 12.00% at the end of the period, no
taxes, and no fees. So, if the investor sells the investment at the end of year one, they will receive Rs.
1,200 as a gain plus the originally invested amount. The investor now has Rs. 11,200 of cash in hand
at the end of year 1. However, inflation alone has reduced the purchasing power of cash. So, out of
this Rs. 11,200, the same Rs. 10,000 could buy goods which are now worth Rs. 10,300.
Therefore, it is important that an investor’s wealth at least keeps up with inflation to maintain the
purchasing power and protect investor wealth.
Leveraged Return
Leveraged return is a multiple of return on the underlying asset. An investment in derivative security,
such as a futures contract, produces a leveraged return because the cash deposited is only a fraction
of the value of the assets underlying the futures contract.
LOS 20a: Describe characteristics of the major asset classes that investors consider
in forming portfolios.
Historical Mean and Expected Return
The expected return is a nominal return that would induce an investor to invest in certain security. It
is a function of the real risk-free rate, expected inflation, and risk premium. It may be expressed as:
1 + E(R) = (1 + rrF) × [1 + E(π)] × [1 + E(RP)]
Where:
rrF is the real risk-free rate of return
E(π) is the expected inflation
E(RP) is the expected risk premium
The return on equities has historically outperformed the return on both long-term government bonds
and T-Bills. However, note that equities may face periods of significant drawdowns during economic
crises. They are, by nature, a more volatile asset class.
Risk-Return Trade-off
This raises the trade-off between the relationship between expected return and volatility. Specifically,
the positive relationship between expected return and volatility is that the more volatile an asset, the
higher its expected return. In an efficient market, it is not possible to obtain a higher return without
taking more risk.
The trade-off may also be explained as a risk premium. This is the additional return that one can make
by taking on an additional unit of risk (usually expressed as standard deviation).
Distributional Characteristics
However, it is not just the standard deviation that matters. Recall from the Quantitative Methods
readings that returns are likely to follow a distribution. Typically, stock returns follow a normal
distribution. It is important to assess the skewness and kurtosis of these returns too.
Market Characteristics
It is also important to assess the liquidity of a stock. This affects the price impact of a trade – for
example, if a small-cap stock has extremely low liquidity and a large institution purchases the stock in
bulk, the price can increase significantly, leaving that investor worse off when purchasing the stock.
Additionally, the greater the bid-ask spread, the worse off the institutional investors. It increases
trading costs for such investors who place bulk orders.
LOS 20b: Explain risk aversion and its implications for portfolio selection.
Following are the few categories of investors depending on their risk appetite:
• Risk Seeking Investors: Such investors “love” risk. They may choose a 50-50 gamble with a
higher payoff over a certain but lower payoff. For example, if you were asked to pick Rs.
10,000 for sure or the chance of Rs. 20,000 with a 50-50 chance, which would you pick? The
probability-weighted expected payoff in both cases is the same – 100% × 10,000 = 10,000 and
50% × 20,000 = 10,000 – but the subjective perception of the reward is different for different
investors.
• Risk Neutral Investors: Such investors are indifferent towards risk. Following from the
example above, they may choose either of the two gambles, and both of the outcomes give
them equal utility.
• Risk Averse Investors: Such investors like to play it safe and choose a certain outcome over
the gamble. For any discussion of risk-return characteristics, we will assume that investors
are risk-averse. Note that a risk-averse investor will only take an additional risk if it increases
the additional expected return.
Risk tolerance is the amount of risk an investor can possibly take to achieve a certain investment goal.
LOS 20c: Explain the selection of an optimal portfolio, given an investor’s utility (or
risk aversion) and the capital allocation line.
Utility Theory and Indifference Curves
We may express these categories in graphical forms. First, let us consider the following utility function:
1
U = E(r) - Aσ2
2
“A” is a measure of risk aversion while σ2 is the variance of the investment’s price, and U is the utility
from the investment. This essentially indicates that as an investor becomes more risk-averse, the
utility of an investment reduces, given that the volatility of the investment remains the same. It also
indicates that a risk-averse investor obtains less utility from the investment as the volatility increases.
Indifference curves with slope upwards for risk-averse investors because they will only take on more
risk if they are compensated with greater expected returns. An investor who is relatively more risk
averse requires a greater increase in expected return to compensate for a given increase in risk. In
other words, a more risk-averse investor will have a steeper indifference curve reflecting a higher
risk aversion coefficient.
We can then plot a utility curve for such investments:
This indicates that as an investor becomes more risk-averse, they obtain higher utility from safer
investments.
We can extend the explanation to all the investor types discussed above:
Capital Allocation Line
Let us assume that we want to create a portfolio with two assets. One is a risk-free asset that yields a
risk-free rate of return Rf and the other is a risky asset that yields a return of Ri. Note that the volatility
of the risk-free asset is zero because the cash flows are certain, while the volatility of the risky asset
may be expressed as σi2 (this is simply the variance of the asset’s returns). The risky asset’s standard
deviation is therefore σi.
We can express the above statements in the following graph:
For this portfolio, this is the capital allocation line. Notice that the straight line between risk and
return indicates that the portfolio’s expected return increases for each additional unit of risk.
Expressed in a linear equation, we can see that:

E(Ri ) - Rf
E(RP) = Rf + σP
σi
Let us look at the above equation in the form y = c + mx. The expected return on the portfolio when
the risky asset is absent is Rf. This is because the portfolio has 0 standard deviation (σP = 0).
E(Ri ) - Rf
When we add a risky asset to the portfolio, we get the slope of the line: . Look at the graph
σi
y2 - y1
once again and recall that the equation of the slope is . Notice that y2 is E(Ri) and y1 is Rf. Also,
x2 - x1
E(Ri ) - Rf
notice that x2 is σi and x1 is 0. Therefore, the slope of the line is simply which is also the Sharpe
σi
ratio.
This line helps us to identify what combination of assets will deliver an expected return and expected
portfolio standard deviation. It helps us identify the optimal weights of one risky asset and one risk-
free asset based on its risk-return profile.
Optimal Portfolios
Now we can combine the capital allocation line with the potential indifference curves. Note that each
point on an individual indifference curve suggests that the investor is indifferent towards risk at any
point on that curve.
The optimal allocation is when the capital allocation line is tangent to the indifference curve.
As can be seen from curve 3, point A is inefficient because the investor can obtain the same utility by
reducing risk until point B. This investor is relatively risk-seeking since they are willing to take on more
risk for the same level of expected return.
Therefore, the capital allocation line suits an investor of curve 2 the most because point M is tangent
to the indifference curve.
An investor of curve 1 is more risk-averse than the other two investors because they demand a higher
expected return for the same level of risk. The capital allocation line does not meet the curve at all, so
this portfolio is not suitable for the investor.
This simply demonstrates that more risk-averse investors demand a higher expected return for the
same level of risk while more risk-seeking investors will accept more risk for marginally less additional
return.
LOS 20d: Calculate and interpret the mean, variance, and covariance (or
correlation) of asset returns based on historical data.
LOS 20e: Calculate and interpret portfolio standard deviation.
LOS 20f: Describe the effect on a portfolio’s risk of investing in less than perfectly
correlated assets.
Portfolio Weights
Let us look at some basic notation before discovering the expected return and standard deviation of
a portfolio.
Throughout this explanation, we will assume that we have two risky assets, Asset A and Asset B. Asset
A weights wA while Asset B weights wB.
The return may be expressed as rA and rB, while the standard deviation may be expressed as σA and σB.
Expected Return
The expected return of the portfolio is simply the weighted average return of each asset:
E(RP) = wArA + wBrB
Variance
The variance of a portfolio is the weighted variance of the individual assets in the portfolio, but it is a
more complex formula:
σ2P = w2Aσ2A + w2Bσ2B + 2wAwBCovA,B
Notice the last term for covariance. When we combine the variance of an asset to the variance of
another asset in a portfolio, there is immediately some covariance between their returns. This term
captures that covariance.
Notice that the covariance may also be expressed in terms of correlation:

CovA, B
ρA,B = σA σ B
So, CovA,B = ρABσAσB
Now we can express the portfolio variance in the following way:
σ2P = w2Aσ2A + w2Bσ2B + 2wAwBρABσAσB
The standard deviation is simply the square root of the above formula. This indicates that the lower
the correlation of returns, the lower the standard deviation of the portfolio.
Covariance and Correlation
The covariance captures the magnitude of the co-movements of the individual instruments. The
higher the covariance, the greater the co-movement. Note that the covariance does not measure the
direction of co-movement since it is always a positive number.
The calculation of sample covariance of historical data is based on the following formula:
Where,
Xi = return on Asset X in period t
Yi = return on Asset Y in period t
X = mean return on Asset X
Y = mean return on Asset Y
N = number of periods
The covariance of the returns of two securities can be standardized by dividing the product of
standard deviations of the two securities. The standardised measure of co-movement is called
correlation and is computed as:
The relation can also be written as:
Cov(x,y) = ρ(1,2) * σx * σy
Correlation varies between -1 to +1 and shows the direction of co-movement between the two
securities.
The correlation captures the direction of co-movement:
• The coefficient correlation +1 or closer to +1 that means deviations from the mean of the two
stocks are directly proportional and move in the same direction.
• A coefficient correlation of -1 or closer means that deviations from the mean or expected
returns are always proportional in opposite directions.
• A coefficient correlation of zero means there is no linear relationship between the two stocks.
• +1 correlation coefficient means stocks are perfectly positively correlated, and -1 means
stocks are perfectly negatively correlated.
Let us take a numerical example to understand the effects of correlation.
Given three years of percentage returns for assets Alpha and Gamma:
Year Asset Alpha Asset Gamma
1 4% 7%
2 –1% –4%
3 12% 15%
Mean return for asset Alpha: (4- 1 + 12) ÷ 3 = 5%

Mean return for asset Gamma: (7- 4 + 15) ÷ 3 = 6%
Sample variance for asset Alpha = [(4 - 5)2 + (-1 -5 )2+ (12 -5 )2] ÷ (3 - 1) = 43
Sample standard deviation for Alpha = √43 = 6.55%
Sample Variance of Asset gamma = [(7 - 6)2 + (-4 - 6)2 + (15 - 6)2] ÷ (3 - 1) = 111
Sample Standard deviation for Gamma = √111= 10.53%
Sample covariance of returns of assets Alpha and Gamma

[(4 - 5) × (7 - 6) + (-1 - 5) × (-4 - 6) + (12 - 5) × (15 - 6)] ÷ (3 - 1) = 42
Correlation of both the assets = 42 / 6.55 × 10.53 = 0.6

Hence, they are positively correlated.
Correlation and Diversification
There is a certain amount of risk attached to every investment regardless of the correlation coefficient.
When not perfectly correlated, it might induce further risk to the investment portfolio.
Let us take an example to understand this well.
Consider 2 assets that have returns variances of 0.0225 and 0.0144, respectively. The assets’ standard
deviations of returns are 15% and 12%, respectively.
Variance = σ2P = w2Aσ2A + w2Bσ2B + 2wAwBρABσAσB
Standard Deviation = √Variance
Correlation = ρ = +1:
σ2 = (0.52)0.0225 + (0.52)0.0144 + 2(0.5)(0.5)(1.0)(0.15)(0.12) = 0.0182
σ = 0.1350 = 13.50%
Correlation = ρ = +0.5:
σ2 = (0.52)0.0225 + (0.52)0.0144 + 2(0.5)(0.5)(0.5)(0.15)(0.12) = 0.0137
σ = 0.1172 = 11.72%
Correlation = ρ = 0:
σ2 = (0.52)0.0225 + (0.52)0.0144 = 0.0092
σ = 0.0960 = 9.60%
Correlation = ρ = –0.5:
σ2 = (0.52)0.0225 + (0.52)0.0144 + 2(0.5)(0.5)(–0.5)(0.15)(0.12) = 0.0047
σ = 0.0687 = 6.87%
Note from the example that the portfolio risk falls as correlation decreases. When the portfolio assets
are perfectly correlated, there would be no diversification benefits, and the portfolio would be at a
relatively higher risk. Two assets with lower correlations are more suitable to a risk-averse investor as
they provide diversification benefits to the investor.
There is a desire to reduce risk amongst all the investors, and the graphical representation clearly
shows that investing in low correlation portfolios reduces substantial amounts of risk.
Now we can plot the risk and return profiles for different portfolios based on their correlations:
This is a visual representation of two assets with different correlation coefficients. The risk-return
profile of a portfolio with a correlation coefficient of -1 will offer the most diversification benefits
because the same level of expected return can be achieved by taking on less risk than a portfolio with
a correlation coefficient of +1.
Similarly, anywhere between -1 and +1 changes the curvature of the profile. For instance, a higher
level of return can be achieved by taking on a 15% standard deviation if the correlation is 0.2 compared
to a correlation of 0.5.
This simply indicates that if the long-term relationships between the correlation of two assets hold in
the future as well, then the risk-return profile of a portfolio of two risky assets can be modified by
changing the weightage of each asset in the portfolio. Investors seeking higher risk may give more
weightage to the riskier asset and vice versa.
More Than Two Risky Assets
The underlying concept, however, remains the same. Portfolio managers hold far more than just two
assets when constructing a portfolio. It is important to see the cross-correlations between all assets
and their standard deviations. The less correlated the basket of assets, the greater the diversification
benefits of the portfolio.
If N is the number of assets in a portfolio, then:
σ2 (N -1)
σP = √ + ρσ2
N N
So, the fundamental principle still holds: the lower the correlation, the lower the standard deviation.
Historical Correlations
Stocks and bonds have been seen as uncorrelated assets and negatively correlated assets in some
economic scenarios. The argument is that when the economic conditions worsen, investors flock from
risk-on trades to risk-off trades. This means that all the money flows into government bonds or
extremely highly rated corporate bonds. This increases the price of bonds and decreases the price of
stocks.
However, this relationship has not held true in recent times. This is due to the high liquidity and low-
interest-rate environment. There is so much money flowing into the system due to quantitative easing
that stocks and bonds are propped up at the same time simply based on the excess liquidity in the
system. Additionally, yields in the Eurozone have become negative, which means that investors are
better off holding cash (or spending it) rather than investing in debt issued by Eurozone countries.
It is also important to see the correlations between different market capitalizations for equities. Large-
cap stocks are deemed to be safer investments, while small-cap stocks are considered riskier.
However, recent data from the U.S. suggests that the correlation among these stocks is high, so the
portfolio manager must question whether adding large-cap stocks to a small-cap portfolio adds
diversification benefits.
Other asset classes like commodities and real estate can provide a hedge against inflation. If
commodities like oil are included in inflation indexes, then having exposure to oil may offset the
disadvantages of inflation. Similarly, having exposure to real estate may be beneficial if real estate
prices increase as inflation increases. The correlations between these assets and inflation are not so
straightforward. It is important to see how and why inflation increases before holding exposure to
inflation-hedging asset classes.
Avenues for Diversification
With Asset Classes
• Correlations between major asset classes are not always high.

• A portfolio that is mixed with stocks, bonds and commodities will be more balanced than a
portfolio that holds only stocks.
• A fund manager can also look at diversification within an asset class – healthcare stocks may
be uncorrelated with airline stocks, for example.
• It is important to assess the weightage of each asset class depending on the risk-return profile
of the securities selected.
• The disadvantage is that many securities may be needed, and this is costly for small investors.
With Index Funds
• It is easier to purchase a NIFTY 50 Index Fund rather than owning each of the 50 securities
individually. This reduces transaction costs and gives exposure to large-cap stocks.
• The same logic can be used for all sorts of stocks, bonds, and commodities.
Among Countries
• Emerging economies like India may offer great stock ideas in the manufacturing or
infrastructure space, while developed countries like the U.S. may offer great stock ideas in
the innovation and technology space.
• Global financial market integration has made it difficult to diversify across countries because
the correlations, in general, are becoming closer to +1.
• It is also important to consider the currency devaluation. For instance, the top Indian I.T.
companies earn close to 50% of their revenues from the U.S. Depreciation of the rupee
against the dollar is beneficial to such companies.
Owning More than ESOP Stocks
• Employee stock option plans (ESOPs) grant the employees of a company the stock of that
company.
• It is beneficial to purchase stocks of other companies to ensure that all eggs are not in one
basket. If the company goes bust, the employee may lose their job, and the stock will have
no value.
Evaluation of New Assets
• Adding or removing assets in a portfolio changes the marginal risk-return characteristics of

the portfolio.
• There is also a cost of adding new assets.
• As a simple rule, if the Sharpe ratio of the portfolio increases when a new asset is added, it is
beneficial to add that asset. This suggests that the portfolio can generate a marginal excess
return over the risk-free rate without increasing marginal risk.
With Insurance
• This is straightforward for bond portfolios since credit default swaps can be purchased to
insure the portfolio against defaults.
• Put options on index funds may be purchased to hedge the risk of risky stock portfolios.
• Any such derivative contract which is negatively correlated with the securities in the
portfolio offers insurance benefits.
LOS 20g: Describe and interpret the minimum-variance and efficient frontiers of
risky assets and the global minimum-variance portfolio.
What is a Minimum Variance Portfolio?
The portfolio has the lowest standard deviation amongst all the portfolios for the given expected
return. Several portfolios may provide a similar return, and for each level, the portfolio manager can
vary the portfolio weights to reduce the standard deviation.
All the portfolios with minimum standard deviation for the given expected return form the efficient
frontier.
We will continue with the assumption that investors are risk-averse. This means that investors will
obtain maximum utility with the highest expected return at the lowest standard deviation.
The efficient frontier coincides with the top portion of the minimum-variance frontier. The portfolios
that have the lowest standard deviation of all portfolios with a given expected return are known as
the minimum-variance portfolios and together they make the minimum-variance portfolio. A risk-
averse investor would only choose portfolios that are on the efficient frontier.
All available portfolios that are not on the efficient frontier have lower expected returns than an
efficient portfolio with the same risk. The portfolio on the efficient frontier that has the least risk is
the global minimum-variance portfolio.
This gives an appropriate idea of the inefficient portfolios and also the efficient frontier and what the
risk-averse investors would be keen on choosing due to the lower standard deviation and higher
expected returns.
Two Fund Separation Theorem

Combining a risky portfolio with a risk-free asset is the process that supports the two-fund separation
theorem. It states that all investors’ optimum portfolios will be made up of risky assets and risk-free
assets. The line representing these possible combinations of risk-free assets and the optimal risky
asset portfolio is referred to as the capital allocation line(CAL).
The optimal risky portfolio is the point at which the capital allocation line is tangent to the efficient
frontier.
Now that the investment decision has been established, the investor can choose the financing
decision. This means that an investor can choose to move along the capital allocation line by
borrowing at a risk-free rate and purchasing more risky assets. The portfolio is still optimal; however,
the investor can choose to move higher or lower on the capital allocation line.
One may also add an indifference curve to the optimal portfolio to complete the investor’s preferred
weightage between risk-free and risky assets.
The standard deviation of an entire portfolio is also necessary and as important as the standard
deviation of stocks. The calculation of the standard deviation and how to interpret it, both of them,
are equally necessary.
Variance returns of a portfolio of two risky assets is calculated as follows:

Var portfolio = w12 σ12 + w22 + σ22 + 2 w1 w2 Cov1,2
W1 is the proportion of the portfolio invested in Asset 1, and w2 is the proportion of the portfolio
invested in Asset 2. w2 must equal (1 − w1).
As we learnt earlier
𝐶𝑜𝑣
𝑃1,2 = 𝜎 𝜎1,2
1 2
Also
𝐶𝑜𝑣1,2 = 𝑃1,2 𝜎1 𝜎2
Substituting this term for Cov12 in the formula for the variance of returns for a portfolio of two risky
assets, we have the following:
Var portfolio =w12 σ12 + w22 + σ22 + 2 w1 w2 p1,2 σ1 σ2
Also, Variance= square of standard deviation
Standard deviation of portfolio = √𝑤12 𝜎12 + 𝑤22 + 𝜎22 + 2 𝑤1 𝑤2 𝑝1,2 𝜎1 𝜎2
Let us take a numerical example to get a better insight into this.

A portfolio of Mr. Zakir is 20% invested in stocks that have a standard deviation of returns of 20%
and is 80% invested in bonds that have a standard deviation of returns of 12%. The correlation of
bond returns with stock returns is 0.50. What is the standard deviation of portfolio returns? What
would it be if stock and bond returns were perfectly positively correlated?
Answer:
Portfolio standard deviation
= √ (0.22) (0. 22) + (0.82) (0.122) + 2(0.2)(0. 8)(0.5)(0.2)(0.12)= 12.10%
If stock and bond returns were perfectly positively correlated, portfolio standard deviation would
simply be the weighted average of the assets’ standard deviations: 0.2(20%) + 0.8(12%) = 13.6%
1. Which of the following asset classes has historically had the highest returns and standard
deviation?
A. Small-cap stocks.
B. Large-cap stocks.
C. Long-term corporate bonds.
2. An investor purchased 100 shares of a stock for $34.50 per share at the beginning of the
quarter. Suppose the investor sold all the shares for$30.50 after receiving a $51.55 dividend
payment. The HPR is closest to:
A. -13.0%
B. -11.6%
C. -10.1%
3. Which of the following return calculating methods is best for evaluating annualized returns
of a buy and hold strategy of an investor who has made deposits to an account for each of
the last 5 years.
A. Geometric mean return

B. Arithmetic mean return
C. Money weighted return
4. A portfolio manager creates the following portfolio
security weight expected std. deviation
1 30 20
2 70 12
The covariance of returns is -0.0240, the expected standard deviation of the portfolio is
closest to:
A. 2.4%
B. 7.5%
C. 9.2%
5. With respect to trading costs, liquidity is least likely to impact the:
A. Stock price
B. Bid-ask spreads
C. Brokerage commissions
Use the following data to answer Questions 6 and 7.
A portfolio was created by investing 25% of the funds in Asset A (standard deviation = 15%) and the
balance of the funds in Asset B (standard deviation = 10%).
1. If the correlation coefficient is 0.75, what is the portfolio’s standard deviation?
A. 10.6%.
B. 12.4%.
C. 15.0%.
2. If the correlation coefficient is –0.75, what is the portfolio’s standard deviation?
A. 2.8%.
B. 4.2%.
C. 5.3%.
3. The dominant capital allocation line is the combination of the risk-free asset and the:
A. Optimal risky portfolio

B. Leveraged portfolio of risky assets
C. Global minimum variance portfolio
4. The portfolio on the minimum variance frontier with the lowest standard deviation is:
A. Unattainable
B. Optimal risky portfolio
C. Global minimum variance portfolio
Answers
1. A is correct. Small-cap stocks
2. C is correct as HPR is calculated using the formula (total amount received - total amount
invested) / total amount invested.
Total Amount Received: (100 shares × $30.50/share) + $51.55 = $3,050 + $51.55 = $3,101.55
Total Amount Invested: 100 shares × $34.50/share = $3,450
HPR = ($3,101.55 - $3,450) / $3,450
= -$348.45 / $3,450 ≈ -10.1%
3. A is correct as the Geometric mean return takes into account the compounding effect of
returns over time, making it suitable for evaluating long-term investment performance. It
considers the sequence of annual returns and calculates the average compound growth rate.
4. A. is correct as using the formula for standard deviation:

σ(p) = √[w1^2 * σ1^2 + w2^2 * σ2^2 + 2 * w1 * w2 * Cov(1,2)]
σ(p) = √[(0.3^2 * 20^2) + (0.7^2 * 12^2) + (2 * 0.3 * 0.7 * -0.0240)]
σ(p) ≈ √0.00641
σ(p) ≈ 2.5
5. C is correct as Brokerage commissions are fees charged by brokers for executing trades on
behalf of investors. These commissions are typically fixed or based on a percentage of the
trade value and are determined by the broker's pricing structure. While liquidity indirectly
affects trading costs, such as bid-ask spreads, it does not directly influence the commission
fees charged by brokers.
6. A is correct. 10.6%.
7. C is correct. 5.3%.
8. A is correct as the Capital Allocation Line (CAL) represents the efficient frontier in the risk-
return space. It depicts the different combinations of a risk-free asset and a risky portfolio that
achieve the highest possible level of expected return for a given level of risk and the optimal
risky portfolio refers to the portfolio that offers the highest expected return for a given level
of risk or the lowest level of risk for a given level of expected return.
9. C is correct as the portfolio on the minimum variance frontier with the lowest standard
deviation is the Global Minimum Variance (GMV) portfolio.
Portfolio Risk and Return: Part II 25
Portfolio Risk and Return: Part II

In this reading, we will cover certain mathematical concepts that are essential to understanding
portfolio risk and return. Ensure that you have a thorough understanding of the following concepts by
the end of this reading:
• Capital Market Line and Security Market Line

• Beta as a measure for systematic risk
• Factor models
• Portfolio evaluation tools
LOS 21a: Describe the implications of combining a risk-free asset with a portfolio of
risky assets.
LOS 21b: Explain the capital allocation line (CAL) and the capital market line (CML).
Combining a risk-free asset with a portfolio of risky assets produces a combination of risk and return.
The investor can choose the level of risk that they would like to take based on their indifference curve
and risk appetite.
What is a Capital Allocation Line (CAL)?
If plotted on a graph, the line of possible return combinations given the risk-free rate and the risk and
return of a portfolio of risky assets.
An investor’s risk and return preferences help us identify the best CAL for each individual.
The above-given diagram illustrates in front of us 3 possible CALs with regards to portfolios A, B, and
C. Portfolio A is the most preferred set for an individual investor as the higher risk with increasing
standard deviations is compensated with higher returns. A combination of the risk-free asset with
risky portfolio A offers the investor the highest possible utility.
Everyone has a different return expectation and a different level of risk aversion. Hence each and
every investor will have a different optimal portfolio and a different CAL.
The modern portfolio theory assumes that all investors have homogenous expectations about risk and
return, correlations, etc. Hence this theory assumes all the investors will have a same optimal CAL.
One also needs to determine the optimal risky portfolio and optimal CAL for investors with
homogenous expectations. The optimal CAL that we want to determine always forms a tangent to the
efficient frontier.
This illustrates that although everyone has their own risk and return preferences, everyone will choose
the same optimal risky portfolio, which becomes the market portfolio.
What is Capital Market Line?
As per the homogenous expectations assumption, the optimal CAL tangent to the efficient frontier is
termed as the Capital Market Line (CML).
Notice that if the investor holds the “market portfolio” (i.e., a portfolio representing a broad-based
index), then the investor’s return is the market's return.
The equation for expected returns is as follows:
E(Rm ) - Rf
σi
For every additional unit of market risk, the investor takes, he can expect to get an additional unit of
market risk premium. This is similar to what we had seen in the previous reading, except that this is
the market's Sharpe ratio rather than the portfolio's Sharpe ratio.
Now assume that investors can borrow at the risk-free rate and earn a higher return. This enables
them to purchase more risky assets (moving towards the right-hand side on the standard deviation
axis), and to increase their expected return (moving upwards on the expected return axis) along the
CML. So, the market portfolio and risk-free asset proportions can change, but the line's slope remains
the same.
This implies that the Sharpe ratio is not affected by leverage – if the slope of the line remains the
same, then the excess return for each additional unit of risk remains the same.
Note that this is only the case when the lending rate and borrowing rate is the same. If the borrowing
rate is higher, then the expected return on the lending portfolio is lower for each unit of additional
risk. This means that at any point after the borrowing portfolio starts, the slope becomes flatter.
There is a kink in the slope, and it looks like this:

What is a passive and active management strategy?
Let us understand these two terms with an example.
Certain investors believe that the markets are informationally efficient and reflect the correct prices.
Such an investor would place majority of their investments in the NIFTY 50 Index, which serves as a
proxy for the market portfolio. The remaining is invested in risk-free assets like government securities.
This is a passive investment strategy.
The investor in an active strategy believes that there is some market inefficiency and that the
benchmark return can be beaten by appropriate security selection and asset allocation. They will build
a different portfolio from the benchmark portfolio and allocate more weightage to securities that they
think will outperform the index.
LOS 21c: Explain systematic and non-systematic risk, including why an investor
should not expect to receive additional return for bearing non-systematic risk.
Any sort of investment in a risky asset bears its own levels of risk. The only way to reduce risk is to
diversify by investing in assets that are not perfectly correlated. If an investment is done in such a
diversified manner, then the portfolio risk is less than the risk borne by each security.
What is systematic and unsystematic risk?
Unsystematic risk is the risk of holding individual securities. Each individual company, for example,
can be seen as its own independent contributor or agent of risk in a portfolio. But when we add several
uncorrelated or not perfectly correlated agents of risk, then we can say that the portfolio is
diversified. This suggests that unsystematic risk, or individual risk, can be diversified.
Systematic risk is the risk of the entire system. It is an inherent risk that cannot be diversified no
matter what you do.
As a simple analogy, let us consider that you are buying some fruits. You have an empty basket in
which you put apples, pears, bananas, etc. Then you realize that the apples are poisoned, but luckily
you have other fruits that you can eat. The risk of one individual fruit did not ruin your entire basket.
Now imagine that you had bought only apples – the entire basket would have been ruined. This
illustrates that the risk of the basket can be diversified up to a certain extent. The systematic risk, in
this case, would be if the poison of the apple affected the other fruits, too – this is something that is
out of your control, and it is a risk that has to be borne.
We can also look at it mathematically and graphically.
TOTAL RISK = SYSTEMATIC RISK + UNSYSTEMATIC RISK

Now consider the above graph in the context of the market. There may be an adverse event like a
pandemic or a “systemic” financial crisis that reduces value in every single security in the market. This
risk cannot be diversified and is denoted by the horizontal line.
However, this scenario is still better than holding only one security that is exposed to a very specific
risk. A systemic event does not even need to take place. It could be that the company files for
bankruptcy, the current management’s strategic decisions cause a sharp fall in the company’s value,
or any such factor independent of the broad market.
Organizations like Smallcase provide diversified portfolios to Investors according to their risk
appetite.
Here as mentioned that unsystematic risk can be diversified, we are rewarded with returns only for
holding systematic risk which cannot be diversified. The reasoning is that investors will not be
compensated/ rewarded for holding risk that can be eliminated at no cost. Hence, we can conclude
that equilibrium security returns depend on the stocks or a portfolio’s systematic risk and not its total
risk as measured by the standard deviation.
LOS 21d: Explain return generating models (including the market model) and their
uses.
As with any other investment, portfolio investments also consider the calculation of returns as one of
the most important aspects. These models are used to estimate the expected returns on risky
securities based on specific factors. For each security, we must estimate the sensitivity of its returns
to each specific factor which can be classified as macroeconomic, fundamental and statistical.
Multifactor models most commonly use macroeconomic factors such as GDP growth, inflation, or
consumer confidence, along with fundamental factors such as earnings, earnings growth, firm size,
and research expenditures. There is not much basis for a statistical approach in finance theory as they
are arrived upon by repeated tests on the same datasets.
The general form of a multifactor model with k factors is as follows:
E(Ri) − Rf = βi1 × E(Factor 1) + βi2 × E(Factor 2) + ....+ βik × E(Factor k)
The above given is a multifactor model, which states that any returns above the risk-free rate for an
asset i is sum of each factor sensitivity or factor loading (β) for Asset i multiplied by the expected value
of that factor for the period. The first factor is often the expected excess return on the market, E(Rm -
Rf).
Another model which is often used is Fama and French. They estimated the sensitivity of security
returns to three factors: firm size, firm book value to market value ratio and the return excess of the
risk-free rate. A fourth factor is suggested by Carhart, which uses prior period returns to measure price
momentums. These four do a good job of explaining differences in returns.
The single factor model is the basic and the simplest factor model. With return on the market, Rm as
its only risky factor can be written as:
E(Ri) − Rf = βi ×[E(Rm) − Rf]
Notice that the left-hand side is the excess return of the asset over the risk-free rate. The factor weight
or factor sensitivity is the expected return. βi, the risk factor, adjusts the excess return on the market
portfolio. So, this model is also sometimes called a single-index model.
A Market Model is a simplified version of the single factor model used to estimate and assets beta
and return above the risk-free rate.
The model can be expressed as:
Ri = αi + βiRm + ei
where:
Ri = return on Asset i
Rm = market return
βi = slope coefficient of the regression
αi = intercept
ei = abnormal return on Asset i
The intercepts and the slope coefficient have been estimated from the historical data available.
LOS 21e: Calculate and interpret beta.
What does the term beta mean in the context of finance?
Beta is the sensitivity of a return on an asset to the sensitivity of a security relative to the market. It is
expressed as the covariance between a security (i) and the market (m).
It can be calculated as follows:

Covariancei,m Covi,m
βi = Variancem
or βi = σ2m
In terms of correlation,
ρi,m σi σm
βi = σ2m
Let us look at both of these cases from a numerical example.
The standard deviation of the return on the market index is estimated as 10%.
1. If Asset A’s standard deviation is 20% and its correlation of returns with the market index is 0.6,
what is Asset A’s beta?
2. If the covariance of Asset B’s returns with the returns on the market index is 0.0027, what is the
beta of Asset B?
ρA,m σA σm 0.6 × 0.2 × 0.1
βA = σ2m
, βA = 0.12
= 1.2
Covi,m 0.0027
βB = σ2m
, βB = 0.12
= 0.27
The beta can also be found by regression analysis. In a basic market model, the returns of the security
are regressed against the returns of the market. The stock price return is the dependent variable (Y
variable), and the market return is the independent variable (X variable). This concept is covered in
detail in CFA Level 2.
The beta is more likely to be found in the following form: E(Ri) − Rf = βi ×[E(Rm) − Rf]
When these variables are regressed, the slope of the line can be found, and this is the beta.
The above-given line is referred to as the asset’s security characteristic line.
Note that the beta is greater than 1 if the slope of the line is greater than 45 degrees. This implies that
the returns of the security are more aggressive than the returns of the market. Simply put, if the
market return is 10%, then the security is expected to return more than 10%. If the beta is less than
1, then the security returns are more defensive than the market returns – if the market return is 10%,
then the security is expected to return less than 10%.
The same is true for the downside – a high beta stock is expected to underperform the market in
recessions, while a low beta stock is expected to suffer less during recessions.
LOS 21f: Explain the capital asset pricing model (CAPM), including its assumptions,
and the security market line (SML).
LOS 21g: Calculate and interpret the expected return of an asset using the CAPM.
What is CAPM?
We can say beta is a standardized measure of risk – it considers the covariance of a security and the
market and standardizes it for the variance of the market. The beta is used in the CAPM equation to
standardize the excess market return over the risk-free rate.
Therefore, the capital asset pricing model (CAPM) measures the returns between excess returns on
the security and the excess returns to the market portfolio.
The CAPM is one of the most popular measures and can be stated as:
E(Ri) = Rf + βi × [E(Rmkt ) – Rf]
For example, if the expected return on the Indian market is 10%, the risk-free rate is 3%, and the beta
of a stock is 1.8, the expected (required) return on this stock is
E(Ri) = 3% + 1.8(10% – 3%) = 15.6%
This theory holds under certain assumptions:
1. Investors are risk-averse and rational. They seek to maximize utility and make investment
decisions based on their optimal preferences.
2. Markets are frictionless – there are no trading costs, taxes, and transaction costs.
3. The investment horizon for all individuals is the same. This is called the single-period
assumption.
4. Investors have similar (or the same) beliefs regarding market expectations.
5. Investments are divisible – the investor can spread their investments into pieces of small
investment. A non-divisible asset is like an antique or an art figure, while a divisible asset is
like a company's stock.
6. Markets are in perfect competition, and investors are price takers. This means that no
individual entity can influence the market prices significantly, and each entity must purchase
the asset at the equilibrium price determined by demand and supply.
Expected Return and Beta
Recall that the higher the beta, the greater the security’s co-movement with the market. A more
aggressive stock is expected to yield a higher return, and a less aggressive stock is expected to yield a
lower return.
Now we can plot the expected return versus beta.
Now let us see the slope of this line. This is extremely similar to what we saw with the capital market
line, except that now we are considering beta instead of standard deviation.
Taking from point M:

E(Rm ) - Rf
Slope = βi
This is also called the Treynor ratio. It implies that the excess return of a portfolio increases with each
unit of beta.
Now we can conclude that:
• The capital market line shows us the incremental excess return for each standard deviation
unit (total risk).
• The security market line shows the incremental excess return for each unit of beta (systematic
risk).
Following is an interesting relationship to note for the SML:
• If the point of expected return and beta plots below the SML of security, then the asset is
overvalued. This is because the investor is not getting enough return for the systematic risk
that they bear. Eventually, market participants will notice this and start to sell the security.
• If the point of expected return and beta plots above the SML of security, then the asset is
undervalued. This is because the investor is getting more than enough return for the
systematic risk that they bear. Eventually, market participants will notice this and start to buy
the security.
Portfolio Beta
The beta of a portfolio is simply the weighted average of all securities of that portfolio based on the
investment value:
βP = w1βi1 + w2βi2 + w3βi3 + … + wNβiN
Similarly, the expected return on the portfolio is:
E(RP) = Rf + βP × [E(Rmkt) – Rf]

LOS 21h: Describe and demonstrate applications of the CAPM and the SML.
There are various applications in the world of finance of CAPM AND SAML. Earlier, we used Beta to
calculate a security expected return now we can calculate a security required
Because the SML shows the equilibrium (required) return for any security or portfolio based on its
systematic risk, analysts often compare their forecast of a security’s return to its required return based
on its beta risk.
Let us take a numerical example to gain a better understanding.
The following figure analyst’s forecasts for three stocks. Assume a risk-free rate of 5% and a market
return of 12%. Compute the expected and required return on each stock, determine whether each
stock is undervalued, overvalued, or properly valued, and outline an appropriate trading strategy.
Forecast Data
Stock Price Today E(Price) in 1 Year E(Dividend) in 1 Year Beta
A $26 $28 $1.00 1.0
B 38 44 1.50 0.8
C 14 16 0.50 1.2
Answer:
Expected and required returns computations are shown in the following figure.
Forecasts vs Required Returns
Stock Forecast Return Required Return
A ($28 − $26 + $1) / $26 = 11.5% 0.05 + (1.0)(0.12 − 0.05) = 12.0%
B ($44 − $38 + $1.5) / $38 = 19.73% 0.05 + (0.8)(0.12 − 0.05) = 10.6%
C ($16 − $14 + $0.5) / $14 = 17.8% 0.05 + (1.2)(0.12 − 0.05) = 13.6%
Stock A is overvalued. It is expected to earn 11.5%, but based on its systematic risk, it should earn
12%. It plots below the SML.
Stock B is undervalued. It is expected to earn 19.73%, but based on its systematic risk, it should earn
12.6%. It plots above the SML.
Stock C is undervalued. It is expected to earn 17.8%, and based on its systematic risk; it should earn
13.6%. It plots on the SML.
The appropriate trading strategy is:
• Short sell Stock A.
• Buy Stock B.
• Hold or buy Stock C.
Remember, any stock not plotting on the SML is ought to be mispriced.
Limitations of CAPM
• Single-factor model: The model only considers systematic risk. A security may be exposed to
various sources of risk, so this model is quite restrictive.
• Single-period model: The model does not account for long-term implications of the expected
return on a stock. This leads to a short-term view on the security.
• “Market” portfolio: There is no clear definition of what comprises the market. For instance,
does it include only stocks or other asset classes too like bonds, commodities, or even art?
Therefore, the true market portfolio may not even be observable.
• Proxy for the market: The proxy is usually taken as a broad-based index of an asset class like
the NIFTY 500 index or a corporate bond index.
• Poor predictor of returns: The model does not accurately predict the expected return of a
stock, given its systematic risk.
• Investor expectations: The model assumes that all investors have the same view regarding
the market, and this is never the case.
Extensions of the CAPM
Arbitrage Pricing Theory
This simply states that portfolios with similar risk characteristics should have similar payoffs. The
model identifies factors betas, and each factor-beta has a factor weight. So, the expected return on a
portfolio is dependent on the risk factors associated with the security.
It is a general model and can be expressed as:
E(RP) = RF + λ1βP,1 + … + λNβP,N
λ is the risk premium of a factor over the risk-free rate, and β is the portfolio's sensitivity to that factor.
For instance, the risk factor in the CAPM is the systematic risk, and the value of beta captures this.
Like CAPM, APT also proposes a linear relationship between expected return and risk. Conversely,
Unlike the CAPM, APT allows numerous risk factors and these need not be common and may vary
from one asset to another. Although, it is a theoretically more flexible to the CAPM, APT is not
commonly used in practise as even it allows multiple factors to calculate the returns, it does not specify
any of the risk factors.
Carhart Model
This model is an extension of the Fama and French models. It considers factors like:
• Market risk premium.

• Risk of small-cap versus large-cap stocks.
• Risk of growth versus value strategies.
• Risk of momentum.
It can be expressed as:
E(Ri) = αi + β1MKT + β2SML + β3HML + β4UMD
Where:
MKT = market risk premium

SML = difference in returns between small-cap and large-cap stocks
HML = difference in return between stocks with a high book-to-market ratio and low book-to-market
ratio
UMD = difference in return between previous year’s winning portfolios (upwards momentum) and
losing portfolios (downwards momentum)
α = intercept factor (i.e., the minimum return if all factors are 0)
β = sensitivity of the security to the respective factor
Note that any study which uses such regression analysis is sensitive to market conditions of the time
frame selected. For example, there may be instances where small-cap stocks have outperformed
large-cap stocks, but this relationship may not persist all the time.
LOS 22i: Calculate and interpret the Sharpe ratio, Treynor ratio, M2, and Jensen’s
alpha.
Analysis of the portfolio managers’ choices and analysing the risk and return of the portfolio is termed
as performance evaluation. By providing accurate data and analysis on investment decisions,
performance evaluation allows portfolio managers to take corrective measures to improve investment
decision-making.
Attribution analysis, an analysis of the sources of returns differences between active portfolio returns
and those of a passive benchmark portfolio, is part of performance evaluation.
Success or failure of active portfolio management cannot simply be determined by comparing

portfolio returns to benchmark returns. A portfolio with greater risk than the benchmark portfolio
(especially beta risk) is expected to produce higher returns over time than the benchmark portfolio.
Hence the risk factor cannot be ignored.
When evaluating a portfolio against a benchmark portfolio, when both of them have different risks,
we need to adjust the risk and return of the active portfolio. Sharpe Ratio is one of the best alternative
ways to consider both risks and return in evaluating portfolio performance.
E(RP ) - Rf
Sharpe Ratio = σP
Sharpe ratio is an ex-ante measure using expected returns and standard deviations. However, it can
also be used as an ex-post (after the fact) measure of portfolio performance, using mean returns and
sample standard deviation over a period. This ratio is based on the total risk rather than systematic
risk. For this reason, the Sharpe ratio can be used to evaluate the performance of concentrated
portfolios and diversified portfolios.
We discovered earlier that the slope of the CML is the Sharpe ratio. The same concept is applied when
assessing the Sharpe ratio of a portfolio.
The M-squared (M2) measure produces the same portfolio rankings as the Sharpe ratio, but there is
a slight adjustment:
M-Squared Ratio = (Sharpe Ratio × σM) + Rf
This is the Sharpe ratio that is scaled by total market risk so that different portfolios can be compared
easily, relative to their performance against a benchmark.
Another tool is the Treynor ratio. We have seen this earlier too on the SML:
E(RP ) - Rf
Treynor Ratio = βP
Notice that the Treynor ratio is simply the Sharpe ratio, except that it adjusts for systematic risk, not
total risk.
Jensen’s Alpha is simply a modification of the CAPM – it measures the difference between actual
return and expected return that was predicted by the CAPM:
Alpha = RP - Rf + βP(Rm - Rf)
Notice that the term after RP is the same formula that we used to calculate the expected return from
CAPM.
This is a better tool to assess the return of a portfolio over the benchmark since it accounts for the
market risk premium and the systematic risk rather than the market return alone.
1. What is the risk measure associated with the capital market line (CML)?
A. Beta risk.
B. Unsystematic risk.
C. Total risk.
2. Highly risk-averse investors will most likely invest the majority of their wealth in:
A. Risky assets
B. Risk-free assets
C. The optimal risky portfolio
3. A portfolio to the right of the market portfolio on the CML is:
A. A lending portfolio.
B. A borrowing portfolio.
C. An inefficient portfolio.
4. As the number of stocks in a portfolio increases, the portfolio’s systematic risk:
A. Can increase or decrease.

B. Decreases at a decreasing rate.
C. Decreases at an increasing rate.
5. The portfolio of a risky asset and a risk-free asset has a better risk-return trade-off than
investing in only one asset type because the correlation between the two is:
A. -1.0
B. 0.0
C. 1.0
6. Which of the following statements about the SML and the CML is least accurate?
A. Securities that plot above the SML are undervalued.

B. Investors expect to be compensated for systematic risk.
C. Securities that plot on the SML has no value to investors.
7. Which of these return metrics is defined as excess return per unit of systematic risk?
A. Sharpe ratio.
B. Jensen’s alpha.
C. Treynor measure.
8. The risk-free rate is 6%, and the expected market return is 15%. A stock with a beta of 1.2 is
selling for $25 and will pay a $1 dividend at the end of the year. If the stock is priced at $30
at year-end, it is:
A. Overpriced, so short it.

B. Underpriced, so buy it.
C. Underpriced, so short it.
9. Portfolio managers who are maximising risk-adjusted returns will seek to invest less in
securities with
A. Lower values, for now, systematic risk

B. Values for a non-systematic variance which is 0
C. Higher values for non-systematic variance
10. Which of the following performance measures is consistent with the CAPM
A. M-Squared
B. Sharpe ratio
C. Jensen’s Alpha
Answers
1. C is correct as the risk measure associated with the CML is total risk as it takes into
consideration both systematic (market) and unsystematic (company-specific) risk.
2. B is correct as highly risk averse investors have a low risk tolerance and prioritize the
preservation of their wealth over the potential for high returns by taking low risk and to
achieve this objective, they tend to allocate the majority of their wealth to risk-free assets.
3. B is correct as a portfolio positioned to the right of the market portfolio on the CML, is a
portfolio with higher level of risk than the market portfolio. A borrowing portfolio implies
that an investor is not only investing in a risky asset but is also borrowing funds to increase
their investment and potential to earn higher returns.
4. A is correct as stocks are added in a portfolio to take benefit of diversification. More the
stocks, more the diversifications hence lower the unsystematic risk which can be elimatined.
However, adding a lot of stocks, diversification may not provide complete protection during
severe market downturns or highly correlated events. In times of market stress or systemic
risks, the correlations among different stocks and asset classes may increase, leading to
portfolio losses across the board.
5. B is correct as the correlation between the risky asset and the risk-free asset is typically
assumed to be low or close to zero. A correlation of 0.0 indicates that the returns of the two
assets are not correlated or do not move together in the same direction. This lack of
correlation is desirable because it means that when the risky asset's returns fluctuate, the
risk-free asset's returns remain unaffected.
6. C is correct as securities that plot on the SML even though as fairly valued, hold value to
investors. Securities on the SML represent a fair trade-off between risk and return, as
indicated by their expected return and systematic risk. Investors may consider these
securities as they provide a reasonable balance between risk and potential reward.
7. C is correct. Treynor measure
8. B is correct. Underpriced, so buy it

To determine if the stock is overpriced or underpriced, we can calculate its expected return
using the Capital Asset Pricing Model (CAPM). The CAPM formula is as follows:
Expected Return = 0.06 + 1.2 * (0.15 - 0.06)
Expected Return = 0.06 + 1.2 * 0.09
Expected Return = 0.06 + 0.108
Expected Return = 0.168 or 16.8%
Comparing the expected return with the current price and the expected future price. The
stock is currently priced at $25, and it is expected to pay a $1 dividend at the end of the
year. So, the total expected future price (including the dividend) is $30 ($25 + $1 = $26).
Expected Return = (Expected Future Price - Current Price) / Current Price

Expected Return = $5 / $25
Expected Return = 0.20 or 20%

Comparing the expected return of 16.8% (as calculated using the CAPM) with the expected
The expected return based on the expected future price (20%) is higher than the expected
return calculated using the CAPM (16.8%). This suggests that the stock is undervalued and
has the potential for higher returns. Therefore, it would be advisable to buy the stock.
9. C is correct as investors are rewarded for holding systematic risk and not unsystematic risk.
Therefore, holding higher values for non-systematic variance will not maximise risk-adjusted
returns.
10. C is correct as the CAPM model links expected return to the stocks Beta (systematic risk).
Jensen Alpha is also a performance measure that evaluates the stock’s risk adjusted return
(excess return) taking into account the stock’s beta.
Portfolio Management: An Overview 43
Portfolio Management: An Overview

Portfolio management is one of the key topics in the CFA charter. Basic concepts will be used
throughout the curriculum until CFA Level 3.
In this reading, we learn about how all different types of investors have different demands about their
investment needs and various investment vehicles. Ensure that you are familiar with the basics of
portfolio management and the investment policy statement.
LOS 22a: Describe the portfolio approach to investing.
Portfolio management has over the years been at the heart of the financial industry. It has various
applications on the buy-side in asset management.
What is a portfolio?
A portfolio is a collection of investments like stocks, commodities, bonds, alternative investment

funds, real estate, antiques, cash, etc. Portfolios are generally constructed with the idea of long-term
wealth creation. Diversification is a key aspect of the portfolio approach to investing. For instance, a
trader may hold an extremely concentrated position in a handful of stocks for a short time, but an
asset management company may hold more than 30-40 stocks to capture long-term themes in certain
sectors.
Risk and return are the primary considerations in a portfolio. The portfolio perspective refers to the
analysis and evaluation of the individual holdings in the portfolio by their contribution to the risk and
returns to the portfolio as a whole. The biggest challenge is to find an optimal balance of assets to
maximize long-term wealth based on the investor’s risk profile.
Modern Portfolio Theory
Harry Markowitz has provided a framework for measuring the risk reduction benefits of
diversification. Essentially, an efficient frontier can be drawn if one can plot the expected return of a
portfolio against the standard deviation. We will discover this later.
One important conclusion of his model is that unless the returns of the risky assets are perfectly
positively correlated, the risk is reduced by diversifying across assets.
Diversification is extremely important when it comes to portfolio management. Let us take a simple
example of A, B, and C, with each stock belonging to a different industry. There is a high probability
that the movements of A, B, and C are not correlated with each other, i.e., when A moves up, B may
move down, or C may move down. The benefit of diversification is that the movements of individual
stocks cancel each other out to some extent.
A diversification ratio can measure the benefits of diversification in reducing the risk of a portfolio:
𝑅𝑖𝑠𝑘 𝑜𝑓 𝑒𝑞𝑢𝑎𝑙𝑙𝑦 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑜𝑓 𝑛 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
Diversification Ratio =
Risk of single security selected at random
The aim is to balance a portfolio according to the investor’s risk profile.

LOS 22b: Describe the steps in the portfolio management process.
The three main steps are:
1. The planning Step.

a) Understanding the client’s needs
b) Preparation of an Investment Policy Statement (IPS)
2. The execution Step.
a) Asset Allocation
b) Security Analysis
c) Portfolio construction
3. The feedback Step.
a) Portfolio monitoring and rebalancing
b) Performance measurement and reporting
1) The Planning Step

This begins with knowing basic things about the investor. For instance, a fund manager may ask
questions including (but not limited to):
➢ The investment horizon.
➢ Risk tolerance.
➢ Tax bracket.
➢ Income needs.
➢ Liquidity needs.
➢ Existing portfolio details.
Now the fund manager is in a better position to make an investment policy statement (IPS). The IPS
is a written planning document that describes the client’s investment objectives and the constraints
that apply to the client’s portfolio. Objectives are return and risk objectives that may be stated in
absolute terms or relative terms. Constraints may include liquidity, unique circumstances, time
horizon, legal, and taxes. The IPS may state a benchmark—such as a particular rate of return (Absolute
or relative) or the performance of a particular market index—that can be used in the feedback stage
to assess the performance of the investments and whether objectives have been met. The IPS may be
reevaluated annually or quarterly to ensure that the client’s portfolio is aligned with the risk and
return expectations. The IPS provides a roadmap for the portfolio management process and helps to
ensure that the portfolio aligns with the investor's goals and constraints.
2) The Execution Step

This includes the next step of constructing a suitable portfolio based on the information gathers and
the IPS made in the previous step. This involves three steps which can be explained in a top-down
method.
Asset allocation
This involves analysing the risk and returns of various investment products (stocks, bonds, alternative
investments, etc.) while keeping the investor's requirements in mind. It may also involve a
macroeconomic analysis to identify the most attractive asset classes based on expected economic
conditions.
Security Analysis
This involves identifying specific securities (Infosys stock, Government of India bonds, etc.) within
asset classes. This may involve a bottom-up analysis to assess the specific characteristics of individual
securities.
Portfolio Construction
This involves deploying the funds into the selected securities in the proportions and restrictions
indicated by the IPS. This is the most specific step and will involve analysing sectoral allocation,
weightage of each asset class, weightage of each security, etc.
• Top-down analysis begins with an overall analysis of the macroeconomic environment before
focusing on specific assets. Assessing the larger economic, political, and social variables that
might have an impact on the market or industry is the first step. The investor will next decide
which sectors or industries are anticipated to do well or poorly in the present economic
situation based on this analysis. The investor will then choose specific equities that are
thought to profit from these patterns.
For instance, a top-down investor would assess the economy's prospects for the coming year
and come to the conclusion that the technology sector will likely perform well as a result of
the increasing dependence on technology. The investor may next search for certain
technological stocks that are in a good position to profit from this development.
• Bottom-up analysis starts by analysing specific businesses or securities before moving up to

the level of the market or sector. Analysis of each company's core components, including its
financial statements, business strategy, competitive advantages, and managerial calibre, is
the main focus. Based on this study, the investor will choose certain securities that are
predicted to do well without taking into account industry trends or the overall
macroeconomic climate.
For instance, a bottom-up investor may research a particular tech business and determine that it has
good financials, cutting-edge products, and a capable management team. The investor may then
decide to invest in this company, regardless of the overall outlook for the technology sector
.
3) The Feedback Step

This is the last final step in the portfolio management process. It involves two steps.
Portfolio Monitoring and Rebalancing
This involves regularly evaluating the market conditions and the client’s profile. The portfolio may be
rebalanced (the weightings of each existing asset are changed) or reconstituted (assets are removed
and added) at regular intervals.
Portfolio Evaluation and Reporting

This involves the assessment of meeting the client’s goals. The client and the portfolio manager must
be on the same page regarding the objectives of the portfolio as described in the IPS. Recall that the
objectives must be assessed regularly, either quarterly or annually.
LOS 22c: Describe types of investors and distinctive characteristics and needs of
each.
There are various types of investors in the financial markets with varying needs for portfolio
management services. For instance, the objectives of an individual investor like yourself will be
significantly different from the objectives of a large banking institution. The investment manager must
therefore recommend a portfolio based on the type of investor.
The various types of investors are as follows:
Individual Investors
These are retail investors or high-net-worth individuals. These most likely include professionals or
business owners seeking an avenue to preserve and grow their wealth.
The ultimate objective for these investors may vary. Some may want to purchase a house; some might
be saving up for healthcare expenses, while others may want to save for educating their children.
Retail participation in Indian markets was at an all-time high as of Q1 of FY 21-22. Factors like ease of
access via online brokerages, low-interest rates on fixed deposits, and better quality of education of
financial products may have potentially caused this increase.
Some countries provide tax benefits on such investments, so pension plans are a popular investment
vehicle for post-retirement sustainability.
LOS 22d: describe defined contribution and defined benefit pension plans
Defined Contribution Pension Plans
A Defined contribution pension plans are retirement savings plans where employees and/or
employers contribute a fixed amount or a percentage of salary to the employee's individual account,
and the eventual retirement benefits are determined by the contributions and investment returns
earned over time. Here, the employee assumes the investment risk and is responsible for managing
the account.
Institutions, Endowments, and Foundations
These are institutional investors, and they hold large portfolios. These investors can be domestic or
foreign. For instance, Reliance Capital Management comes under the top 20 institutional investors of
India. Such investors also have a huge influence on the market since they trade securities in bulk,
which can move the market for those securities.
Defined Benefit Pension Plans
The employer fully funds a defined benefit pension plan, and they manage all the investments hence
undertaking investment risks. The pension obligation requires complicated calculations and actuarial
assumptions (these can be seen in various companies’ notes to financial statements in annual
reports). The employee receives the benefits after retirement.
An endowment is a financial asset donated to an institution, such as a university or charity, to provide

ongoing support. The funds are invested in a diversified portfolio to earn a return and may include
restrictions on usage. Endowments provide long-term funding but require careful management.
Example: Harvard University endowment is an example of an endowment, valued at over $40 billion.
It provides support for academic programs, financial aid for students, and other institutional needs
A pool of money that has been set up to fund certain ongoing research which is of high value to the
country or the world is a foundation. It may be regarding some scientific research or some ongoing
disease. The main objective is to reduce the inflation-adjusted value of the assets. Foundations and
endowments typically have long investment horizons, high-risk tolerance, and, aside from their
planned spending needs, little need for additional liquidity. For instance, the best example is the PM
CARES Fund set up due to the outbreak of COVID-19.
Banks
Banks also invest a large sum of their liquidity in secure financial assets. Their main objective in terms
of investments is liability matching (i.e., setting up their balance sheet to ensure that the timing of
cash inflows meets the timing of cash outflows) and earning net interest income (i.e., earning more
on the receipt of interest on loans and investments than the interest paid out from deposits). Banks
must also meet capital quality standards, so their balance sheets may be geared more towards low
risk and high liquidity assets.
Insurance Companies
Insurance companies receive regular premiums from their clients, and these premiums are carefully
invested in keeping the fund ready in case of a payout. The types of investment and the investment
horizons depend majorly on the kind of insurance sold. Life insurance companies have a relatively
long-term investment horizon, while property and casualty (P&C) insurers have a shorter investment
horizon because claims are expected to arise sooner than for life insurers.
Investment Companies and Mutual funds
Various asset management companies (AMCs) hold thousands of crores of rupees in several stocks
and bonds. For instance, some of the top mutual funds in India by assets under management (AUM)
are SBI Mutual Fund, HDFC AMC, and ICICI AMC.
Mutual funds offer various investment categories in different asset classes to provide products to all
types of investors. For instance, a young professional with a long-term time horizon may invest in a
risky equity scheme, while a soon-to-retire veteran may invest in fixed-income funds to receive a
monthly cash flow. So, it is important to note that mutual funds may hold investments in stocks, bonds,
and commodities.
Recently, a start up from Bangalore named SMALLCASE started providing various portfolios for people
to invest in. It had various portfolios that were sector-specific, area-specific, and different amounts of
risk exposure. Such platforms make the beginning of an investment journey a bit easy.
Sovereign Wealth Funds
Sovereign wealth funds are investment funds owned by a government or state entity, typically
funded by surplus revenues. An example is the Government Pension Fund Global, owned by the
Norwegian government, is one of the largest sovereign wealth funds in the world with over $1.4
trillion in assets.
The various characteristics of Investors are demonstrated in the table below:
Investor Risk tolerance Investment Liquidity needs Income needs

Horizon
Individuals Subjective Subjective Subjective Subjective
Banks Low Short High Interest payments
and withdrawals
Endowments High Long Low Level of spending
Insurance Low Short for property High Low
and casualty, long
for life insurance
Mutual Funds Depends on fund Depends on fund High Depends on fund
features features features
Defined benefit High Long Low Varies with age of
pensions the fund
LOS 22e: Describe aspects of the asset management industry.
Asset management companies manage the investments which the clients make – for instance, an
individual investor like you can invest in a mutual fund scheme, and the fund manager of that scheme
will invest the funds based on the mandate of the scheme.
Such companies are also referred to as buy-side firms – they literally buy the assets and manage the
investments over a longtime horizon. A sell-side firm is a broker/dealer that sells securities and
provides independent investment research to buy-side firms. Remember that a sell-side firm sells
research and brokerage services while the buy-side firm calls the shots about what goes into an
investment portfolio. A buy-side firm may also conduct in-house research and publish research reports
based on their own investment outlook regarding a security, sector, or the market in general.
Active versus Passive Management
Active asset managers attempt to outperform a predetermined performance benchmark. For

instance, the HDFC Focused 30 Fund will invest in a basket of 30 or so stocks and will try to outperform
a benchmark like the NIFTY 500 Total Return Index.
Passive asset managers attempt to match or track returns of a predetermined benchmark. For
instance, the HDFC Index Fund – NIFTY 50 Plan will invest in a basket of stocks representing the NIFTY
50 index so that the portfolio matches the index returns as close as possible.
The rationale for passive investment is simple – research has proven that the average active fund
manager finds it increasingly difficult to beat the benchmark as markets become more efficient. This
is especially true after considering the investment fees and expense ratios that they charge to clients.
So, passive investing is deemed a low-cost method of investment that can deliver returns that are
linked to broad market indexes.
An investment manager may also deploy a smart beta approach that focuses on exposure to a
particular market risk factor. For instance, the investment team may find that small-cap stocks have
outperformed large-cap stocks during the early stages of an economic upturn. So, the portfolio may
be tilted towards these riskier stocks to capture the increased risk and return of small-cap stocks.
Traditional versus Alternative Asset Managers
Traditional asset managers focus on long-only equity, fixed-income, and multi-asset investment
strategies. In traditional asset management, the management fee is based on assets under
management.
Alternative asset managers focus on hedge funds, private equity, and various other strategies.
Alternative asset managers’ revenue is based on management fee and performance fees based on the
returns earned for the investors.
Ownership Structure
The majority of AMCs are privately owned – hedge funds may be incorporated as a limited liability
partnership. It is important to note if the owners have invested their personal capital into the
company. This ensures more alignment with the objective of long-term wealth creation.
Asset Management Industry Trends
Passive Investing
In recent years the passive management industry has seen huge growth due to low cost for investors
and difficulty for active managers to generate returns above the benchmark rate. Also, there are
questions if active managers are able to add value over time considering developed markets to be
efficient. For instance, 50% of U.S. mutual fund investments are in passive funds as of 2021.
Big Data
The asset management industry is constantly capturing potential upside from using qualitative and
quantitative data. Third parties and in-house IT investments have increased as a result due to the
increasing demand for relevant data points. Two key qualitative sources are:
• Social media data: Managers can gauge things like market sentiment, consumption trends,
and general investor consensus on specific trends from tools like keyword searches on social
media platforms such as Twitter. These platforms also encourage investor interest and
education of financial markets as more and more people have access to company-specific
announcements.
• Imagery and sensor data: Geographic information systems allow fund managers to track
things like real-time cargo locations, weather conditions, and company-specific data like
parking usage of retail outlets. For instance, a commodities trader can find these tools useful
because they can easily track the amount and location of oil barrels that are circulating in the
world.
Robo-Advisers
These are automated tools that advise retail individual investors, for instance, regarding portfolio
allocation, tax-loss harvesting, and investment strategy, among other services. The investor must
provide appropriate information regarding the risk tolerance and portfolio expectations so that the
software can provide the most unbiased recommendation. The underlying trends in the robo -
adviser category is:
• Young investors: “Mass affluent” investors with small sums of money may be left out of the
key demographic for large investment advisors. Robo-advisers and similar platforms allow
this generation access to financial market advice at their fingertips.
• Lower fees: Research shows that robo-advisers charge 0.20% in fees annually while the
typical investment manager may charge 1.0% on the AUM. There is an inherent bias here in
that robo-advisers typically recommend effective, low-cost products (like ETFs) that get the
job done for the client.
• New entrants: Low barriers to entry have encouraged investment managers to offer robo-
advisory services. This allows them to capture a new audience with relatively fewer
acquisition costs.
LOS 22f: Describe mutual funds and compare them with other pooled investment
products.
Pooled investment contains the investment funds of various investors, which are in a single portfolio.
One of the most famous and most useful forms of pooled investment is a mutual fund. The minimum
amount for mutual funds in India is usually Rs. 500 or Rs. 1,000 depending on the scheme. This enables
thousands of people to gain exposure to portfolios that an experienced fund manager manages.
Put simply; a pooled investment is when several anonymous people invest their money in a scheme
that a portfolio manager runs. The scheme is standardized – the investment objective and risk profile
are already mandated by the fund manager, so the investor must be careful when picking an
appropriate scheme.
Think about it this way: you want to invest Rs. 10,000 to gain exposure to the I.T. industry, so you
invest in Tata Digital India Fund. The fund manager will pick certain stocks depending on the scheme’s
objective. Thousands of people like you will have invested a certain amount in the scheme – the
aggregate is called the AUM of the scheme. You may purchase units of this scheme (similar to buying
shares of a company), representing proportionate ownership in that scheme (just like a stock). Now
you can see how a mutual fund is a pooled investment vehicle. The investment of all investors in the
scheme will increase by 10% if the investment value of the scheme increases by 10%.
The total net value of the assets in the fund (pool), which is managed divided by the shares issued, is
referred to as the net asset value (NAV) of each share.
Funds can be in two forms:
• Open-end fund.
• Closed-end fund.
Open-end Fund
The investors can buy the newly issued units of the fund at NAV. The cash invested by the new
investors is invested into portfolio securities by the fund managers. Investors can initiate redemption
of their units. The fund managers charge a management fee which is calculated as a percentage of
the net asset value of the fund.
No-load funds do not charge additional fees for purchasing shares upfront or for redeeming shares.
Load funds keep charging fees on investment or redemption or both.
Closed-end Fund
These are managed similarly to open-ended funds; except they do not take new investments into the
funds or allow redemption of any kind. The shares of such closed-end funds trade on the exchange
or over the counter like equity shares. For instance, SBI Tax Advantage Fund and Reliance FHF are
some of India's closed-end mutual funds.
However, close-ended funds may be listed on exchanges to ensure that the investor still has liquidity
in the scheme and can sell the units when needed. This is more relevant for ETFs. For instance, the
Nippon India ETF Gold BeEs can be purchased just like a stock on exchanges, and it will show in the
Demat account of the investor.
In India, open-ended funds do not need to be held in Demat form. Additionally, they may be held
digitally via platforms like Coin (by the brokerage, Zerodha).
A key distinction between open-end and close-end funds is that an investor must transact directly with
the mutual fund (or a mutual fund distributor) for open-end schemes. Note that this may be done
digitally too. However, the units of a close-end fund trade on exchanges, so the investor is actually
purchasing the units from another investor who wants to sell the units at the trading price.
Types of Mutual Funds
Mutual funds may create schemes across various investment categories. Some types of mutual funds
include:
Money Market Funds
Such funds are extremely risk-averse and invest in extremely short-term debt securities. Most of their
income comes from interest, so they hold a very low risk of changes in the unit value. Funds are
differentiated by the types of money market securities they purchase and their average maturities.
Some of these schemes can be tax-free if the fund manager invests in tax-free underlying securities.
However, there have been instances where the scheme’s NAV has drastically declined due to the drop
in value of the underlying securities.
Bond Mutual Funds
These kinds of mutual funds invest in fixed income securities and earn on the interest payments
received. These types of mutual funds are further classified based on maturities, credit ratings and
issuers. The maturity varies from short-term debt funds to long-term debt funds, and the fund
manager may invest in corporate bonds, government bonds, and municipal or state bonds. The major
difference between a bond mutual fund and a money market fund is the maturity of the underlying
assets.
Bond funds in India have the benefit of indexation. So, if the investor holds a bond scheme of a mutual
fund for more than 3 years, then the investment value is indexed to inflation.
Stock Mutual Funds
These types of mutual funds are for investors with a higher risk appetite and longer time horizons.
Such funds invest the funds into equity securities, and these are inherently more volatile than bond
funds. There are various types of index funds and sector funds that are available to investors.
Index funds are passive investment vehicles, and they try to replicate the returns and the
performance of the index. An actively managed portfolio is one where the fund managers invest in
various securities where they try to outperform the returns of the benchmark indexes. Actively
managed funds charge a higher management fee and a higher turnover of securities in a given year.
This also leads to higher tax liabilities.
Stock schemes can vary across market capitalization, sectors, and themes.
Hybrid/Balanced Funds
These funds invest in a combination of equity and debt securities. Aggressive hybrid schemes have a
greater allocation towards equity securities, while conservative hybrid schemes have a greater
allocation towards debt securities. Such funds can also be multi-asset funds – for instance, HDFC Multi-
Asset Fund invests in stocks, bonds, and gold. The fund manager may rebalance and reallocate
securities based on the market expectations and fund objectives, mandates and strategies
These schemes provide a more balanced portfolio across asset classes and may be suitable for first-
time investors who do not want to take on too much risk.
A separately managed account (SMA) is a portfolio that a single investor completely owns, and the
holdings are adjusted according to the investor's needs. For instance, an AMC may manage Sachin
Tendulkar’s shares in a completely different portfolio independent of the AMC's schemes to the
general public. This is a customized portfolio based on his individual investor profile.
Other Forms of Pooled Investments
The various forms of pooled investments are:
Exchange-Traded Funds
ETFs are a type of pooled investment vehicle usually based on an index.
A fund manager creates the ETF by analyzing and deciding which assets the ETF will hold. Once the
assets have been finalized, the fund manager contacts an institutional investor who owns those
securities. The institutional investor deposits the basket of securities with the fund sponsor (held
through a custodian). The institutional investor receives creation units for the deposited securities.
The creation units typically represent 50,000 to 100,000 ETF shares. It is important to note that the
weight of securities deposited is often in the proportion of what it is trying to represent.
For example, suppose an exchange-traded fund finalizes to invest in the following securities: Adani
Ports, BEL, HDFC Bank and Reliance. The ETF fund manager will contact an institutional investor who
owns the securities. That investor will deposit the given basket of securities with the ETF and will
receive creation units. These units are then traded on exchanges for the general public to trade.
Note that this is a closed-end fund. There is no minimum investment amount, and one can simply buy
a unit of the ETF from a brokerage. ETFs can be traded intraday. Dividends on ETFs are paid out to the
unitholders, whereas dividends on mutual fund schemes are typically re-invested.
Difference between Mutual Funds and ETFs:
Feature Mutual Funds ETFs
Structure Open-ended (unlimited shares) Closed-ended (fixed number of shares)
Priced and traded once a day after Traded throughout the day on stock
Trading market close exchange
Price NAV-based price Market-based price
Minimum Varies by fund, generally higher than Varies by fund, generally lower than mutual
Investment ETFs funds
Cannot trade intraday, only after market Can be traded intraday, anytime during
Trading Flexibility close market hours
Hedge Funds
These are less regulated than typical asset management companies and require significantly higher
minimum investment amounts. Investment requirements can be as high as $250,000 to $1 million, so
these are only available to qualified investors.
More details are provided in the alternative investment readings.
Private Equity and Venture Capital
These funds invest directly in either established or early-stage companies with the objective of a
strategic shakeup to increase the company’s value. The fund will then exit (or sell their stake) to
owners, another company, or retail investors via IPOs. This also requires a huge investment and is
accessible to qualified investors only. At times, fund managers also take an active role in managing
the company they have invested in.
More details are provided in the alternative investment readings.

1. Private equity and venture capital funds:
A. Expect that only a small percentage of investments will pay off.

B. Play an active role in the management of companies.
C. Restructure companies to increase cash flow.
2. With respect to the portfolio management process, the asset allocation is determined in the
A. Planning step
B. Feedback step
C. Execution step
3. Which of the following investment products is most likely to trade at their net asset value
per share?
A. Exchange-traded funds
B. Open-end mutual funds
C. Closed-end mutual funds
4. Which of the following pooled investments is most likely characterized by a few large
investments?
A. Hedge funds
B. Buyout funds
C. Venture capital funds
5. Hedge funds most likely:
A. Have stricter reporting requirements than a typical investment firm because of their use
of leverage and derivatives.
B. Hold equal values of long and short securities.
C. Are not offered for sale to the general public.
6. Investors should use the portfolio approach to:
A. Reduce risk
B. Monitor risk
C. Eliminate the risk
7. Which of the following institutions will, on average have the greatest need for liquidity?
A. Banks
B. Investment companies
C. Non-life insurance companies
8. Portfolio diversification is least likely to protect against losses:
A. During severe market turmoil.

B. When markets are operating normally.
C. When the portfolio securities have a low return correlation.
9. A defined benefit plan with a large number of retirees is likely to have a need for?
A. Income
B. Liquidity
C. Insurance
10. Which of the following institutional investors will have the longest time horizon:
A. Defined benefit plan

B. University endowment fund
C. Life insurance company
Answers
1. B is correct as Private equity and venture capital funds typically invest in companies with
high growth potential or those in need of a turnaround. To maximize their returns on
investment, they take an active approach in managing these companies.
2. C is correct. Execution step
3. B is correct as open-end mutual funds, is most likely to trade at their net asset value (NAV)
per share which are designed to be bought and sold at their NAV, that represents the total
value of the fund's assets minus its liabilities divided by the number of shares outstanding.
The NAV is calculated at the end of each trading day based on the market value of the fund's
holdings.
4. B is correct as buyout funds, is most likely characterized by a few large investments.

They typically focus on acquiring controlling stakes in established companies. These funds
pool capital from various investors to fund their investment activities.
5. C is correct as hedge funds are a type of private equity investments and are hence not
available to the public for sale.
6. A is correct as the portfolio approach involves diversifying investments across different asset
classes, industries, geographical regions, and securities. By doing so, investors can reduce
the overall risk of their portfolio.
7. A is correct as banks
8. A is correct as during severe market turmoil, even though diversification exists, correlation
among different asset classes increases.
9. B is correct. Liquidity
10. B is correct. University endowment fund

Basics of Portfolio Planning and Construction 58
Basics of Portfolio Planning and Construction

Now that you are familiar with the risk-return profile and the capital allocation methods, we will get
into the details of portfolio planning. Ensure that you have a thorough understanding of the contents
and uses of investment policy statements and how this affects portfolio allocation. Also, understand
the ESG considerations.
LOS 23a: Describe the reasons for a written investment policy statement (IPS)
The s of portfolio planning entails a deep dive into the client’s risk profile, return expectations, and
investment objective.
An investment policy statement (IPS) must be formulated to have an objective framework for the
portfolio allocation process. An investment manager is not likely to produce a good result for a client
without knowing the client’s needs, circumstances, and constraints.
A general Investment policy statement begins with the investor’s goals in terms of risk and return. This
should be determined upon mutual agreement. Investor’s expectations must be compatible with the
risk tolerance.
For instance, a young investor would have a higher tolerance for risk, and hence high returns can be
achievable. The same cannot be duplicated for a retired government employee who will have lower
risk tolerance.
LOS 23b: Describe the major components of an IPS.
There is no standard format to the Investment Policy Statement, but most conform to a basic
structure. The major components of an IPS typically address the following: -
• Introduction: A brief description of the client.
• Statement of the Purpose of the IPS itself.
• Statement of Duties and Responsibilities: Outlines the obligations of the client and
investment manager.
• Procedures: To keep the IPS updated and general protocol to follow for contingencies.
• Investment objectives of the client.
• Investment constraints.
• Investment Guidelines: How the IPS will be executed (includes the use of leverage and
permissible risk).
• Evaluation and Review: Guidance on feedback.
• Appendices: Includes the strategic allocation process and the rebalancing policy.
IPS will contain a clear statement about client requirements and constraints, and an investment
strategy based on the following will be formulated and a benchmark to evaluate against.
LOS 23c: Describe risk and return objectives and how they may be developed for a
client.
The investment objectives and investment constraints are arguably the key components of the IPS,
which set out the risk and return objectives. Return objectives and expectations must be consistent
with the risk objectives and constraints that apply to the portfolio.
The risk objectives take various forms. There might be an absolute risk objective which might say,
“Have no decrease in portfolio value during the next 12-month period” or to “Not decrease in value
by more than 2% at any point over any 12 months.” Low absolute percentage risk may result in
investments in bonds and government securities. Standard deviation and value at risk are also
absolute risk measures.
Relative risk objectives would be based on a benchmark like the NIFTY 50 or the LIBOR to measure
risk. For example, tracking error – the deviation of returns relative to a benchmark – is a relative risk
objective. For a bank, the return objective may be relative to the bank’s cost of funds.
The return objectives may be stated on an absolute or relative basis. An absolute return objective may
state the desired returns in nominal or real terms, while a relative return objective could be
outperformance relative to an index or even peer group. However, a good benchmark should be
investable, making return objectives relative to peers or other managers and institutions less
appropriate.
The return objective should be clearly stated as either before or after fees and pre-tax or post-tax. The
return objective must be consistent with the client’s risk objective and appropriate for the market and
economic environment. For instance, it is unreasonable for an investor of a low-risk appetite to have
the NIFTY Small Cap 250 Index as a benchmark.
LOS 23d: Explain the difference between the willingness and the ability (capacity)
to take risks in analyzing an investor’s financial risk tolerance.
A client’s overall risk tolerance depends on their ability to bear risk and their willingness to take on risk.
Financial risk tolerance is made up of two factors:
• The ability to take on risks.

• The willingness to take on risks.
The two may not always go together; an investor may have the ability to take on risk but may be
extremely risk-averse and unwilling to expose himself to any potential loss.
The ability to bear risk is measured typically in terms of time horizon, expected income, and level of
wealth relative to obligations. Typically, an investor with a longer time horizon has a greater ability
to bear the risk as there is more scope to recover losses over the time horizon. Similarly, an investor
with large wealth relative to its liabilities will typically be able to withstand greater risk.
The willingness to take on risks has a psychological component. While there is no single agreed-upon
method for measuring willingness to take on risk, this may be gauged through discussion with the
client and the use of psychometric questionnaires.
When the adviser’s assessments of an investor’s ability and willingness to take investment risk are
compatible, there is no real problem selecting an appropriate level of investment risk. If the investor
is willing to take on risk but cannot do so, then the final decision is with the investor themself.
When the situation is opposite (i.e., there is less willingness but high ability), the advisor will educate
the client about available investment opportunities and correct any misconceptions about investing.
The approach will most likely be to conform to the lower of the investor’s ability or willingness to bear
risk, as constructing a portfolio with a level of risk that the client is clearly uncomfortable with will not
likely lead to a good outcome in the investor’s view.
For instance, a retired businessman would have savings of over 3 Crore rupees but would not be willing
to risk his fund and would want a stable interest income. It is an advisor’s duty to educate the investor,
but the final decision lays with him.
LOS 23e: Describe the investment constraints of liquidity, time horizon, tax
concerns, legal and regulatory factors, and unique circumstances and their
implications for the choice of portfolio assets.
Following are the investment constraints that a client may typically face.
Liquidity
Liquidity is the ability to convert investments to cash instantly. For example, large-cap stocks are liquid
investments While real estate is an illiquid investment.
For institutions, there could be rules around this, like spending requirements in the case of
endowment funds. When a client has a known liquidity requirement, the portfolio manager should
allocate a portion of the portfolio to cover this liability by ensuring the allocated assets can be quickly
converted to cash at the point in time at which the obligation needs to be met.
Illiquid investments in hedge funds and private equity funds, typically not traded and have restrictions
on redemptions, are unsuitable for investors who may unexpectedly need access to the funds.
Time Horizon
This is directly related to risk. The longer the time horizon, the higher the risk appetite, and the lesser
the liquidity requirements. It might be risky for an investor who has fund requirements in a short
period of time. Safe and liquid investments such as government securities or a bank certificate of
deposit would be a perfect fit. However, suggesting a PE fund to a client who has a turnaround time
of 7 years may not be suitable because the money has to be locked in for that much time for the
investor to realize some returns.
Tax Situation
Apart from an individual’s overall tax rate, the tax treatment of various investment accounts is also
considered in portfolio construction. Taxpaying individuals in the USA might prefer investing in tax-
free bonds rather than taxed bonds and invest in equities on which they earn capital gains taxed at a
lower rate.
Various investment accounts like retirement or pension accounts provide tax benefits and are
exempted from tax requirements. Such investment vehicles are great attractions for a large number
of people.
For example, In India, investments in public provident fund, pension fund provide tax benefits and can
be claimed as a deduction.
Legal and Regulatory
In addition to all the financial regulations that apply to the investors, there are other specific
regulations depending on the individual's characteristics. In some countries, pension funds are subject
to restrictions on their portfolio composition. In the case of individuals, they may have access to non-
public information on a particular listed company by virtue of directorship and, as such, are restricted
from trading on that company ahead of the release of company financial results.
For instance, an investor in Abu Dhabi and an Investor in Hong Kong might have to follow the legal
and regulatory requirements to follow country wise.
Unique Circumstances and ESG
Sustainable investing is one of the non-financial considerations. Some investors would not want to
invest in companies that produce tobacco, alcohol, or weapons. Investors may also want to stay away
from countries with track records of human rights violations. Unique investor preferences may also
be based on diversification needs when the investor’s income depends heavily on the prospects for
one company or industry. A founder would not want a competitor to invest in his company.
For instance, certain investors in India might refrain from investing in companies like McDowell’s, ITC,
or United Breweries as they produce alcoholic and tobacco products.
ESG methods can be used to build a portfolio that supports sustainable investing. An investment
manager can use certain screens for ESG investing:
• Negative screening: Excludes companies with malpractices related to ESG.

• Positive screening: Actively searches for companies with beneficial ESG attributes.
• ESG integration: Considers ESG as a systematic (or market) risk in the risk assessment process.
• Thematic investing: Actively investing in specific themes that support ESG practices.
• Engagement/active ownership: Taking a majority stake in a company to promote ESG
practices from the inside out.
• Impact investing: The investment focus is to create social impact in a way that generates
positive returns.
LOS 23f: Explain the specification of asset classes in relation to asset allocation.
Strategic Asset Allocation
This draws out the asset allocation based on the IPS-mandated expectations and constraints of the
investor. The point is to understand how much systematic and unsystematic risk the investor can
bear. Systematic risk is the risk of the entire system (the economy and the financial markets) – this
cannot be diversified and must be borne by the investor. Unsystematic risk can be diversified, but the
asset allocation must be such that there is a fine balance between unsystematic and systematic risk
so that the investment manager can deliver adequate returns to the portfolio.
This is when the manager must consider standard deviation, correlation and the efficient frontier to
create a portfolio of risky assets.
Capital Market Expectations

The investment manager must also be aware of the investor’s understanding of the capital markets.
For instance, the investor should know that bond markets deliver lower but safer returns than equity
markets. The portfolio can then be balanced accordingly, and expectations can be set accordingly.
It is also important to educate the investor regarding the relatively new asset classes like alternative
investment funds (PE funds and hedge funds), algorithmic funds, and any newly regulated product
that enters the market. Cross-country diversification is also important.
Mutual funds in India have released products that give Indian investors exposure to FAANG+ stocks in
the U.S. The traditional investor must be made aware of such products since they might be beneficial
to their portfolios.
Stocks are usually classified by market capitalization (large-cap, mid-cap, and small-cap) or by style
(value and growth). The investment manager needs to assess the risk-return profile of such equities
before recommending them to investors.
Bonds can be divided based on maturities or criteria, whether they are foreign or domestic,
government or corporate, or investment-grade or speculative.
The investment manager must be prepared with all sorts of investment products and information
regarding equity, bond, and commodity markets so that they can advise the client whenever there is
a need to rebalance the portfolio. For instance, the investment manager should know that the equity
portion of an individual's portfolio with a low-risk appetite should be reduced when valuations are
extremely high.
The investment manager may also use machine learning tools to simulate scenarios and then advise
the client based on a portfolio if the economic scenario changes.
These factors circle back to the investor’s indifference curve, the efficient frontier, and the capital
allocation line.
LOS 23g: Describe the principles of portfolio construction and the role of asset
allocation concerning the IPS.
Risk Budgeting
The investment manager will ascertain the total level of risk that an investor can bear. They will then
divide this risk into different assets and asset classes so that the overall portfolio risk does not exceed
the pre-determined level of risk.
The IPS will already state this pre-determined level of risk, so the investment manager must be aware
of how to distribute this risk while carrying out strategic asset allocation.
Tactical Asset Allocation
This is more of an opportunistic allocation. For instance, if the Indian economy is coming out of
recession and the manager has seen that infrastructure funds perform well during these periods, they
may suggest a thematic mutual fund scheme in infrastructure.
The portfolio risk-return profile may deviate from the mandated levels, but it is not a permanent shift.
It is even more beneficial if the investment pays off because the manager has delivered a higher return
in a relatively short amount of time.
Security Selection
Just as it is important to identify which sectors will perform well in an economy, it is just as important
to pick the right stocks. Continuing from the example above, the infrastructure space has several
applications and several companies. Whether capital goods, cement, or infrastructure ancillaries
outperforms the entire space is up to the manager’s expertise.
However, it is also important to set limits for how much the portfolio’s risk-return profile can deviate.
It should not happen that the manager takes an excessive risk, and the investment does not pay off.
Also, remember that there is always an opportunity cost of investing in new assets. The money could
have been used in safer bets that were in line with the IPS, and these could have paid off a safer but
positive return.
There are two specific issues with active portfolio management:
1. An investor may have multiple managers managing the fund with a similar benchmark. One
may overweigh a stock, and one may underweight a stock, and hence there is no active
management risk. The overall risk budget is underutilized.
2. When all managers are actively managing with the index as the benchmark, trading may be
excessive overall. This extra trading could have negative tax consequences, specifically
potentially higher capital gains taxes, compared to an overall efficient tax strategy.
What is the core-satellite approach?

The core-satellite approach invests the majority, or core, portion of the portfolio in passively managed
indexes and invests a smaller, or satellite, portion in active strategies. Decreases chances of excessive
trading.
Developments and Criticisms in Portfolio Management
Robo-Advisors
These are effective and low-cost tools for ordinary retail investors to gain access to financial markets.
They typically use machine learning software to assess investor risk and match this with the acceptable
universe of investments.
Note that these types of services typically recommend broad-based, low-cost products like ETFs rather
than specific securities. Investment managers can incorporate such software into the decision-making
process.
Time Horizons
The study of standard deviations, correlations, systematic risk, etc., is extremely subjective to the time
horizon chosen. For example, stocks and bonds may have had a negative correlation hundred years
ago, but so much has changed from a policy standpoint since then that the correlations have become
positive for certain time frames.
LOS 23h: Describe how environmental, social, and governance (ESG) considerations
may be integrated into portfolio planning and construction.
What is ESG?
Environmental, social and governance factors are collectively referred to by the acronym “ESG”. ESG
integration is the practice of considering environmental, social, and governance factors in the
investment process, and can be implemented across all asset classes, including equities, fixed income,
and alternative investments.
This topic is explained in detail in the Corporate Finance readings.
ESG has become an integral part of corporate policy, and the investment management industry has
also become aware that positive ESG scores benefit the long-term sustainability of a company. This is
essential in the light of climate change, human rights, integration of different types of capital, and
brand value.
Companies are also becoming more transparent about their ESG practices by providing integrated
annual reports. These are essentially annual reports which also discuss corporate social responsibility
issues.
Due to such developments, investment managers are considering ESG risk as a systematic risk while
understanding the risk of a company or a portfolio. The aim is to protect the portfolio from the
downside of ESG malpractice and also to position the portfolio so that it may benefit from positive
ESG practices.
1. In preparing an investment policy statement which is the most difficult to quantify?
A. Time horizon
B. Ability to accept risk
C. Willingness to accept risk
2. Risk assessment questionnaires for investment management clients are most useful in
measuring:
A. Value at Risk
B. Ability to take risk
C. Willingness to take risk
3. For asset allocation purposes, asset classes should be specified such that correlations of
returns are relatively:
A. Low within each asset class and low among asset classes.
B. High within each asset class and low among asset classes.
C. Low within each asset class and high among asset classes.
Answer
1. C is correct as While all the options listed (time horizon, ability to accept risk, willingness to
accept risk) are important factors to consider when creating an IPS, the willingness to accept
risk can be particularly challenging to quantify.
2. C is correct as Risk assessment questionnaires are commonly used tools in the investment
industry to assess an investor's risk profile and preferences. These questionnaires help
determine the level of risk an investor is willing to take in their investment portfolio
3. B is correct. High within each asset class and low among asset classes.
The Behavioural Biases of Individuals 66
The Behavioural Biases of Individuals

In this reading, we will discover emotional biases and cognitive errors. These are the human
characteristics of investing. No matter how logical and quantitative our investment processes may be,
the human processes of emotion and cognition impede truly rational investing.
Behavioural finance is the argument against the “rational investor”, so ensure that you have
understood the different types of biases and their consequences on the decision-making process. The
detection and guidelines are more for a deeper understanding of how to apply this information.
LOS 24a: Compare and contrast cognitive errors and emotional biases.
Behavioural biases can be either cognitive errors or emotional biases.
Cognitive Errors
These arise from “faulty” human reasoning. They represent the pitfalls of human cognition and
reasoning abilities. It is the way humans perceive things rather than seeing them objectively.
They can be resolved through better reasoning, information, advice, and re-arranging a problem into
rational pieces and rational processes.
Emotional Biases
Like emotions, these arise on the spot, and they may not have much rationale behind them. They can
be seen as impulses or intuitions.
These are typically difficult to resolve from an investing perspective.
LOS 24b: Discuss commonly recognized behavioural biases and their implications
for financial decision making.
We will now discover types of cognitive errors and emotional biases in detail.
1. Cognitive Errors
Belief Perseverance Biases
Suppose you believe that Rohit Sharma is the best cricket player globally, but someone provides a list
of statistics to prove that there are better players out there in all formats of cricket. Objective views
challenge your belief, and this creates cognitive dissonance.
Then it is up to you whether you want to change your belief or not. If you do not change your beliefs
and are “married to your opinion”, belief perseverance is necessary. You will choose to focus on the
details that you want to focus on and ignore all data that goes against your view.
This manifests in different ways.
Conservatism Bias
This is like the explanation above: you will not change your view (or under-react to new information)
when you are presented with ideas against your beliefs.
Consequences:
• Slow to update a forecast: You may not incorporate new information regarding a company’s
operations in your long-term view.
• Maintain prior beliefs: You will keep thinking about what you always thought even when you
are presented with new data.
Detection:
• If an analyst does not give appropriate weightage to new information.

• If the analyst believes there is a cognitive cost (mental effort) to update the beliefs rather
than a benefit to the financial model.
Guidance:
• Become aware of such biases and begin to weigh new information appropriately.
• Ask questions like, “How will this information change my forecast?” or “To what extent
should I incorporate this new information?” and so on.
• If the new information is complex, then understand it from other people.
Confirmation Bias
This means you are likely to actively seek views and data that support your beliefs to strengthen them.
In this case, you are not giving enough analysis to the other side of the picture. For example, you can
pick out Rohit Sharma’s IPL statistics but completely ignore his test match scores (or vice versa) for
the benefit of your argument.
Consequences:
• Likely to consider only positive information over the negatives.

• Make a biased screening criterion that only picks out data that will support a view.
• Make portfolios that are extremely concentrated only towards one view.
• Hold only the ESOPs of the company at which they work because of the faith in just one
company alone.
Detection:
• Lack of people who challenge the status quo in investment committees.

• Unanimous agreement on market outlooks.
Guidance:
• Challenge the investment thesis, challenge the source of new data, challenge the opinion that
is formulated from such sources.
• Encourage transparency and openness in the decision-making process.
Representativeness Bias
This is like saying, “This market situation feels a lot like the 2007 situation before the crisis”. It is when
certain factors look very similar to things that have happened before. But this is not entirely true
because no two situations are ever truly the same.
This manifests as base-rate neglect – the occurrence of an event in the overall population is neglected
to favour new but small information – or as sample size neglect – the sample is considered a true
representative of the true population.
Consequences:
• Individual data points drive the forecast instead of seeing the bigger picture.
• Decisions are made based on classifications or “buckets” of data instead of seeing the bigger
picture.
Detection:
• Basing decisions on how the past has played out.
Guidance:
• Ask whether the “buckets” of data are correct. For example, “Can this new data point really
be classified in the same bucket as what happened last time?” or “Which classification does
this new data point really belong to?”
Illusion of Control
It is inappropriate to assume that an investor has control over the behaviour and direction of the
overall market. However, some investors do believe that they have more control than they think they
do. This can be seen in clear gambles like the lottery – people may select a lottery card by seeing their
lucky number or a combination of good numbers on it, increasing their probability of winning the
lottery.
Consequences:
• Poor diversification: Investors may overweight a stock simply because they like a company or
a security based on such illusions.
• Overtrading: Investors may trade more based on this illusion, thinking they control their
profits and losses. Trading costs can catch up for large investors.
• Overly detailed financial models: It does not make sense to have a financial model with 10
sheets if these sheets do not have informational value. It is only an illusion that the analyst
has covered the minute details of the valuation.
Detection:
• Extremely detailed analyses with less informational value.

• Over-rationalizations for overtrading and for making very specific investments.
Guidance:
• Investment managers should recognize that the most they can do are manage and diversify
risk.
• For example, there is no true control over the path of stock prices, so it is best to understand
that external forces can affect the price regardless of company fundamentals.
• Acknowledge that one can never work with truly perfect information and manage the
downside risk accordingly.
Hindsight Bias
This is the “I knew it all along” effect. You think that an event was much more predictable than it
actually was. When making a prediction, you were working with imperfect information, but after the
event happened, you told all your friends that you really knew that things would play out exactly how
they did.
Consequences:
• Overestimation and overconfidence in predicting an outcome that has already happened.

• It can also lead to the investor thinking that the investment manager did not do a good job.
Think about it this way: when an IPS is made, all parties are working with truly imperfect
information regarding the future. Suppose the portfolio allocation does not deliver the
desired result. In that case, the investor may believe that the manager has not done a good
job without remembering that there was imperfect information before.
Detection:
• Claiming that an outcome was more predictable than people thought.

• Not recognizing that new information was provided after the prediction was made.
Guidance:
• Record the investment decisions and all the facts at the time of the decision.
• Evaluate the facts and ensure that the investment process is dynamic throughout the life of
the investment horizon.
Processing Errors
These are errors of illogically or irrationally processing new information. They may be less related to
beliefs and memories and more related to flaws in processing information.
Anchoring and Adjustment Bias
Think of an anchor like something that pulls your decision towards one piece of old information in
light of new information. For example, if you ask five friends how an outfit looks on you, you may be
“anchored” towards the opinion of your closest friend who you asked first, even though the other four
friends have an objectively better opinion.
It is closely related to conservatism bias too.

Consequences:
• An analyst may stick to the original investment thesis and the original financial model’s
assumptions even when new information is provided.
• Downside and upside adjustments are not made appropriately, and the investment outlook
may not be holistic.
Detection:
• Giving more weight to original beliefs than is practical.

• Giving more weight to the opinion of a favourite external analyst and sticking to that view
even when there is information that contradicts this view.
Guidance:
• Investment managers may have certain stock targets within a certain time frame. If the stock
does not reach that target, then the investor may hold on to that stock for longer than needed.
So, one must ask questions like, “Am I still expecting the stock to reach the target or am I
anchored to my previous analysis?”
• It is also important to ask questions like, “Is the current forecast based on previous
expectations and previous data or have I adequately incorporated the new information?”
Mental Accounting
Suppose you have purchased a pen and you keep it in one pocket of your shorts, then you purchase a
pencil and keep it in another pocket. Is your total investment divided into these two separate pockets,
or is it the sum total of the money spent on these two items?
Similarly, when an investor purchases different securities and treats them as two different profit and
loss accounts, it is possible to forget that the portfolio gain is the sum of all the parts rather than the
individual parts alone.
Consequences:
• Investors may forget about the correlation of assets in the context of the entire portfolio if
they see the assets as individual pieces of the puzzle. This may lead to suboptimal
diversification.
• There may be a tendency to spend the money from interest payments on fixed-income
securities rather than using capital gains from other securities for the same purposes. The
investor runs the risk of reducing principal and therefore reducing future interest income.
• Suppose you have invested Rs. 10,000, and the return is Rs. 1,500. You may look at the Rs.
1,500 as return generated from the markets and assume that this is “house money”. So, your
risk appetite increases, and you may choose to gamble the Rs. 1,500 in riskier bets. In fact, the
total portfolio is worth Rs. 11,500 regardless of how the portfolio is composed.
Detection:
• Looking at two securities in an individual context instead of looking at the entire portfolio.
• Not considering the additional portfolio risk from adding a new security.
Guidance:
• Consider the entire puzzle as a whole rather than looking at the pieces individually.
• Consider the cross-correlations of all securities in a portfolio before adding new assets.
Framing Bias
This refers to how a problem or a statement is framed in your mind. For instance, if someone tells
you that 1 in 10 startups succeed, you may not realise the extent that 9 in 10 do not succeed.
Similarly, you may be subject to narrow framing when you do not understand the other side of the
coin and the long-term effects of an investment decision.
Consequences:
• Misjudge an investor's risk tolerance simply based on how a question was framed and how
they have interpreted it.
• More weightage is given to short-term factors without understanding the bigger picture.
Detection:
• Focusing more on the benefits and forgetting about the risks.

• Sticking to a reference point and not seeing the other side.
Guidance:
• One may ask questions like, “Was the investment decision made based on the gains or based
on downside risk and potential losses?”
• Consider the future prospects and try to capture the most open-minded view and
consequences of an investment decision.
Availability Bias
This bias can manifest from sources like:
• Retrievability: The quickest answer wins even though there may be more answers that are
logical and well-reasoned.
• Categorization: The problem is categorized in a “search set”, and then the answer is
obtained from that set itself instead of considering that the categorization itself was
incorrect.
• Experience: Lack of experience or expertise may result in a suboptimal solution.
• Resonance: You are more likely to empathize or choose a solution that is “closest” to your
personal experiences.
Consequences:
• The opportunity set of decisions is limited.

• Choosing investment products or investment advice based on quantity or frequency of
advertisement rather than quality.
• An investor may give more weightage towards the sector in which they work instead of
diversifying into different sectors.
Detection:
• Making snap decisions without considering all information.

• Assuming that the most prominent option is the best option.
Guidelines:
• An investment manager may ask questions like, “Did you construct your portfolio based on
the views from the sector in which you work?” or, “Did you base your investment on the fact
that you use that company’s products or see their advertisements often?”
2. Emotional Biases
Loss-Aversion Bias
Loss-aversion bias is demonstrated when an investor refuses to sell positions that are trading below
their original cost to avoid realizing losses. By contrast, loss-averse investors tend to sell “winning”
investments early to lock in gains. Taken together, these tendencies are known as the disposition
effect – the investor hates losing more than they like winning.
Consequences:
• An investor holds on to losing investments.

• Winning investments are sold sooner as well instead of letting the unrealized gains increase.
This induces overtrading, and the investor may be unaware of trading costs from doing so.
However, trading may decrease if the majority of a portfolio’s positions are trading below
their purchase price.
Guidance:
• Objectively weigh the potential for future gains rather than holding a short-term view.
• Realize the loss and re-allocate the principal to winning investments.
• Have strict rules like stop-loss limits to cut the losses as soon as possible.
Overconfidence Bias
Investors demonstrate overconfidence bias by holding an irrational belief in the superiority of their
knowledge and abilities. The investor is also subject to self-attribution bias, which indicates that they
take more credit than is justified for winning positions. Similarly, they may externalize and blame
external circumstances when things do not go their way.
This may also lead to the investor making investment decisions from a “gut feeling”, which is not an
objective rationale for investment decision-making.
Consequences:
• Underestimating risks and overestimating the potential returns.

• Under-diversification of the portfolio.
Guidance:
• Maintain and review trading records to assess the confidence of a prediction and the
confidence of the certainty.
• “Anyone can make money in a bull market” is a suitable phrase to remind people of their
overconfidence and the self-attribution bias.
Self-Control Bias
In a general sense, self-control bias is a lack of self-discipline. In the context of investing, self-control
bias is the inability to put off current consumption and save for the future.
Consequences:
• Insufficient savings.
• Excessive borrowing to finance current consumption.
Status Quo Bias
Investors go with the herd. They do not do their own due diligence and tend to do nothing for their
own investments.
Consequences:
• Holding an inappropriate asset allocation and an inappropriate amount of risk.

• Failing to explore certain investment opportunities.
Detection:
• Holding too many securities that are closely linked to the views of your closest circles.
• Holding securities that objectively do not match your risk-return profile.
Guidance:
• Education and information of the quantitative aspects of the risk-return profile.

• Explaining the benefits of diversification to suit the investor’s risk-return profile.
Endowment Bias
Suppose you buy a cricket jersey which is worth Rs. 10,000. The team that you support does not
perform worse or better in the next three months. But because of your personal attachment (literally
personal investment) to this product, you will not part with it for less than Rs. 10,000.
Essentially, you will not sell an asset for less than what you bought simply due to your emotional
investment into the asset. This is especially true if you hold the stock of a company at which you work.
Consequences:
• Failing to sell (and replace) certain assets.

• Holding an inappropriate asset allocation.
Detection:
• Holding onto an asset that has been passed down from generations, although there is less
objective value in holding it now.
• Feeling extremely loyal to a particular asset and having a “soft spot” for such assets.
Guidance:
• Asking the investor, a question like, “If you had Rs. 10,000 to spend right now, then would you
buy that same asset?” The rationale is that if the investor would not buy the asset now, why
would they hold on to it?
• Similarly, one can go based on price alone, “Would you buy this same asset at the current
market price today?” If the answer is no, then there is no reason to hold on to it since the
investor does not see value in buying the asset.
Regret-Aversion Bias
A past incident with an asset has left a bitter taste with the client’s investor experience. However, it is
important to note that the fundamentals of a company, for example, can change drastically over a
period of a few quarters.
Consequences:
• Conservatism and feeling afraid to purchase the same asset or investment product based on
past experiences.
• Status quo and herding bias may come into play again because investors may choose the route
that feels safer to them based on the views of their closest circles.
Detection:
• The investor may have simply invested in the asset at a bad time and regrets the decision.
• The investor gives more weightage towards the past experience rather than looking forward.
Guidance:
• Educating the investor about bad timing.

• Educating the investor about the fundamental reasons for investing in the asset.
• Providing objective and quantitative risk-return benefits of investing in the future of the asset.
LOS 24c: Describe how behavioural biases of investors can lead to market
characteristics that may not be explained by traditional finance.
We will now explore a few market anomalies and studies showing that investors do not always act
rationally.
What are market anomalies?
A market anomaly is a price action that contradicts the expected behaviour of the stock market. Some
financial anomalies appear only once and disappear, but others appear consistently throughout
historical chart analysis. Traders and investors can use these unusual market behaviours to find
opportunities throughout the stock market.
These are essentially blips in the rationality of investors.
Some well-documented market anomalies are listed below.
Calendar Effects
Calendar effects are a group of anomalies that occur at particular times or on particular dates
throughout the year. They are:
• Monday effect: The Monday effect, also known as the ‘weekend effect’, is the tendency of
stock prices to close lower on Mondays than on the previous Friday.
Many supporters of behavioural finance speculate that the Monday effect is caused by the
negativity surrounding a new working week. But others believe that a more likely
explanation of the weekend effect is that companies often release bad news on Friday
evenings after the market has closed. This would be supported by the tendency of investors
to sell off their stocks on Friday afternoons to avoid slippage over the weekend.
• Turn-of-the-month effect: Turn-of-the-month refers to the pattern of a stock’s value rising

on the last day of each trading month, with the price momentum continuing for the first
three days of the next month.
Historically, the outsized gains at the turn of each month have a higher combined return
than all 30 days in the month. There is little agreement about whether this is just a
coincidence of random behaviour or the result of positive business news being more likely to
be announced at the end of the month.
• January effect: The January effect describes the pattern of increased trading volume, and
subsequently higher share prices, in the last week of December and the first few weeks of
January. While it is also known as the turn-of-the-year effect, the term ‘January anomaly’ is
more commonly used to refer to the tendency of small-company stocks to outperform the
market in the first two to three weeks of January.
It is believed that the January is caused by the turn of the tax calendar. Typically, according
to this theory, prices drop in December when investors sell off their assets to realise capital
gains. And, the increases in January are caused by traders rushing back into the market.
• Holiday effect: The holiday effect, or pre-holiday effect, is a calendar anomaly that describes
the tendency for the stock market to gain on the final trading day before a public holiday.
The most frequently cited explanation for this is that people are naturally more optimistic
around holidays, translating into positive market movement. An alternative explanation is
that short-sellers are more likely to close their positions before holidays.
The holiday anomaly can also be attributed to expectations that there will be volatility at
these times – the holiday effect becomes self-fulfilling as traders buy or sell around the same
historical anomalies.
Momentum Effect
The momentum effect is based on historical technical analysis that suggests recent stock market
‘winners’ are more likely to continue to outperform the ‘losers’ – or that stocks with a strong upward
trajectory are likely to continue to rise in short to medium-term.
The momentum anomaly suggests that traders can take advantage of these price movements by going
long on winners and shorting the losers.
One of the popular explanations for the momentum effect is that markets do not immediately price
in new information but do so more gradually.
Let’s say a company releases good news, but buyers under-react and take a while to flood the market;
the price increase would be more gradual. This makes it appear that the winners are taking consistent
gains
Bubbles and Crashes
The definition of a bubble is not fixed in financial theory, but it is usually when inflated asset prices
persist for a long time before crashing significantly.
Bubbles do have rational foundations. For example, the tech bubble in the early 2000s had some
rational ground because of the revolution in technology. However, the exuberantly high stock prices
were not justified by the fundamentals of the companies. Essentially, there was a lot more expectation
than the tech companies could deliver, and eventually, several tech stocks in the U.S. crashed
simultaneously.
One explanation is that investors tend to extrapolate into the future. This means that they assume
the short-term benefits will continue for a long period. These benefits are assumed to be larger than
is justified, and they are also discounted at a lower required rate due to the perceived lack of risk.
Value Effect
This anomaly refers to the tendency of stocks with below-average balance sheets to outperform
growth stocks on the market due to investor belief in companies’ potential.
Normally, if the market value is higher than the book value per share, a stock is considered overvalued,
while a stock with higher than a market value is often considered undervalued. While this would
usually prompt the market to correct, the value effect sees traders behaving counter to accepted
practice and buying shares that are technically overvalued.
Although there is increased risk in investing in low-book-value stocks – as they could fall into financial
distress – it is weighed up against the potential for superior returns.
1. A scientist runs a series of unweighted coin-flipping experiments with Bob, Bill, and Jane as
test subjects.
The scientist first invites Bob to wager $100 on the coin flip result, offering $300 if Bob is
correct. Bob refuses.
Bill, however, is willing to pay $100 for the chance to win $150 ($50 profit) on correctly
calling heads or tails because he recently lost $50 in a casino, and he must break even on
gambles for the week.
Finally, the scientist does not ask Jane to wager money but instead offers her a choice of
taking $50 or winning $100 if the next coin flip comes up heads. Jane takes the $50.
Which investor has acted rationally?
A. Bob
B. Bill
C. Jane
2. Status quo bias is least similar to which of the following biases?
A. Endowment
B. Regret aversion
C. Confirmation
3. Momentum can be partially explained by the following behavioural biases except?
A. Availability
B. Home Bias
C. Regret
Answers
1. C is correct. Jane
2. C is correct. Confirmation
3. B is correct. Home Bias

Introduction to Risk Management 79
Introduction to Risk Management

We learn about risk management. The framework is broad enough to be applied in general and to
financial firms, individuals, and the management of securities portfolios in any context. The main idea
is that organizations should estimate the various risks they face, reduce some risks, and accept or
increase other risks.
The learning outcomes from this reading would be the various methods for risk management,
categorization of types of risks, and the various risk mitigation methods all offer testable material.
LOS 25a: Define risk management.
Suppose you want to drill some oil in an ocean. You scout several locations, and you find a potential
spot. There is some amount of risk that you will not be able to extract as much as you thought, and
there is some amount of uncertainty that there may be no oil at all.
Risk management lies somewhere in the middle. Note that one has to take some amount of risk for
additional reward, so it is inappropriate to assume that risk and uncertainty are the same.
The process of risk management seeks to:
1. Identify the risk tolerance of the organization.
2. Identify and measure the risks that the organization faces.
3. Modify and monitor these risks.
The process of risk management does not seek to minimize or eliminate risk completely. The
organization may increase its exposure to risks if it decides to take on more risk to manage and
respond to it. The fund or organization may decrease the risk exposure if it is not able to manage it
well. Through these choices, the firm aligns the risks it takes with its risk tolerances for these various
types of risk.
LOS 25b: Describe features of a risk management framework.
Risk management is the process in which the level of risk to be taken is defined, and the levels of risk
are measured with the objective of maximizing the company or portfolio value. Risk management is
not about minimizing risk; it is about actively understanding and pursuing those risks that maximize
the chance of achieving goals and minimizing failure.
Risk management has to be tailored to the enterprise and requires a custom solution. The risk
management framework should address the following areas:
● Rules and policies for risk governance to be in place.
● Risk-taking capacity of an organization.
● Identifying and measuring existing risks.
● Managing and mitigating risks to achieve the optimal bundle of risks.

● Keep a check over the risk exposure levels.
● Effective communication.
● Performing strategic risk analysis.
This is quite a general framework, but all of this should be addressed in any of the frameworks which
are prepared.
Risk should be seen from a top-down perspective. This is the enterprise view, and it maintains that
one must look at the total risk that the organization can take as a whole. Then appropriate risk
management policies can be set to achieve goals.
For instance, a stock trading firm should have proper policies and risk levels to be exposed to. They
should have proper firm-wide communication and time to time risk analysis. The risk exposure is to
be mitigated and managed well and continuously keep a check on it.
LOS 23c: Define risk governance and describe elements of effective risk governance.
What is risk governance?
Risk governance is the top-down process that directs and aligns risk management to support the goals
of the enterprise. The governing body determines the organization’s goals and objectives and also its
risk appetite or tolerance. Risk tolerance dictates which risks are acceptable, which risks should be
mitigated, and which risks are unacceptable.
Risk governance provides organization-wide guidance on the risks that should be pursued efficiently,
risks that should be subject to limits, and risks that should be reduced or avoided.
A risk management team can provide a way for various parts of the organization to bring up risk
measurement issues, integration of risks, and the best ways to mitigate undesirable risks. This is where
the quality of human capital, expertise and judgement comes into play. Some companies have MDs,
CEOs and non-executive directors who are veterans in their industry for this very reason – they have
decades of knowledge and have seen the struggles and successes of their respective industries.
LOS 25d: Explain how risk tolerance affects risk management.
The risk tolerance of an organization involves setting the overall risk exposures that the organization
will take. This is done by identifying the risks that the firm can take and risks that the firm should
avoid. Some of the factors that determine an organization’s risk tolerance are its expertise in its lines
of business, its skill at responding to negative outside events, its regulatory environment, and its
financial strength and ability to withstand losses.
It is also important to look at risk from a regulatory standpoint. A company must ensure that risk
governance systems are already in place based on the current regulatory environment. Additionally,
it is also important to look at how a company deals with malfeasance or regulatory oversight after the
event has taken place. The result is that risk tolerance assessment is a dynamic process and should be
evaluated at all times, depending on the external environment.
Risk-taking and strategic goals should centre around the core competencies of the organization. The
appropriate risk tolerance level should be selected and communicated before a crisis event and should
serve as strategic guidance for the management team. Once the risk tolerance is determined, the
overall risk framework should be geared towards managing, monitoring and communicating the risk
tolerance.
LOS25e: Describe risk budgeting and its role in risk governance.
What is risk budgeting?
Risk budgeting is the process of allocating firm resources to assets (or investments) by considering
their various risk characteristics and how they combine to meet the organization’s risk tolerance. The
target is to diversify the investments with an overall acceptable risk and have the greatest accepted
returns over time.
A risk budget may be complex and multi-dimensional or make use of simple risk measures. The single-
dimensional risk measures most commonly used in portfolio management are:
• Standard deviation.
• Beta.
• Value at Risk (VAR).
• Scenario loss.
A multi-dimensional approach consists of layers of the risk budget. For example, factor analysis may
be performed to determine the risk premiums to various factors. The factor exposure may then have
a strategic overlay, ensuring the overall equity risk as measured by beta is within a particular tolerance
level.
Another way to allocate a risk budget is to identify specific risk factors that comprise the overall risk
of the portfolio or organization. In this case, specific risk factors that affect asset classes to varying
degrees, such as interest rate risk, equity market risk, and foreign exchange rate risk, are estimated
and aggregated to determine whether they match the overall risk tolerance of the organization.
LOS 25f: Identify financial and non-financial sources of risk and describe how they
may interact.
There are two types of risk an organization might be exposed to:
• Financial Risk
• Non-Financial Risk
Financial risks originate from financial markets and might arise from changes in share price or interest
rates. Non-financial risks are from outside of the financial market environment and could be as a result
of environmental or regulatory changes or an issue with customers or suppliers
The three primary types of financial risk are:
1. Market risk: This arises from movements within the financial market environment like share
prices, interest rates, exchange rates, commodity prices and other economic or industry
market factors.
2. Credit risk: The risk of loss due to the failure of one party to pay another an outstanding
obligation. Credit risk may be defined as default risk or counterparty risk. Defaults and
bankruptcies have long-term implications for borrowers and may be irrecoverable.
3. Liquidity risk: The risk of loss when selling an asset at a time when market conditions make
the sales price less than the underlying fair value of the asset.
Some non-financial risks include:
1. Settlement risk: Closely related to default risk is the risk around the timing of payments
between counterparties. For example, one party may have observed the agreements of a
currency swap, but the other party may not.
2. Legal risk: The risk of being sued, particularly in litigious environments, or the risk that a
counterparty will not uphold a contractual obligation.
3. Regulatory risk: Compliance risk is made up of regulatory risk, accounting risk, and tax risk.
When laws and regulations are updated, this may create the need for financial restatements,
back-taxes or other penalties.
4. Model risk: This is the risk of valuation error when the valuation of a particular security is
based on a wrongly specified price model.
5. Tail risk: The likelihood or probability of a material negative outcome is often understated in
financial models, and it is often related to model risk. Financial markets do not follow a normal
distribution of returns but tend to have “fat tails”, and if the internally selected model does
not account for this, tail risk is introduced.
6. Operational risk: This is the risk that human error, faulty organizational processes, inadequate
security, or business interruptions will result in losses. Example can be a cybercrime.
7. Solvency risk: A company may not survive if it runs out of cash and becomes insolvent. In
times of solvency pressure, a company may be forced to liquidate assets at unfavourable
prices simply to raise the necessary cash. Solvency risk can be easily mitigated by using less
leverage, using more stable sources of funding, and incorporating solvency measures at the
governance level of the business.
8. Accounting risk: This is the risk that the organization’s accounting policies and estimations are
judged to be incorrect.
For individuals, risks, such as the risk of death (mortality risk) before providing for their family’s future
needs and the risk of living longer than anticipated (longevity risk) so that assets run out, are very
important in financial planning.
For instance, most people manage the risks by add health insurance, so they get cashless treatment
at the hospital due to Mediclaim benefits.
The mortality risk is often addressed by life insurance contracts and longevity by investments and
annuity. An individual's risks are much different from that of an organization, but choosing which risks
to bear is the same. Often, risk models do not adequately account for risk interactions and understate
the overall risk. The governance board, company management, and financial analysts should be aware
of the potential for combined risks and try to incorporate a more holistic risk view rather than treating
different risk categories in isolation.
The Interaction of Risk

Sometimes the classification of risk is inappropriate. For example, something that may be considered
counterparty risk may also be default risk. This may be the case for leveraged instruments or other
complex derivatives. In extreme market conditions, one party may not be able to pay the other party
at all for the difference in the position’s value. The counterparty risk transcends to default risk, and
one of the parties suffers a higher chance of a greater loss in investment value.
It is also important to see if the risk is systemic. The best way to detect this is to check if there is a
domino effect. This was the case in the 2008 financial crisis. Borrowers of home loans could not repay
mortgages; this meant that banks could not recover funds from giving loans, and eventually the lack
of funds trickled down to the mortgage-backed securities. Several banking and financial companies
held such securities, and they suffered great losses.
LOS 25g: Describe methods for measuring and modifying risk exposures and factors
to consider in choosing among the methods.
Measures of risk for specific asset types include standard deviation, beta, and duration.
• Standard deviation is a measure of the volatility of asset prices and interest rates. Standard
deviation may not be the appropriate measure of risk for non-normal probability distributions,
especially those with a negative skew or positive excess kurtosis (fat tails). E.g., Like many of
the financial crises before it, the 2007/2008 financial crisis brought to the fore the divergence
between the normal distribution and asset return distributions.
• Beta is a measure of the sensitivity of a security’s returns to the overall market portfolio. It
indicates systematic risk and is particularly appropriate for equity portfolios.
• Duration is a measure of the price sensitivity of debt securities to changes in interest rates.
Derivatives Risk (also known as the Greeks of options)
• Delta: It measures the degree to which an option is exposed to changes in the underlying asset
price. It’s the ratio of the change in the call option price to the change in the underlying price.
• Gamma: This is the sensitivity of delta to changes in the price of the underlying asset.
• Vega: This is the sensitivity of derivatives values to the volatility of the underlying asset's price.
• Rho: Rho measures the expected change in an option’s price per 1% change in interest rates.
It tells us how much the price of an option should fall or rise in response to an increase or
decrease in the risk-free rate of interest.
What is Tail Risk?

It is possible uncertainty of the worst possible outcomes. Value at Risk (VaR) and conditional (CVaR)
are commonly used.
VaR can be defined as the maximum amount of loss under normal business conditions that can be
incurred with a given confidence interval. It can also be viewed as the worst possible loss under normal
conditions over a specified period. Suppose an analyst calculates the monthly VaR as $100 million at
95% confidence.
This simply means that under normal conditions, in 95% of the months, we expect the fund to make
a profit or lose no more than $100 million. Put differently, the probability of losing $100 million or
more in any given month is 5%.
As is always the case with estimates of risk, incorrect inputs or inappropriate distribution assumptions
will lead to misleading results. Given these limitations, VaR should be used in conjunction with other
risk measures.
Conditional VaR (CVaR) is the expected value of a loss, given that the loss exceeds a minimum
amount. CVaR is similar to the measure of loss given default used to estimate risk for debt securities.
What are stress testing and scenario analysis?
To complement VaR measures, scenario analysis and stress testing are undertaken to try and
understand the expected loss under different market stress conditions. One of the approaches that
have been used to incorporate stress tests in VaR models involves trying to assess whether the stress
test loss is part of the loss distribution developed in the VaR estimation. This way, a
hypothetical/historical stress scenario can be associated with a given probability.
Managing the risk to an organization of very infrequent events is quite difficult. The risk of the
bankruptcy of a firm that has never experienced significant financial distress is often an estimate
rather than a data-driven. Estimates of risk can also be based on the market prices of insurance,
derivatives, or other securities that can be used to hedge those risks. These hedging costs provide
information on market participants’ aggregate estimate of the expected loss of specific risks.
As the risk of bankruptcy, operational risks may also seem difficult to quantify. These may result in
huge costs to the organization.
Unexpected changes in tax laws or the regulatory environment can impose large costs on an
organization.
Modifying Risk Exposures
Risk modification is not necessarily about risk reduction. It may be about reallocating risk towards the
desired risk target or exposure. There are four main categories of risk modification:
Risk Prevention and Avoidance
One way to avoid risk is to not engage in the activity with an uncertain outcome. If political risks in a
country are to be avoided, simply not investing in securities of firms based in that country or not
expanding a business enterprise to that country would avoid those risks. The decision to avoid a
specific risk altogether will be made at a board level where it will be determined that some business
activities are not worth pursuing based on the risk-return trade-off.
Risk Acceptance
For risks that management has decided to bear, the organization will seek to bear them efficiently.
Diversification may offer a way to bear a specific risk more efficiently. It makes sense to have exposure
to a particular risk in many cases but to do so efficiently. Individuals or companies may choose to self-
insure. This may mean simply bearing the risk of setting aside some provision to cover losses should
they occur.
Risk Transfer
Insurance is a type of risk transfer. With a risk transfer, another party takes on the risk. The risk of fire
destroying a warehouse complex is shifted to an insurance company by buying an insurance policy
and paying the policy premiums. As for an insurance company, the insurers are not highly correlated
to reduce risk. An insurance company with highly correlated risks (or a single very large risk) may itself
shift some of the resulting risks by buying reinsurance from another company.
A company may also engage in surety bonds and fidelity bonds:

• With a surety bond, an insurance company has agreed to make a payment if a third party fails
to perform under the terms of a contract or agreement with the organization.
•
• Fidelity Bonds are bonds that will pay for losses that result from employee theft or
misconduct.
Risk Shifting
This refers to the changing of the distribution of risk outcomes rather than passing the risk to another
party. Risk shifting is often carried out through hedging by using financial market derivatives.
Derivatives are either forward commitments or contingent claims. Forward commitments are
agreements that create a transaction obligation between two parties in the future at an agreed price
or rate. These include forward contracts, futures contracts, and swaps. Contingent claims are when
both parties are mutually obligated to each other. Options grant the rights but not the obligation to
transact, and consequently, the buyer of the option pays a premium at the start of the contract.
Choosing Among Risk Modification Methods
Choosing which risk mitigation method to choose is a critical part of the risk management process. No
single option may have an advantage, and a cost-benefit trade-off may be required. Low-cost
precautions against risks with few benefits should always be the first step. The end result is a risk
profile that matches the risk tolerance established for the organization and includes the risks that top
management has determined match the organisation's goals in terms of cost versus potential returns.
1. Which of the following may be controlled by an investor:
A. Risk
B. Raw returns
C. Risk-adjusted Returns
2. The process of risk management includes:
A. Minimizing risk
B. Maximizing returns
C. Defining and measuring risks being taken
3. A risk management framework least likely includes:
A. Risk governance, risk mitigation, and strategic risk analysis.

B. Identifying and measuring risks, risk policies and processes, and risk governance.
C. Risk mitigation, tracking the organization’s risk profile, and establishing position limits.
4. Risk governance should most appropriately be addressed within an organization at:
A. The enterprise level.

B. The business unit level.
C. The individual employee level.
5. Risk shifting is most likely achieved by:
A. Risk mitigation.
B. Using derivative securities.
C. Transferring risk to an insurance company.
Answer
1. A is correct as investors have some degree of control over the level of risk, they are willing to
take in their investment portfolio.
2. C is correct as risk management is the practice of identifying, assessing, and mitigating risks
to minimize potential losses and protect assets.
3. C is correct. Risk mitigation, tracking the organization’s risk profile, and establishing position
limits
4. A is correct as risk governance refers to the framework, processes, and structures through
which an organization identifies, assesses, monitors, and manages risks. It involves
establishing accountability, responsibility, and oversight for risk management activities.
5. B is correct.
Formula 87
Formula
Portfolio Risk and Return: Part I

end of period value Pt +Divt Pt − P0 + Divt
• Holding period return = beginning of period value − 1 = P0
−1= P0
R1 +R2 +⋯RN
• Arithmetic mean return = n
•
n
Geometric mean = √(1 + R1 ) × (1 + R1 ) × (1 + R n ) − 1
Cov1,2
• Correlation: ρ1,2 =
σ1 × σ2
• Standard deviation for a two-asset portfolio:
σp = √w12 σ12 + w22 σ22 + 2w1 w2 σ1 σ2 ρ1,2 Or √w12 σ12 + w22 σ22 + 2w1 w2 Cov1,2
Portfolio Risk and Return: Part II

E(RM ) − Rf
• Equation of the CML: E(R p ) = R f + ( σM
) σP
σP
= E(R p ) = R f + (E(R M ) − R f ) ( )
σM
• Total risk = systematic risk + unsystematic risk
Covi,mkt σi
• βi = σ2mkt
= ρi,mkt σ
mkt
• CAPM: E(R i ) = R f + βi [E( R mkt ) − R f ]
Rp − Rf
• Sharpe ratio =
σP
σP
• M-squared = (R p – R f ) − (R M – R f )
σM
Rp − Rf
• Treynor measure = βp
• Jensen’s alpha = ∝p = R p − [R f + βp ( R M − R f )]
“
“
Weekday Weekend Sel

f-Paced

Portfolio Management and Wealth Planning - Zell Education 2024

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Portfolio Management and Wealth Planning - Zell Education 2024

Uploaded by

Copyright:

Available Formats

“

Weekday Weekend Sel

Portfolio Risk and Return: Part I

Holding Period return

Holding Period Return = (End of Period Value ÷ Beginning of Period Value) - 1

and with dividends

[(23,000 + 200) ÷ 20,000] – 1 = 16.00%.

These may be calculated as a simple average or as a geometric average.

Arithmetic Mean or Mean Return

Mean Return = (HPR1 + HPR2 + HPR3 + … + HPRn) ÷ n

(16.00% + 12.00% + 18.00%) ÷ 3 = 15.33%

Geometric Mean Return

The geometric return is calculated as:

Geometric Mean Return = n√(1 + R1 ) × (1 + R2 ) ×(1 + R3 ) × … × (1 + Rn ) - 1

Notice that the arithmetic return (4.17%) is overstated.

Let us consider the following example:

Details (Rs. million) Year 1 Year 2 Year 3

Withdrawal by the 0.00 (12.00) (5.00)

Balance at the end of 33.00 33.60 33.64

Time Net Cash Flow

Time-Weighted Rate of Return

Few steps to follow to calculate time-weighted return:

• Compute the holding period return.

• Beginning value = Rs. 500

• Beginning value = Rs. 1,040 (2 shares)

• Dividends paid = Rs. 24 (Rs. 12 per share)

Step 2: Calculate the HPR for each holding period.

HPR1 = [(520 + 12) ÷ 500] − 1 = 6.40%

HPR2 = [(Rs. 1,060 + 24) ÷ Rs. 1,040] − 1 = 4.23%

Step 3: Find the CAGR.

(1 + Time-Weighted Return)2 = 1.0640 × 1.0423

Time-Weighted Return = [(1.064) × (1.0423)]1/2- 1 = 5.30%

Historical Mean and Expected Return

1 + E(R) = (1 + rrF) × [1 + E(π)] × [1 + E(RP)]

rrF is the real risk-free rate of return

E(π) is the expected inflation

E(RP) is the expected risk premium

Utility Theory and Indifference Curves

We can then plot a utility curve for such investments:

Capital Allocation Line

We can express the above statements in the following graph:

Expressed in a linear equation, we can see that:

E(RP) = wArA + wBrB

σ2P = w2Aσ2A + w2Bσ2B + 2wAwBCovA,B

Notice that the covariance may also be expressed in terms of correlation:

So, CovA,B = ρABσAσB

Now we can express the portfolio variance in the following way:

σ2P = w2Aσ2A + w2Bσ2B + 2wAwBρABσAσB

Covariance and Correlation

Xi = return on Asset X in period t

Yi = return on Asset Y in period t

X = mean return on Asset X

Y = mean return on Asset Y

The relation can also be written as:

The correlation captures the direction of co-movement:

Let us take a numerical example to understand the effects of correlation.

Year Asset Alpha Asset Gamma

Mean return for asset Alpha: (4- 1 + 12) ÷ 3 = 5%

Mean return for asset Gamma: (7- 4 + 15) ÷ 3 = 6%

Sample covariance of returns of assets Alpha and Gamma

Correlation of both the assets = 42 / 6.55 × 10.53 = 0.6

Correlation and Diversification

Let us take an example to understand this well.

Variance = σ2P = w2Aσ2A + w2Bσ2B + 2wAwBρABσAσB