Investment Management

Module 5 : Portfolio Management

Module 5 : Portfolio Management

Portfolio Management: Meaning -Need –Objectives –process of Portfolio management

–Selection of securities and Portfolio analysis. Construction of optimal portfolio using
Sharpe’s Single Index Model. Portfolio Performance evaluation (Problems on Portfolio
Performance).

Portfolio

In the world of finance, a portfolio refers to a collection of investments held by an

individual or institution. It's essentially a container for all your investment assets,
representing your overall financial picture.

Portfolios are typically comprised of a variety of asset classes, each with distinct
risk-return profiles, with the core purpose being to generate returns and achieve
financial goals.

Spreading your investments across various asset classes and sectors is crucial. This
helps mitigate risk, as a downturn in one area can be offset by gains in another.

Aggressive investors may hold a higher percentage of stocks, while conservative

investors might favor bonds or cash equivalents.

Periodically reviewing and rebalancing your portfolio to maintain your target asset
allocation is vital. Market fluctuations can cause your asset weights to drift, so
rebalancing helps you stay on track.

Portfolio Management

Portfolio management is the professional practice of overseeing a collection of

investments to achieve predetermined financial objectives. It entails crafting a
diversified asset allocation aligned with an investor's risk tolerance and time
horizon, meticulously selecting securities within each asset class, and
continuously monitoring and rebalancing the portfolio to optimize returns and
mitigate risk throughout the investment journey.

Need / Objectives of Portfolio Management

● Maximize Returns: Invest in a way that grows your wealth over time, but
consider this alongside risk tolerance.
● Manage Risk: Balance the potential for growth with the possibility of loss.
Diversification is key!
● Achieve Financial Goals: Align your portfolio with your long-term plans,
whether it's retirement, a down payment on a house, or educational
expenses.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

● Maintain Liquidity: Ensure you have access to cash when needed, balancing
long-term goals with short-term needs.
● Optimize Asset Allocation: Spread your investments across different asset
classes like stocks, bonds, and cash equivalents to achieve your desired
risk-return balance.
● Protect Capital: While seeking growth, prioritize the preservation of your
principal investment.

Portfolio Management Process

Building a successful portfolio is the cornerstone of achieving your financial goals.

It's the process of selecting investments, allocating them strategically, and
managing the overall risk and return profile.

Traditionally portfolio construction emphasized investor needs and qualitative

analysis. It's a practical approach that can be broken down into these key steps:

1. Investor Profile Analysis: This initial step involves understanding your

investment goals (retirement, education funding, etc.), risk tolerance (how
much market volatility you can handle), and time horizon (when you'll need
access to your funds). Your financial situation, including income, expenses,
and debts, also plays a role.

2. Asset Allocation: This involves dividing your investment capital across

various asset classes like stocks, bonds, cash equivalents, and potentially
alternative investments. The allocation percentages depend on your risk
tolerance and goals. Aggressive investors might allocate more to stocks for
higher growth potential, while conservative investors might favor bonds for
stability.

3. Asset Mix Selection: Based on your investor profile and asset allocation
plan, determine the specific percentage you'll dedicate to each asset class.
There are general guidelines, but adjustments are necessary based on your
circumstances.

4. Investment Selection: Within chosen asset classes, research and select

individual investments like stocks, mutual funds, or ETFs. The traditional
method employs a top-down analysis:

○ Macroeconomic Analysis: Evaluate the overall economic climate and

its potential impact on different asset classes.
○ Industry Research: Analyze specific industries within chosen asset
classes to identify promising sectors.
○ Company Selection: Research individual companies within chosen
industries based on financial health, growth potential, and valuation.

5. Diversification: Spreading your investments across various asset classes and

sectors is crucial. This helps mitigate risk by ensuring a downturn in one
area is potentially offset by gains in another.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

6. Rebalancing and Monitoring: Periodically monitor your portfolio's

performance and rebalance it as needed to maintain your target asset
allocation. Market fluctuations can cause your asset weights to drift, so
rebalancing helps you stay on track.

Prior to the 1950s, portfolio construction relied heavily on the traditional method.
This method focused on qualitative factors like investor goals, risk tolerance, and
top-down analysis of economic trends and industries. Diversification was a key
principle, but there lacked a formal framework for optimizing risk and return.

Enter Harry Markowitz and his groundbreaking work in the 1950s, which led to the
development of Modern Portfolio Theory (MPT). MPT introduced a paradigm shift
in portfolio construction by incorporating a mathematical framework.

Modern Portfolio Theory / Henry Markowitz Model

History

Harry Markowitz, Nobel Prize-winning American economist developed the

Modern Portfolio Theory. He introduced a groundbreaking investment strategy
called modern portfolio theory in his article “Portfolio Selection” in The Journal of
Finance in 1952. Harry Markowitz’s original theory has fundamentally changed the
way that people and institutions invest.

For his theory of allocation of financial assets under uncertainty, also known as the
theory of portfolio choice, Markowitz shared the 1990 Nobel Memorial Prize in
Economic Sciences with William F. Sharpe and Merton Miller. Specifically, the
Nobel Committee cited the theory of portfolio choice developed by Markowitz as
the “first pioneering contribution in the field of financial economics.” The Nobel
Committee also acknowledged that Markowitz’s original portfolio theory was the
basis for “a second significant contribution to the theory of financial economics”:
the Capital Asset Pricing Model (CAPM), a theory of price formation for financial
assets, developed by William Sharpe and other researchers in the 1960s

Imagine the 1950s, how would someone build a portfolio of assets. They would look
at the assets with the most potential and buy them.
Markowitz argued that investors are risk averse and potential return is not the only
factor that determines an investment decision. Investors did diversification based
on the logic of don’t put all your eggs in one basket. But does buying 10 or 20 stocks
make it a diversified portfolio? There was no discussion of the quantity and
composition of securities in the portfolio.
You need a truly diversified portfolio with one asset that pays when it rains and one
asset that pays when it doesn’t rain. There was no model or formula for that. So he
went on to create the first mathematical model for portfolio creation using the
mean and variance of portfolio. It showed how to create a portfolio with the
optimal risk return characteristics. For the first time, the benefits of diversification
have been codified and quantified.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

Expected Return of portfolio is the weighted average of expected returns of

securities in the portfolio. Variance is not a weighted average of individual security
variances rather it also takes into account the benefit of diversification through
covariance or correlation.

● Also Called as the Mean-Variance Model.

● Allocating funds to not perfectly correlated assets (negative or less
correlated) can reduce the overall risk of the portfolio. This is the power of
diversification. This is taken into account while calculating the portfolio risk
through the covariance aspect.
● Performance of a portfolio is more important than performance of an
individual securities.It focuses on the relationship between assets in a
portfolio in addition to the individual risk that each asset carries.
● It exploits the fact that a negatively correlated asset offsets losses that are
incurred on another asset. For example, crude oil prices and airline stock
prices are negatively correlated.

Diversification is a portfolio allocation strategy that aims to minimise idiosyncratic risk

by holding assets that are not perfectly positively correlated

(Idiosyncratic risk also called unsystematic risk is the risk that is particular to a specific
investment – as opposed to risk that affects the entire market or an entire investment
portfolio. Idiosyncratic risks are rooted in individual companies or individual
investments. It could be corporate culture, operating strategy, financial policies etc)

Assumptions of Modern Portfolio Theory

1. Rational Investors: MPT assumes that investors are rational

decision-makers who aim to maximise their utility or expected returns
while minimising their risk.
2. Mean-Variance Framework: MPT assumes that investors evaluate and
compare investment opportunities based on their mean
(expected) returns and variances (or standard deviations) as measures of
risk.
3. Efficient Markets: MPT assumes that markets are efficient, meaning that all
relevant information is quickly and accurately reflected in the prices of
securities. Investors have access to the same information and respond to it
in a rational manner.
4. Homogeneous Expectations: MPT assumes that investors have similar
expectations about future returns and risks of assets. It implies that
investors agree on the same probability distributions for asset returns.
5. No Transaction Costs: MPT assumes that there are no transaction costs,
such as fees, commissions, or taxes, associated with buying or selling
securities. This assumption allows for frictionless trading and simplifies the
analysis and optimization of portfolios.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

6. Single-Period Investment Horizon: MPT assumes that investment

decisions are made for a single period, without considering any specific time
frame for holding investments. This assumption facilitates the analysis and
calculation of portfolio risk and returns without considering the impact of
changes over time

MPT argues that risk and reward are positively correlated in investing; if you opt
for low-risk investments, such as bonds or cash, you can expect lower returns.
You'll need to invest in investments with more risk, like stocks, to receive higher
returns. You might not be willing to take the gamble and put your money into those
investments, though. It depends on your comfort level with risk. The way to
overcome the risk, according to MPT, is through diversification. This theory
promotes the spread of money across different asset classes and investments.MPT
says you can hold a certain asset type or investment that is high in risk, but when
you combine it with others of different types, the whole portfolio can be balanced.
Then its risk is lower than the individual risk of underlying assets or investments.
For instance, you wouldn't hold only risky stocks or only low-return bonds.
Instead, you would buy and hold a mixture of both to ensure the largest possible
return over time.

Efficient Frontier

You can have an infinite number of combinations of allocations into a portfolio.

However, only a subset of these combinations are efficient.

According to Modern Portfolio Theory, a portfolio frontier, also known as an

efficient frontier, is a set of portfolios that maximises expected returns for each
level of standard deviation (risk). A typical portfolio frontier is illustrated below:

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

According to the MPT, rational risk-averse investors should hold portfolios that
fall on the efficient frontier (since they provide the highest possible expected
returns for a given level of standard deviation)

If a certain portfolio lands on the “efficient frontier” section of the graph, it is

considered efficient, which means it delivers the maximum return for that
investor’s risk tolerance. Portfolios outside the efficient section of the graph have
either too much risk vs. return or too little return vs. risk. Of course, because the
risk tolerance and return expectations of each investor are different, there is no
one single efficient portfolio.

Global minimum variance portfolio is the portfolio on the efficient frontier with
the lowest amount of risk. Portfolio’s in the efficient frontier below the global
minimum variance portfolio are considered sub-optimal.

Add On Info
Plotting the Expected Return and Risk of a two asset portfolio to create the efficient
frontier
How To Graph The Efficient Frontier For A Two-Stock Portfolio In Excel
Use Excel to graph the efficient frontier of a three security portfolio

Capital Market Line (CML)

This line represents the relationship between risk and return for portfolios that
include a risk-free asset (like cash) and the market portfolio (representing all risky
assets). The CML slopes upwards, indicating that higher expected returns come
with higher risk. The point where the CML touches the efficient frontier is called
the tangency portfolio, which offers the highest expected return for a given level of
risk compared to any other portfolio combination.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

Security Market Line (SML) : Similar to the CML, but applies to individual
securities. The SML shows the expected return versus risk (beta) for individual
assets relative to the market portfolio. Assets plotting above the SML are
considered undervalued, while those below are considered overvalued.The SML is a
graphical representation of the Capital Asset Pricing Model (CAPM). It shows the
relationship between an asset's expected return and its systematic risk, measured
by its beta.

Limitations of Modern Portfolio Theory

Assumptions of Rationality: MPT assumes that investors are rational and make
decisions solely based on expected returns and risks. However, in reality, investors
may be influenced by emotions, cognitive biases, and other non-rational factors
that can impact their investment decisions.

Focus on Historical Data: MPT heavily relies on historical data for estimating
expected returns, variances, and covariances of assets. This assumption assumes
that past performance is indicative of future performance. However, market
conditions, correlations, and other factors may change over time, making
historical data less reliable for predicting future outcomes.

Normal Distribution Assumption: MPT assumes that asset returns follow a normal
distribution, which may not always hold true in reality. Financial markets can

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

experience extreme events and exhibit non-normal behavior, such as fat tails or
skewness, which the normal distribution fails to capture adequately.

Ignores Transaction Costs: MPT often overlooks the impact of transaction costs,
such as brokerage fees, taxes, and market impact costs. These costs can erode
portfolio returns and impact the practical implementation of MPT strategies.

Lack of Consideration for Behavioral Factors: MPT does not explicitly account for
behavioral factors, such as investor sentiment, herd behavior, or market
inefficiencies arising from cognitive biases. These behavioral factors can lead to
market anomalies and deviations from MPT's assumptions.

Sensitivity to Input Parameters: MPT outcomes are highly sensitive to the input
parameters, such as expected returns, volatilities, and correlations. Small changes
in these inputs can significantly affect the optimal portfolio allocations, potentially
leading to suboptimal outcomes.

Inability to Predict Black Swan Events: MPT struggles to account for rare,
unforeseen events known as "Black Swan" events. These events, characterized by
their extreme impact and low probability, can have a significant impact on
portfolio performance but are difficult to incorporate into MPT's risk and return
models.

Key takeaways

1. Diversification is key: MPT emphasises the importance of diversification in

reducing portfolio risk. By combining assets with low or negative
correlations, investors can achieve a more efficient portfolio that offers a
better risk-return trade-off.

2. Risk and return are related: MPT recognizes that there is a positive
relationship between risk and return. Investors should expect to be
compensated for taking on higher levels of risk. MPT helps in finding the
optimal balance between risk and return based on an investor's preferences.

3. Efficient frontier: MPT introduces the concept of the efficient frontier,

which represents the set of portfolios that offer the highest expected return
for a given level of risk or the lowest risk for a desired level of return.
Portfolios that lie on the efficient frontier are considered to be the most
efficient or optimal.

4. Quantitative approach: MPT provides a quantitative approach to portfolio

construction and asset allocation. It incorporates statistical measures such
Alan Job Jose
St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

as expected returns, standard deviation, covariance, and correlation to

analyse and optimise portfolios.

5. Asset allocation matters: MPT highlights the significance of asset allocation

in determining portfolio performance. The allocation of investments across
different asset classes has a greater impact on portfolio returns and risk
compared to the selection of individual securities.

Sharpe’s Single Index Model

In the Markowitz model a number of co-variances have been estimated. If a

financial institution buys 150 stocks, it has to estimate 11,175
i.e., (N2- N)/2 correlation coefficients.

Sharpe's Single Index Model, simplifies this process by primarily considering the
relationship between individual securities or portfolios and a broad market index.
It assumes that the performance of a security or portfolio can be explained by its
exposure to the market factor, represented by the market index.

Casual observation of the stock prices over a period of time reveals that most of the
stock prices move with the market index.
When the Sensex increases, stock prices also tend to increase and vice-versa. This
indicates that some underlying factors affect the market index as well as the stock
prices

Therefore, Sharpe assumed that the return of a security is linearly related to a

single index like the market index.

Calculation of return as per sharpe’s single index model

- Alpha
A measure of the excess return of an investment in comparison to a benchmark
index. Alpha of 1 indicates that the investment outperforms the benchmark by 1%
and Alpha of -1 indicates that the investment underperforms the benchmark by 1%.

- Beta

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

Beta is a measure of the sensitivity of an investment's returns to changes in the

overall market, indicating how volatile the investment is relative to the market.

Calculation of risk as per sharpe’s single index model

Total risk = Systematic risk + Unsystematic risk

Systematic risk

Unsystematic risk

It is also called as residual risk and represented as

Assumptions of Sharpe’s Single Index Model

Linear Relationship: The model assumes a linear relationship between the excess
return of a security or portfolio and its exposure to the market factor, represented
by the returns of a market index.

Single-Factor Exposure: It assumes that the performance of a security or portfolio

can be explained by its exposure to a single systematic risk factor, which is
typically the market factor.

Homogeneous Expectations: The model assumes that all investors have the same
expectations regarding the relationship between securities and the market factor,
as well as their risk and return characteristics.

Efficient Market: It assumes that markets are efficient, meaning that all relevant
information is immediately reflected in stock prices and there are no opportunities
for consistently outperforming the market.

Constant Risk-Free Rate: The model assumes a constant risk-free rate of return,
which serves as a baseline for evaluating the excess return of securities or
portfolios.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

Stationary and Normal Distribution: It assumes that returns follow a stationary

and normally distributed pattern, allowing for statistical analysis and estimation
of beta.

No Transaction Costs or Taxes: The model assumes frictionless trading, without

considering transaction costs or taxes associated with buying and selling
securities.

Sharpe’s Optimal portfolio

Sharpe had provided a model for the selection of appropriate securities in a

portfolio. It involves two steps
1. Ranking the investments using Treynor ratio (Excess return to beta)
2. Calculating Ci and determining the cut off rate

Treynor ratio / Excess return to beta

The highest Ci is selected as the C* - Cut of rate

In the ranked order, stocks above the C* is selected for portfolio allocation

Sharpe ratio and Treynor ratio

The Sharpe ratio and Treynor ratio are both risk-adjusted performance measures used in
finance, but they differ in terms of the risk measure they use in the denominator and the type
of risk they focus on. Sharpe ratio uses standard deviation as the denominator whereas
Treynor ratio uses Beta as the denominator. Sharpe ratio measures the excess return per unit
of total risk. Treynor ratio measures the excess return per unit of systematic risk or market
risk.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

Limitations of Sharpe’s Single Index Model

Single-Factor Consideration: The Single Index Model assumes that the

performance of a security or portfolio can be explained by its exposure to a single
systematic risk factor, typically represented by the market index. This assumption
oversimplifies the complexities of real-world investment scenarios, as there may
be multiple factors influencing returns and risk.

Linear Relationship Assumption: The model assumes a linear relationship

between the excess return of a security or portfolio and its exposure to the market
factor. However, in practice, this relationship may not always hold true, especially
during periods of extreme market volatility or structural changes in the economy.

Homogeneous Expectations: The Single Index Model assumes that all investors
have the same expectations regarding the relationship between securities and the
market factor, as well as their risk and return characteristics. In reality, investors
may have diverse expectations and may differ in their assessments of risk and
return.

Efficient Market Hypothesis: The model relies on the assumption of market

efficiency, where all relevant information is immediately reflected in stock prices.
However, market inefficiencies can exist, leading to potential mispricing of
securities and deviations from the model's predictions.

Limited Consideration of Non-Market Risk Factors: The Single Index Model

primarily focuses on systematic or market risk factors and does not explicitly
consider non-market or firm-specific risks. Factors such as management quality,
industry dynamics, competitive position, and company-specific events can
significantly impact the performance of an investment but are not directly
captured by the model.

Reliance on Historical Data: The Single Index Model relies on historical data to
estimate expected returns and volatilities. This assumption assumes that the
historical relationship between securities and the market factor will hold true in
the future. However, future market conditions and events may differ from
historical patterns, potentially leading to inaccurate estimates.

No Consideration of Transaction Costs and Taxes: The model does not account for
transaction costs or taxes associated with buying and selling securities. In practice,
these costs can impact the actual returns on investments and should be considered
when evaluating investment decisions.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

Key takeaways

● It focuses on the relationship between individual securities or portfolios and

a broad market index.
● The model assumes a linear relationship between the excess return of a
security or portfolio and its exposure to the market factor.
● It helps evaluate the risk-adjusted return by considering the Sharpe ratio,
which measures the excess return per unit of risk.
● The model provides insights into the systematic risk contribution of a
security or portfolio.
● It simplifies the analysis by considering a single factor, typically represented
by the returns of a market index.
● The Single Index Model has limitations, including the assumption of a linear
relationship and homogeneous expectations among investors.
● It does not consider non-market risks, transaction costs, and individual
preferences.
● The model offers a framework for understanding the risk-return trade-off
and making informed investment decisions.

Portfolio performance measurement

Portfolio performance measurement is the compass that guides investors along

their financial journey. It's the process of evaluating how your investments are
performing over time, allowing you to assess progress towards your goals, identify
areas for improvement, and ultimately make informed investment decisions.

Need for measuring portfolio performance

Imagine driving across the country without a map or GPS. You might reach your
destination eventually, but the journey would be inefficient and stressful.
Similarly, navigating the investment landscape without measuring portfolio
performance can lead to missed opportunities and potentially derail your financial
goals. Here's why it's crucial:

● Track progress towards goals: Measures portfolio performance to see if it's

on track to meet your financial goals (retirement, major purchase, etc.).
Knowing the return allows for adjustments if needed.

● Evaluate investment strategy: Performance measurement helps assess if

your chosen asset allocation and investment strategy are effective. It
highlights areas for improvement or confirms a successful approach.

● Identify risk tolerance: By monitoring performance and its volatility, you

can understand your risk tolerance. If the portfolio experiences more risk
than you're comfortable with, adjustments can be made.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

● Make informed decisions: Data-driven decisions are crucial in investment

management. Performance measurement provides the data to make
informed choices about buying, selling, or rebalancing the portfolio.

● Benchmark against indexes: Compare your portfolio's performance to

relevant market indexes to see how it stacks up. This helps understand if
your asset selection and strategy are performing competitively.

● Communicate with advisors: Performance metrics are essential for

communicating with financial advisors. They can use this data to tailor
investment strategies and make recommendations.

Additional Information:

Benchmarks

Imagine a measuring stick for investments! That's what a benchmark is. It's a
standard used to compare the performance of:

● Individual Stocks: See how a stock stacks up against the broader market
(Sensex or Nifty).
● Mutual Funds: Check if a fund is performing better than its chosen index.

Benchmark is a broader term referring to any standard used for comparison. In

finance, it can encompass various things investors use to measure performance,
like:

● Market indices (which are the most common type)

● Past performance (e.g., comparing current returns to historical averages)
● Risk-free rate of return (e.g., government bond yields)

In the world of finance, an index is a type of benchmark that essentially a basket

of securities that represents a specific segment of the market. It tracks the
performance of these securities and provides a single numerical score that
reflects the overall performance of that group.

Why are Benchmarks Important?

● Performance Check: See if your investments are keeping pace with the
market or a specific sector.

● Risk Assessment: Compare volatility of your investment to its benchmark

to understand the risk involved.

● Investment Decisions: Choose index funds to match market performance

or actively managed funds aiming to beat the benchmark.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

Methods of measuring portfolio performance

Effectively measuring your portfolio's performance is vital for any investor. It

allows you to track progress towards your financial goals, assess the effectiveness
of your investment strategy, and identify areas for potential improvement.

Return Measures

1. Total Return

This is the most basic metric and reflects the overall change in your
portfolio's value over a specific period. It encompasses both capital
appreciation (increase in asset prices) and any income generated (dividends,
interest). It's calculated as:

2. Annualized Return(CAGR):

This expresses your portfolio's total return as if it were earned over a

one-year period. It allows for easier comparison across different
timeframes. CAGR (Compound Annual Growth Rate) is one of the methods
used to annualize total return. It calculates a smoothed annual growth rate
that reflects how much your portfolio would have grown each year if the
total return were achieved through a series of equal annual increases.

3. XIRR (Extended Internal Rate of Return)

XIRR (Extended Internal Rate of Return) is a valuable metric for calculating

the annualized return of an investment that involves irregular cash flows.
Unlike simpler return measures like total return or annualized return (which
assume consistent cash flow timing), XIRR incorporates the timing and
amount of each cash flow to provide a more accurate picture of performance.

Many investments, like mutual funds with Systematic Investment Plans

(SIPs) or those with frequent deposits and withdrawals, have cash flows at
irregular intervals. XIRR considers these variations, unlike traditional
methods that might misrepresent the return.

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

XIRR is a powerful tool for investors seeking a more accurate understanding

of their investment returns, especially when dealing with irregular cash flow
patterns.

Risk Measures

Understanding the level of risk your portfolio is exposed to is crucial

1. Standard Deviation

Standard deviation measures the dispersion of your portfolio's returns around its
average return. In simpler terms, it tells you how much your returns fluctuate over
time.

A higher standard deviation indicates greater volatility - your returns deviate

more significantly from the average. This suggests a potentially riskier portfolio.

A lower standard deviation implies less volatility - returns tend to stay closer to
the average, suggesting a potentially less risky portfolio.

Limitations

● Standard deviation treats all deviations (positive and negative) equally. A

portfolio with consistent losses can have a low standard deviation, which
might be misleading.

● It doesn't consider the direction of the deviations. Significant downward

movements (losses) can be more concerning than upward fluctuations
(gains).

Additional Information:

The 68-95-99.7 rule

The 68-95-99.7 rule, also known as the empirical rule, is a principle in statistics
that applies to normally distributed data. It describes the probability of finding
data points within a certain number of standard deviations (SD) from the mean
(average). Here's the breakdown of the rule:

● 68%: Approximately 68% of the data falls within one SD of the mean.
● 95%: Roughly 95% of the data falls within two SDs of the mean.
● 99.7%: About 99.7% of the data falls within three SDs of the mean.

Let's say you're analyzing an investment with an expected annual return (mean)
of 10% and a standard deviation (SD) of 3%. The 68-95-99.7 rule can help you
understand the potential range of returns for this investment:

Alan Job Jose

St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

● 68% Confidence Interval: Within one standard deviation (3%) of the 10%
mean, you can expect returns to fall between 7% and 13% (10% ± 3%) in
roughly 68% of the years.
● 95% Confidence Interval: Expanding to two standard deviations (6%), the
range widens to 4% and 16% (10% ± 6%) in approximately 95% of the
years.
● 99.7% Confidence Interval: Considering three standard deviations (9%),
the total range becomes 1% and 19% (10% ± 9%) for 99.7% of the years.

Interpretation
The 68-95-99.7 rule doesn't predict the exact return for any particular year.
However, it provides a framework for understanding the probability of returns
falling within certain ranges based on the historical average (mean) and
volatility (standard deviation).

2. Beta

Beta measures the relative volatility of your portfolio compared to a benchmark

(usually a broad market index). It essentially tells you how much your portfolio's
returns tend to move with the market.

A beta of 1 indicates your portfolio's returns move in line with the market.

A beta greater than 1 suggests your portfolio's returns are more volatile than the
market. It amplifies market movements - both upwards and downwards.

A beta less than 1 implies your portfolio's returns are less volatile than the market.
It doesn't move as much as the market in either direction.

Limitations

● Beta assumes a linear relationship between your portfolio and the

benchmark. This may not always hold true.

● It only considers market risk, not other types of risk like interest rate or
credit risk.

3. Maximum Drawdown

Maximum drawdown measures the largest peak-to-trough decline in the value of

your portfolio over a specific period. It highlights the most significant loss your
portfolio experienced during that time frame.

A higher maximum drawdown indicates a larger single decline in portfolio value,

suggesting a potentially riskier investment.

A lower maximum drawdown implies a smaller decline experienced, suggesting a

potentially less risky investment.

Limitations
Alan Job Jose
St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

● Maximum drawdown only captures the biggest single decline, not the
frequency or severity of smaller losses.

● The timeframe used for calculating maximum drawdown can impact the
result. A longer period might reveal a larger drawdown.

These three measures provide valuable insights into the risk profile of your
portfolio. Here's how you can leverage them:

● Compare your portfolio's risk to its return. A high return with high
standard deviation or beta might be suitable for a high-risk tolerance
investor.

● Benchmark your portfolio against a relevant index. Compare your

portfolio's beta and maximum drawdown to the benchmark to understand
its relative risk.

● Track these measures over time. Monitor how these risk measures evolve to
assess changes in your portfolio's risk profile.

Risk-adjusted return measures

While raw returns are important, a complete picture of your portfolio's

performance requires considering the risk involved in achieving those returns.
Risk-adjusted return measures address this by incorporating risk into the
evaluation.
Alan Job Jose
St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

1. Sharpe Ratio

The Sharpe Ratio measures the additional return your portfolio generates per unit
of risk taken, compared to the risk-free rate (typically the return on government
bonds). It essentially helps you gauge how much excess return you're getting for
the volatility you endure.

● Formula: Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard

Deviation of Portfolio Returns

A higher Sharpe Ratio indicates better risk-adjusted performance. You're

generating more return per unit of risk.

A lower Sharpe Ratio suggests less efficient risk management. You might be
getting similar returns with less risk elsewhere.

Limitations

● Sharpe Ratio assumes normal distribution of returns, which might not

always be true.

● It only considers total volatility (standard deviation), not specifically

downside risk.

2. Treynor Ratio

Similar to the Sharpe Ratio, the Treynor Ratio focuses on excess return, but it uses
beta instead of standard deviation as the risk measure. Beta reflects how much
your portfolio's returns move with the market.

● Formula: Treynor Ratio = (Portfolio Return - Risk-Free Rate) / Beta

A higher Treynor Ratio implies better risk-adjusted performance specifically

related to systematic (market) risk.

A lower Treynor Ratio suggests the portfolio might not be efficiently capturing
market risk for the return it generates.

Limitations

● Treynor Ratio assumes a linear relationship between your portfolio and the
market, which might not always hold true.

● It doesn't consider unsystematic risk (risk specific to individual

investments).

3. Jensen's Alpha

Alpha measures the excess return (above what the market would expect based on
beta) generated by your portfolio. It essentially helps you understand how much
your portfolio manager potentially outperformed the market after adjusting for
risk.
Alan Job Jose
St.Francis College, Bengaluru
Investment Management
Module 5 : Portfolio Management

● Formula: Alpha = Portfolio Return - (Risk-Free Rate + Beta * (Market

Return - Risk-Free Rate))

A positive alpha indicates your portfolio manager potentially outperformed the

market after adjusting for risk.

A negative alpha suggests the portfolio underperformed the market relative to its
risk.

Limitations

● Past alpha doesn't guarantee future alpha.

Additional Information:

Alpha and Jensen's alpha

Alpha and Jensen's alpha are two key metrics used for this purpose. Alpha simply
measures if your portfolio outperformed a chosen benchmark (like a market
index), but doesn't consider risk. Jensen's alpha refines this by incorporating
risk. It uses the CAPM model to estimate the expected return based on your
portfolio's risk profile, and then sees if you actually achieved more than that
(positive alpha) - potentially indicating skillful management. So, alpha gives a
basic idea of beating a benchmark, while Jensen's alpha adds a layer of
sophistication by considering how much risk you took to achieve that
outperformance.

4. Sortino Ratio

Similar to the Sharpe Ratio, the Sortino Ratio measures risk-adjusted return, but it
focuses on downside risk (volatility of negative returns) instead of total volatility.
This can be particularly relevant for investors who are more concerned about
potential losses.

● Formula: Sortino Ratio = (Portfolio Return - Risk-Free Rate) / Downside

Deviation of Portfolio Returns

A higher Sortino Ratio indicates better risk-adjusted performance considering

primarily downside risk.

A lower Sortino Ratio suggests the portfolio might be exposed to more significant
downside risk for the return it generates.

Limitations

● Sortino Ratio requires defining what constitutes a "downside return."

Different methods can lead to slightly different results.

● It doesn't account for total volatility, which can still be important.

Alan Job Jose

St.Francis College, Bengaluru