SYBCOM Semester IV

Portfolio Management - I
Syllabus
Module 1
Portfolio Management: An Overview
1.1 Introduction to Investment, Objectives and Characteristics of Investment, Concept of Portfolio
Management, Objectives of Portfolio management, Portfolio approach to investing, Portfolio
management process, Types of Investors, Forms of Pooled Investments.

1.2 Portfolio Construction, Principles of Portfolio Construction, Investment Constraints, Assets

Allocation, Traditional Portfolio Theory, Modern Portfolio Theory.

Module 2

Portfolio Risk and Return

2.1 Historical Risk and Return, Risk Aversion, Portfolio Standard Deviation, Calculation of
Expected Return and Risk, Calculation of mean, variance and covariance, standard deviation, The
Efficient Frontier.

2.2 Systematic and Nonsystematic Risk, Beta, Capital Allocation Line, Capital Market Line,
Calculate and interpret Beta, Capital Asset Pricing Model (CAPM), Security Market Line (SML),
Calculate and interpret Sharpe Ratio, Treynor Ratio and Jensen Ratio.
 Module 1
Portfolio Management: An Overview

INTRODUCTION OF INVESTMENT

An investment is an asset or item that is purchased with the hope that it will generate income or
will appreciate in the future. Investments can be stocks, bonds, mutual funds, interest-bearing
accounts, land, derivatives, real estate, gold silver etc., anything an investor believes will
produce income (usually in the form of interest or rents) or become worth more.

DEFINITION OF INVESTMENT

(1) "An investment operation is one which, upon through analysis promises safety of principal
and an adequate return. Operations not meeting these requirements are speculative."

-By Graham and Qadd's Security Analysis

(2) Investment management is the process of managing money, including investment, budgeting,
banking and taxes, also called as money management.

MEANING AND CONCEPT OF INVESTMENT

Investment is a term for several closely related meanings in finance and economics.

(a) Investment according to Theoretical Economics: Investment means the production of

capital goods - goods which are not consumed but instead used in future production.

Example include:

Building.

• A rail road.

• A factory clearing land.

• Putting oneself through college.

(b) Investment according to Finance Term: Investment means buying of assets. For example.

• Buying stocks and bonds.

• Investing in real estate.
• Mortgages.

These investments may then provide a future income and increase in value (i.e. investing in real
estate).
 OBJECTIVES OF INVESTMENT

MAIN OBJECTIVES:

Depending on the life stage and risk appetite of the investor, there are three main objectives of
investment: safety, growth and income.

(1) Safety: While no investment option is completely safe, there are products that are preferred
by investors who are risk averse. Some individuals invest with an objective of keeping their
money safe, irrespective of the rate of return they receive on their capital. Such near-safe
products include fixed deposits, savings accounts, government bonds, etc.

(2) Growth: While safety is an important objective for many investors, a majority of them invest
to receive capital gains, which means that they want the invested amount to grow. There are
several options in the market that offer this benefit. These include stocks, mutual funds, gold,
property, commodities, etc. It is important to note that capital gains attract taxes, the percentage
of which varies according to the number of years of investment.

(3) Income: Some individuals invest with the objective of generating a second source of income.
Consequently, they invest in products that offer returns regularly like bank fixed deposits,
corporate and government bonds, etc.

OTHER OBJECTIVES:

While the aforementioned objectives are the most common ones among investors today, some
other objectives include:

(4) Tax exemption: Some people invest their money in various financial products solely for
reducing their tax liability. Some products offer tax exemptions while many offer tax benefits on
long-term profits.

(5) Liquidity: Many investment options are not liquid. This means they cannot be sold and
converted into cash instantly. However, some people prefer investing in options that can be used
during emergencies. Such liquid instruments include stock, money market instruments and
exchange-traded funds, to name a few.

6) Minimize risk: Investing in different types of securities help to minimize risk. To minimize
the risks associated with investment, you should always diversity your portfolio over well
researched asset class. It is also important to diversify within each asset class.
 NATURE AND CHARACTERISTICS OF INVESTMENT:

Investment refers to invest money in financial physical assets and marketable assets. Major
investments feature such as risk, return, safety, liquidity, marketability conceal ability, capital
growth, purchasing power, stability and the benefits.

The major characteristics of investments are outlined as:

(1) Risk.
(2) Return.
(3) Safety.
(4) Liquidity.
(5) Marketability.
(6) Conceal ability.
(7) Capital growth.
(8) Purchasing power stability.
(9) Stability of income.
(10) Tax benefits.

(1) Risk: Risk refers to the loss of principal amount of an investment. It is one of the major
characteristics of an investment.

The risk depends on the following factors:

(a) The investment maturity period is longer; in this case, investor will take larger risk.

(b) Government or Semi Government bodies are issuing securities which have less risk.

(c) In the case of the debt instrument or fixed deposit, the risk of above investment is less due to
their secured and fixed interest payable on them. For instance Debentures.

(d) In the case of ownership instrument like equity or preference shares, the risk is more due to
their unsecured nature and variability of their return and ownership character.

(e) The risk of degree of variability of returns is more in the case of ownership capital compare
to debt capital.

(f) The tax provisions would influence the return of risk.

(2) Return: Return refers to expected rate of return from an investment.

Return is an important characteristic of investment. Return is the major factor which influences
the pattern of investment that is made by the investor. Investor always prefers to high rate of
return for his investment.
(3) Safety: Safety refers to the protection of investor principal amount and expected rate of
return. Safety is also one of the essential and crucial elements of investment. Investor prefers
safety about his capital. Capital is the certainty of return without loss of money or it will take
time to retain it. If investor prefers less risk securities, he chooses Government bonds. In the
case, investor prefers high rate of return investor will choose private securities and safety of
these securities is low.

(4) Liquidity: Liquidity refers to an investment ready to convert into cash position. In other
words, it is available immediately in cash from. Liquidity means that investment is easily
realizable, saleable or marketable. When the liquidity is high, then the return may be low.

An investor generally prefers liquidity for his investments, safety of funds through a minimum
risk and maximization of return from an investment.

(5) Marketability: Marketability refers to buying and selling of securities in market.

Marketability means transferability or sale ability of an asset. Securities are listed in a stock
market which is not listed. Public Limited Companies shares are more easily marketable than
which are not listed Public Limited Companies shares are more easily transferable than those of
private limited companies.

(6) Conceal ability: Conceal ability is another essential characteristic of the investment. Conceal
ability means investment to be safe form social disorders, government confiscations or
unacceptable levels of taxation; property must be concealable and leave no record of income
received from its use or sale. Gold and precious stones have long been esteemed for these
purposes, because they combine high value with small bulk and are readily transferable.

(7) Capital Growth: Capital growth refers to appreciation of investment. Capital growth has
today become an important character of investment. It is recognizing in connection between
corporation and industry growth and very large capital growth. Investors and their advisers are
constantly seeking 'growth stock' in the right industry and bought at the right time.

(8) Purchasing Power Stability: It refers to the buying capacity of investment in market.
Purchasing power stability has become one of the import traits of investment. Investment always
involves the commitment of current funds with the objective of receiving greater amounts of
future funds.

(9) Stability of Income: it refers to constant return form an investment. Another major
characteristic feature of the investment is the stability of income. Stability of income must look
for different path just as security of principal. Every investor always considers stability of
monetary income and stability of purchasing power of income.

(10) Tax Benefits: Tax benefits are the last characteristic feature of the investment. Tax benefits
refer to plan an investment programme without regard to one's status may be costly to the
investor. There are actually two problems:

(a) One concerned with the amount of income paid by the investment.
(b) Another is the burden of income tax upon that income.

INVESTMENT ALTERNATIVES/ AVENUES IN INDIA

There are many types of investments and investing styles to choose from. Mutual funds,
individual stocks and bonds, closed-end, mutual funds, real estate, various alternative
investments and owning all or part of a business are just a few examples.

(1) Equity shares: Equity investments represent ownership in a running company. By

ownership, we mean share in the profits and assets of the company but generally, there are no
fixed returns. It is considered as a risky investment but at the same time, they are most liquid
investments due to the presence of stock markets.

(2) Debentures or Bonds: Debentures or bonds are long term investment options with a fixed
stream of cash flows depending on the quoted rate of interest. They are considered relatively less
risky. An amount of risk involved in debentures or bonds is dependent upon which the issuer is.
For example, if the issuer is government, the risk is assumed to be zero. Following alternatives
are available under debentures or bonds:

(i) Government securities.

(ii) Savings bonds.
(iii) Public Sector Units bonds.
(iv) Debentures of private sector companies.

(3) Mutual Fund: A mutual fund is a professionally-managed investment scheme, usually run
by an asset management company that brings together a group of people and invests their money
in stocks, bonds and other securities. The biggest advantage of investing through a mutual fund
is that it gives small investors access to professionally-managed, diversified portfolios of
equities, bonds and other securities, which would be quite difficult to create with a small amount
of capital.

(4) Public Provident Fund: The Public Provident Fund is a savings-cum-tax-saving instrument
in India, introduced by the National Savings Institute of the Ministry of Finance in 1968. The
aim of the scheme is to mobilize small savings by offering an investment with reasonable returns
combined with income tax benefits.

(5) National Saving Certificate: National Savings Certificates, popularly known as NSC, is an
Indian Government Savings Bond, primarily used for small savings and income tax saving
investments in India. It is part of the postal savings system of Indian Postal Service (India Post).
These can be purchased from any Post Office in India by an adult (either in his/her own name or
on behalf of a minor), a minor, a trust, and two adults jointly. These are issued for five and ten
year maturity and can be pledged to banks as collateral for availing loans. The holder gets the tax
benefit under Section 80C of Income Tax Act, 1961.
(6) Preference Share: Preference shares are shares which are preferred over common or equity
shares in payment of surplus or dividend i.e. preference shareholders are the first to get dividends
in case the company decides to pay out dividends. Owners of preference shares gets fixed
dividend. However, in the event of liquidation of the company they are paid after bond holders
and creditors, but before equity holders.

(7) Life insurance and general insurance: They are one of the important parts of good
investment portfolios. Life insurance is an investment for the security of life. The main objective
of other investment avenues is to earn a return but the primary objective of life insurance is to
secure our families against unfortunate event of our death. It is popular in individuals. Other
kinds of general insurances are useful for corporates. There are different types of insurances
which are as follows:

(i) Endowment Insurance Policy.

(ii) Money Back Policy.

(iii) Whole Life Policy.

(iv) Term Insurance Policy.

(v) General Insurance for any kind of assets.

(8) Real Estate: In India investing in real estate is considered as the best form of investment but
only after gold. Historically real estate has performed well in India.

(9) Gold: The only form of investment which most of our mothers and fathers would believe in.
Gold is considered as the best investment in India, that is the only reason why India is the highest
consumer of gold in the world.

(10) Post Office Savings: The Post Office Savings Account is the deposit scheme offered by the
department of post on which fixed interest is paid. The individual investors deposit a good
portion of their financial assets in a postal savings account in order to earn a fixed rate of interest
on the investments.

(11) Public deposits: Public deposits refer to the unsecured deposits invited by companies from
the public mainly to finance working capital needs. A company wishing to invite public deposits
makes an advertisement in the newspapers.

(12) Corporate deposit: A Corporate deposit is an interest bearing deposit bank product offered
to corporate banking customers by banks and accredited financial institutions. Corporate deposit
target customers can include large commercial companies, public institutions, government
agencies and large non-profits.
 FACTORS CONDUCIVE FOR INVESTMENT IN INDIA/ INVESTMENT
ATTRIBUTES

Investments are evaluated to decide or choose the right investment. Evaluation of investment
involves evaluating the attributes of investments. Return, risk, liquidity, tax benefits and
convenience are the key attributes taken into consideration before investing in any particular type
of investment.

Investments are an integral part of any business. Every company has investments in many forms
whether they are in projects or assets. Income from investments has a direct impact on the
profitability of the company and it is one of the primary responsibilities of a finance manager to
effectively invest the company's funds in optimizing its profits.

In essence, for effective investment, investment alternatives need to be analysed or evaluated.

Following attributes of investments can be taken into consideration for evaluating the
investments.

(1) Rate of return: A good rate of return on an investment is the first and the foremost
condition for effective investment. The rate of return is the ratio of the sum of annual
income and price appreciation for the purchasing price of the asset or investment.

Rate of Return = Annual Income + (Ending Price – Beginning Price)

Beginning Price
The rate of return on various investment avenues would vary widely.

(2) Risk: The rate of return from different investment options varies a lot. More the risk and
more are the profits. It is a general phenomenon that more return is expected out of a high-risk
investment.

(3) Liquidity: Liquidity means marketability of an investment. For example, equity shares of a
big company can be easily liquidated in the stock markets. On the other hand, money invested in
an asset (machinery) cannot be liquidated as easily as the equity share. An investment is
considered highly marketable or liquid it can be easily transacted with low transaction cost and
low price variation. A finance manager looks for more liquid investments when the funds are
available for the short period. Liquidity is always given a preference because it helps the
managers remain flexible.

(4) Tax Benefits: It is true for some investments and not for all. Most of the countries have tax
incentives for particular investments except tax-free countries. So, for investments which have
tax benefits, it is an important consideration because taxes form a major part of their expenses.

Tax benefits are mainly of 3 types:

(i) Initial tax benefits. This is the tax gain at the time of making the investment, like life
insurance.

(ii) Continuing tax benefit. Is the tax benefit gained on the periodic return from the investment,
such as dividends.

(iii) Terminal tax benefit. This is the tax relief the investor gains when he liquidates the
investment. For example, a withdrawal from a provident fund account is not taxable.

(5) Convenience: Convenience means ease of investment. When an investment can be made and
looked after easily, we consider it as convenient investing. For example, it is easy to invest in
equity shares compared to real estate because real estate involves a lot of documentation and
legal requirements.

(6) Safety: While no investment option is completely safe, there are products that are preferred
by investors who are risk averse. Some individuals invest with an objective of keeping their
money safe, irrespective of the rate of return they receive on their capital. Such near-safe
products include fixed deposits, savings accounts, government bonds, etc.

(7) Growth: While safety is an important objective for many investors, a majority of them invest
to receive capital gains, which means that they want the invested amount to grow. There are
several options in the market that offer this benefit. These include stocks, mutual funds, gold,
property, commodities, etc. It is important to note that capital gains attract taxes, the percentage
of which varies according to the number of years of investment.

(8) Marketability: Marketability refers to buying and selling of securities in market.

Marketability means transferability or saleability of an asset. Securities are listed in a stock
market which are more easily marketable than which are not listed. Public Limited Companies
shares are more easily transferable than those of private limited companies.

(9) Purchasing Power Stability: It refers to the buying capacity of investment in market.
Purchasing power stability has become one of the import traits of investment. Investment always
involves the commitment of current funds with the objective of receiving greater amounts of
future funds.

(10) Liquidity: Liquidity refers to an investment ready to convert into cash position. In other
words, it is available immediately in cash from. Liquidity means that investment is easily
realisable, saleable or marketable. When the liquidity is high, then the return may be low for
example, UTI units. An investor generally prefers liquidity for his investments, safety of funds
through a minimum risk and maximisation of return from an investment.

MEANING OF PORTFOLIO MANAGEMENT

Portfolio means a combination of financial assets and physical assets. The financial assets are
shares, debentures and other securities while physical assets include gold, silver, real estates, rare
collections, etc. A portfolio is planned to stabilize the risk of non-performance of various pools
of investment.

Portfolio Management guides the investor in a method of selecting the best available securities
that will provide the expected rate of return for any given degree of risk and also to mitigate
(reduce) the risks. It is a strategic decision which is addressed by the top-level managers.

Investment portfolio composing securities that yield a maximum return for given levels of risk or
minimum risk for given levels of returns are termed as "efficient portfolio".

Portfolio management thus refers to investment of funds in such combination of different

securities in which the total risk of portfolio is minimized while expecting maximum return from
it.

DEFINITION OF PORTFOLIO MANAGEMENT

Portfolio management can be defined as "The process of selecting a bunch of securities that
provides the investing agency a maximum return for a given level of risk or alternatively ensures
minimum risk for a given level of return."

OBJECTIVES/ADVANTAGES OF PORTFOLIO MANAGEMENT

The main objectives of portfolio management in finance are as follows:

1. Security of Principal Investment.

2. Consistency of Returns.

3. Capital Growth.

4. Marketability.

5. Liquidity.

6. Diversification of Portfolio.

7. Favourable Tax Status.

OBJECTIVES OF FINANCIAL PORTFOLIO MANAGEMENT

(1) Security of Principal Investment: Investment safety or minimization of risks is one of the
most important objectives of portfolio management. Portfolio management not only involves
keeping the investment intact but also contributes towards the growth of its purchasing power
over the period. The motive of a financial portfolio management is to ensure that the investment
is absolutely safe. Other factors such as income, growth, etc., are considered only after the safety
of investment is ensured.

(2) Consistency of Returns: Portfolio management also ensures to provide the stability of
returns by reinvesting the same earned returns in profitable and good portfolios. The portfolio
helps to yield steady returns. The earned returns should compensate the opportunity cost of the
funds invested.

(3) Capital Growth: Portfolio management guarantees the growth of capital by reinvesting in
growth securities or by the purchase of the growth securities. A portfolio shall appreciate in
value, in order to safeguard the investor from any erosion in purchasing power due to inflation
and other economic factors. A portfolio must consist of those investments, which tend to
appreciate in real value after adjusting for inflation.

(4) Marketability: Portfolio management ensures the flexibility to the investment portfolio. A
portfolio consists of such investment, which can be marketed and traded. Suppose, if your
portfolio contains too many unlisted or inactive shares, then there would be problems to do
trading like switching from one investment to another. It is always recommended to invest only
in those shares and securities which are listed on major stock exchanges, and also, which are
actively traded.

(5) Liquidity: Portfolio management is planned in such a way that it facilitates to take maximum
advantage of various good opportunities upcoming in the market. The portfolio should always
ensure that there are enough funds available at short notice to take care of the investor's liquidity
requirements.

6) Diversification of Portfolio: Portfolio management is purposely designed to reduce the risk

of loss of capital and/or income by investing in different types of securities available in a wide
range of industries. The investors shall be aware of the fact that there is no such thing as a zero
risk investment. More over relatively low risk investment give correspondingly a lower return to
their financial portfolio.

(7) Favourable Tax Status: Portfolio management is planned in such a way to increase the
effective yield an investor gets from his surplus invested funds. By minimizing the tax burden,
yield can be effectively improved. A good portfolio should give a favourable tax shelter to the
investors. The portfolio should be evaluated after considering income tax, capital gains tax, and
other taxes.

The objectives of portfolio management are applicable to all financial portfolios. These
objectives, if considered, results in a proper analytical approach towards the growth of the
portfolio. Furthermore, overall risk needs to be maintained at the acceptable level by developing
balanced and efficient portfolio. Finally, a good portfolio of growth stocks often satisfies all
objectives of portfolio management.
PHASES OF PORTFOLIO MANAGEMENT

Portfolio management involves complex process which the following steps to be followed
carefully:

(1) Identification of objectives and constraints.

(2) Selection of the asset mix.

(3) Formulation of portfolio strategy.

(4) Security analysis.

(5) Portfolio execution.

(6) Portfolio revision.

(7) Portfolio evaluation.

Now each of these steps can be discussed in detail:

(1) Identification of objectives and constraints: The primary step in the portfolio management
process is to identify the limitations and objectives. The portfolio management should focus on
the objectives and constraints of an investor in first place. The objective of an Investor may be
income with minimum amount of risk, capital appreciation or for future provisions. The relative
importance of these objectives should be clearly defined.

(2) Selection of the asset mix: The next major step in portfolio management process is
identifying different assets that can be included in portfolio in order to spread risk and minimize
loss.

In this step, the relationship between securities has to be clearly specified. Portfolio may contain
the mix of Preference shares, equity shares, bonds etc. The percentage of the mix depends upon
the risk tolerance and investment limit of the investor.

(3) Formulation of portfolio strategy: After certain asset mix is chosen, the next step in the
portfolio management process is formulation of an appropriate portfolio strategy. There are two
choices for the formulation of portfolio strategy, namely

(6) an active portfolio strategy; and

(6) a passive portfolio strategy.

An active portfolio strategy attempts to earn a superior risk adjusted return by adapting to market
timing, switching from one sector to another sector according to market condition, security
selection or a combination of all of these.

A passive portfolio strategy on the other hand has a pre- determined level of exposure to risk.
The portfolio is broadly diversified and maintained strictly.

(4) Security analysis: In this step, an investor actively involves himself in selecting securities.

Security analysis requires the sources of information on the basis of which analysis is made.
Securities for the portfolio are analysed taking into account of their price, possible return, risks
associated with it etc. As the return on investment is linked to the risk associated with the
security, security analysis helps to understand the nature and extent of risk of a particular
security in the market.

Security analysis involves both micro analysis and macro analysis. For example, analysing one
script is micro analysis. On the other hand, macro analysis is the analysis of market of securities.
Fundamental analysis and technical analysis help to identify the securities that can be included in
portfolio of an investor.

(5) Portfolio execution: When selection of securities for, investment is complete the execution
of portfolio plan takes the next stage in a portfolio management process. Portfolio execution is
related to buying and selling of specified securities in given amounts. As portfolio execution has
a bearing on investment results, it is considered one of the important step in portfolio
management.

(6) Portfolio revision: Portfolio revision is one of the most important steps in portfolio
management. A portfolio manager has to constantly monitor and review scripts according to the
market condition. Revision of portfolio includes adding or removing scripts, shifting from one
stock to another or from stocks to bonds and vice versa.

(7) Performance evaluation: Evaluating the performance of portfolio is another important step
in portfolio management. Portfolio manager has to assess the performance of portfolio over a
selected period of time. Performance evaluation includes assessing the relative merits and
demerits of portfolio, risk and return criteria, adherence of the portfolio management to publicly
stated investment objectives or some combination of these factors.

Portfolio Approach to Investing

The portfolio perspective refers to evaluating individual investments by their contribution to the
risk and return of an investor’s portfolio. The alternative to taking a portfolio perspective is to
examine the risk and return of individual investments in isolation. An investor who holds all his
wealth in a single stock because he believes it to be the best stock available is not taking the
portfolio perspective—his portfolio is very risky compared to holding a diversified portfolio of
stocks. Modern portfolio theory concludes that the extra risk from holding only a single security
is not rewarded with higher expected investment returns. Conversely, diversification allows an
investor to reduce portfolio risk without necessarily reducing the portfolio’s expected return. In
the early 1950s, the research of Professor Harry Markowitz provided a framework for measuring
the risk-reduction benefits of diversification. Using the standard deviation of returns as the
measure of investment risk, he investigated how combining risky securities into a portfolio
affected the portfolio’s risk and expected return. One important conclusion of his model is that
unless the returns of the risky assets are perfectly positively correlated, risk is reduced by
diversifying across assets
In the 1960s, professors Treynor, Sharpe, Mossin, and Lintner independently extended this work
into what has become known as modern portfolio theory (MPT). MPT results in equilibrium
expected returns for securities and portfolios that are a linear function of each security’s or
portfolio’s market risk (the risk that cannot be reduced by diversification). One measure of the
benefits of diversification is the diversification ratio. It is calculated as the ratio of the risk of an
equally weighted portfolio of n securities (measured by its standard deviation of returns) to the
risk of a single security selected at random from the n securities. If the average standard
deviation of returns for the n stocks is 25%, and the standard deviation of returns for an equally
weighted portfolio of the n stocks is 18%, the diversification ratio is 18 / 25 = 0.72. If the
standard deviation of returns for an equally weighted portfolio is 25%, there are no
diversification benefits and the diversification ratio equals one. A lower diversification ratio
indicates a greater risk-reduction benefit from diversification.
While the diversification ratio provides a quick measure of the potential benefits of
diversification, an equal-weighted portfolio is not necessarily the portfolio that provides the
greatest reduction in risk. Computer optimization can calculate the portfolio weights that will
produce the lowest portfolio risk (standard deviation of returns) for a given group of securities.
Portfolio diversification works best when financial markets are operating normally;
diversification provides less reduction of risk during market turmoil, such as the credit contagion
of 2008. During periods of financial crisis, correlations tend to increase, which reduces the
benefits of diversification.
Portfolio Management Process

1. Planning Phase

This is the foundational step where investment objectives and constraints are established.

a. Identifying Investor Objectives

• Risk Tolerance: Understanding how much risk the investor is willing and able to take.
• Return Expectations: Setting realistic return goals based on the investor's risk appetite.
• Investment Horizon: Defining short-term, medium-term, or long-term goals.
• Liquidity Needs: Assessing the need for cash or easily accessible investments.
• Tax Considerations: Factoring in tax efficiency based on jurisdiction and investment choices.
• Legal and Regulatory Constraints: Ensuring compliance with legal frameworks.

b. Asset Allocation Strategy

• Strategic Asset Allocation (SAA): Long-term allocation based on risk/return objectives.

• Tactical Asset Allocation (TAA): Short-term adjustments to capture market opportunities.
• Diversification: Spreading investments across asset classes to reduce risk.

2. Implementation Phase

This step involves the actual construction and execution of the investment strategy.

a. Security Selection

• Choosing specific securities (stocks, bonds, real estate, etc.) within the asset allocation plan.
• Fundamental and technical analysis to identify opportunities.
• Evaluation of market trends and macroeconomic factors.

b. Portfolio Construction

• Weighting assets based on strategic allocation.

• Ensuring proper diversification across industries, geographies, and sectors.
• Optimizing for risk-adjusted returns (e.g., using models like CAPM, Markowitz’s Modern Portfolio
Theory).

c. Execution

• Buying and selling securities through brokers or trading platforms.

• Minimizing transaction costs and slippage.
• Ensuring regulatory compliance during transactions.

3. Monitoring and Rebalancing Phase

Continuous oversight to ensure the portfolio aligns with the investment goals and risk tolerance.
a. Performance Measurement

• Comparing actual returns with benchmarks and targets.

• Key performance indicators (KPIs) like return on investment (ROI), alpha, beta, Sharpe ratio.

b. Risk Management

• Monitoring market risks, credit risks, and liquidity risks.

• Using tools such as Value at Risk (VaR), stress testing, and scenario analysis.
• Hedging strategies using derivatives if necessary.

c. Rebalancing

• Adjusting the portfolio periodically to maintain the desired asset allocation.

• Selling overperforming assets and buying underperforming ones to reduce drift.
• Considering cost-efficiency and tax implications during rebalancing.

4. Evaluation and Reporting Phase

Regular assessment of the investment strategy's effectiveness and adjustments if needed.

a. Performance Reporting

• Periodic reports (monthly, quarterly, annually) for investors or stakeholders.

• Detailed breakdown of returns, risks, and market conditions.

b. Review and Adjustments

• Revisiting investment goals based on changes in financial conditions, life events, or market shifts.
• Adapting to new economic trends, policy changes, or technological advancements.

5. Risk Management and Governance

Throughout the process, a strong governance structure ensures that investment decisions align with
the overall objectives and ethical considerations.

• Establishing compliance guidelines and ethical standards.

• Internal controls and audits to ensure investment policy adherence.
• ESG (Environmental, Social, Governance) considerations in modern portfolios.

By following this structured portfolio management process, investors can systematically achieve
their financial objectives while managing risk effectively.

Forms of Pooled Investments

Pooled investments refer to the practice of combining funds from multiple investors to invest in a
portfolio of assets, typically managed by professional investment managers. The primary goal is to
provide access to diversified investments that individual investors might not be able to achieve on
their own due to cost, expertise, or scale limitations.
Here are the main types of pooled investments:

1. Mutual Funds

• Description: Mutual funds pool money from many investors to invest in a diversified
portfolio of stocks, bonds, or other securities. These funds are managed by professional
fund managers.
• Key Characteristics:
o Open-ended, meaning you can buy or sell shares at the current net asset value
(NAV) at the end of each trading day.
o Suitable for both long-term and short-term investors.
o Typically have management fees (expense ratios).

2. Exchange-Traded Funds (ETFs)

• Description: ETFs are similar to mutual funds in that they pool investors' money to invest
in a diversified portfolio. However, ETFs trade on stock exchanges like individual stocks,
allowing investors to buy and sell shares throughout the trading day.
• Key Characteristics:
o Lower expense ratios than mutual funds.
o Can be bought and sold at market prices during the trading day.
o May track indexes (e.g., S&P 500) or sectors.
o Tax efficiency compared to mutual funds due to the "in-kind" creation and
redemption process.

3. Hedge Funds

• Description: Hedge funds are private pooled investment vehicles that typically target high-
net-worth individuals or institutional investors. They use more aggressive strategies like
leverage, short selling, derivatives, and alternative assets.
• Key Characteristics:
o Often have higher fees (e.g., 2% management fee and 20% performance fee).
o Invest in a wide range of assets, including equities, bonds, commodities, real estate,
or private equity.
o Less regulation compared to mutual funds and ETFs.
o May require high minimum investments.

4. Private Equity Funds

• Description: Private equity funds pool capital from investors to invest in private companies
or engage in buyouts of public companies. The goal is typically to improve the companies'
operations and then sell them for a profit after several years.
• Key Characteristics:
o Invest in private, unlisted companies.
o Long investment horizons (5–10 years or more).
o Focus on high returns through operational improvements or mergers and
acquisitions (M&A).
o High minimum investment requirements, typically reserved for accredited investors.

5. Real Estate Investment Trusts (REITs)

 • Description: REITs pool capital from investors to purchase, operate, and manage real
estate properties. REITs can be publicly traded on exchanges or private.
• Key Characteristics:
o Invest in income-generating real estate (commercial, residential, industrial, etc.).
o Offer liquidity (if publicly traded).
o Typically pay out a large portion of income as dividends to investors.
o Can be tax-efficient if they meet certain regulatory requirements (e.g., distributing
90% of taxable income to shareholders).

6. Unit Investment Trusts (UITs)

• Description: A UIT is a fixed portfolio of securities selected at the inception of the trust.
Unlike mutual funds, UITs are not actively managed after the initial selection of securities,
and they have a fixed life span.
• Key Characteristics:
o Generally have a set maturity date.
o Passive investment strategy, as the portfolio remains unchanged.
o Suitable for conservative investors seeking steady income.

7. Venture Capital Funds

• Description: Venture capital (VC) funds invest in early-stage companies with high growth
potential, often in the technology or biotech sectors. These funds usually focus on startups
or companies looking for funding in their early stages.
• Key Characteristics:
o Higher risk but potentially high rewards.
o Investors include institutional investors, wealthy individuals, and occasionally
family offices.
o Long investment horizons, with exits occurring through IPOs, acquisitions, or
secondary sales.

8. Funds of Funds (FoFs)

• Description: A fund of funds invests in other pooled investment vehicles, such as hedge
funds, mutual funds, or private equity funds, rather than directly in securities.
• Key Characteristics:
o Diversification across multiple fund managers and strategies.
o Can provide exposure to specialized asset classes or strategies that individual
investors might not access otherwise.
o May have higher fees due to the layering of fees from both the underlying funds and
the fund of funds itself.

9. Commodity Pools

• Description: Commodity pools are pooled investment vehicles that invest in commodity
futures, options, and other commodity-based instruments. They allow investors to gain
exposure to the commodity markets without directly trading commodities themselves.
• Key Characteristics:
o Can invest in agricultural products, metals, energy, and more.
o Managed by a commodity pool operator (CPO).
 o Suitable for investors seeking exposure to commodities without the complexity of
direct trading.

10. CLOSED-END FUNDS

• Description: Closed-end funds are similar to mutual funds in that they pool investor capital
and invest in a portfolio of securities. However, unlike mutual funds, closed-end funds issue
a fixed number of shares that are traded on exchanges.
• Key Characteristics:
o Fixed number of shares (not redeemable).
o Can trade at a premium or discount to their NAV.
o Typically used by investors seeking specific investment strategies, such as high
yields or niche markets.

Conclusion

Pooled investments offer various options for different types of investors, from mutual funds and
ETFs for retail investors to hedge funds, private equity, and venture capital funds for more
sophisticated, high-net-worth individuals. The structure, strategies, risk profiles, and costs of these
investment vehicles vary widely, making it important for investors to choose a vehicle that aligns
with their goals, risk tolerance, and investment horizon.

Types of Investors

Investors can be categorized based on various factors such as their investment goals, risk tolerance,
time horizon, and the nature of their investment strategies. Below are the main types of investors:

1. Individual Investors

• Description: These are everyday retail investors who manage their own personal finances
and make investment decisions on their own or through financial advisors.
• Subtypes:
o Conservative Investors: Prefer low-risk investments like bonds, dividend-paying
stocks, or money market funds. They prioritize preserving capital over high returns.
o Moderate Investors: Have a balanced approach, willing to take on some risk for
potential growth. They typically hold a mix of stocks, bonds, and alternative
investments.
o Aggressive Investors: Seek higher returns and are willing to take on higher risks.
They often invest in stocks, emerging markets, and more volatile assets like options
or cryptocurrency.

2. Institutional Investors

• Description: These are organizations that pool large sums of money to invest on behalf of
others. They typically manage much larger portfolios than individual investors.
• Examples:
 o Pension Funds: Invest retirement savings for individuals, often focusing on long-
term, stable returns through a mix of equities, bonds, real estate, and other assets.
o Insurance Companies: Invest premiums collected from policyholders in a
diversified portfolio to generate income to pay future claims.
o Endowments and Foundations: These organizations, often affiliated with
universities, charities, or nonprofit institutions, manage large pools of capital to
generate long-term returns for their purposes.
o Sovereign Wealth Funds: State-owned investment funds or entities that manage
the national savings or revenue of a country, often investing in a wide range of asset
classes globally.

3. Venture Capitalists (VCs)

• Description: Venture capitalists invest in early-stage companies, typically startups with

high growth potential. VCs provide funding in exchange for equity, with the goal of
eventually exiting the investment through an IPO, acquisition, or other liquidity events.
• Characteristics:
o High risk, high reward approach.
o Focus on sectors like technology, healthcare, biotech, or fintech.
o Typically require a substantial level of due diligence and actively participate in the
company’s management and growth.

4. Private Equity Investors

• Description: Private equity (PE) investors provide capital to private companies or take
public companies private. Their goal is to enhance the company’s value through
restructuring, operational improvements, or strategic acquisitions, and later sell it for a
profit.
• Characteristics:
o Invest in companies at various stages (early-stage, growth-stage, or buyouts).
o Longer investment horizons (often 5–10 years).
o May involve taking control of companies and providing strategic direction.
o High minimum investment requirements and illiquidity.

5. Hedge Fund Investors

• Description: Hedge funds pool capital from accredited investors or institutions and use a
wide variety of strategies, including long/short equity, derivatives, arbitrage, and more, to
achieve high returns with lower correlation to market indices.
• Characteristics:
o Employ sophisticated, often high-risk strategies, such as leverage and short selling.
o Typically charge performance fees (e.g., "2 and 20" — 2% management fee and
20% of profits).
o Open only to accredited investors or institutional investors due to high minimum
investments and risk.
o Focus on absolute returns, seeking to profit regardless of market conditions.

6. Angel Investors
 • Description: Angel investors are typically individuals who provide early-stage funding to
startups or small businesses in exchange for equity or convertible debt. They often invest in
companies that have not yet reached the venture capital stage.
• Characteristics:
o Often the first external investors in a company.
o Invest smaller amounts compared to VCs but can provide crucial seed capital.
o Usually have industry expertise and may offer mentoring in addition to capital.
o Invest in exchange for equity or convertible notes, and often have a hands-on role in
the business's development.

7. Day Traders

• Description: Day traders are individual investors or institutions that buy and sell financial
instruments within the same trading day, aiming to profit from short-term price movements.
• Characteristics:
o Engage in high-frequency trading, often using margin (borrowed funds) to amplify
potential returns (or losses).
o Rely heavily on technical analysis, market trends, and trading platforms to identify
opportunities.
o Typically have a high risk tolerance and short-term investment horizon.

8. Long-Term Investors (Buy and Hold)

• Description: These investors focus on purchasing assets, particularly stocks or bonds, and
holding them for many years, often with a focus on capital appreciation and/or dividends.
• Characteristics:
o Low turnover in their portfolios; they prefer to hold assets through market
fluctuations.
o Believe in the power of compounding returns over time.
o Tend to invest in established companies or index funds with a long-term outlook.
o Generally less active in managing their investments than short-term traders.

9. Value Investors

• Description: Value investors seek stocks or assets that are undervalued compared to their
intrinsic worth, often based on fundamental analysis. They believe the market has mispriced
the asset, providing an opportunity to buy low and sell high.
• Characteristics:
o Focus on low price-to-earnings (P/E) ratios, strong balance sheets, and undervalued
companies.
o Long-term approach, with an emphasis on buying stocks that are out of favor or
mispriced.
o Famous value investors include Warren Buffett and Benjamin Graham.

10. Growth Investors

• Description: Growth investors focus on companies or assets that exhibit above-average

growth potential, even if the stock price seems expensive relative to its current earnings.
They look for high future earnings potential rather than current value.
• Characteristics:
 o Invest in high-growth sectors, like technology, biotech, and emerging industries.
o Expect capital appreciation rather than dividends.
o Willing to take on more risk for the potential of higher returns.
o Often have a medium- to long-term investment horizon.

11. Income Investors

• Description: Income investors seek investments that provide steady, reliable income, often
through dividends, interest, or rental income. This category includes those who focus on
bonds, dividend-paying stocks, or real estate investment trusts (REITs).
• Characteristics:
o Focus on fixed-income securities (e.g., bonds, dividend-paying stocks).
o Often seek stable, predictable income streams rather than capital gains.
o Suitable for retirees or those looking for consistent cash flow.

12. Impact Investors (Socially Responsible Investors)

• Description: Impact investors focus on generating positive social or environmental impact

alongside financial returns. This approach may include investments in companies, projects,
or funds that align with specific ethical, social, or environmental values.
• Characteristics:
o Prioritize environmental, social, and governance (ESG) criteria.
o Invest in companies, funds, or projects that contribute to sustainable practices or
social good.
o Often see their investments as a way to achieve both financial and societal
outcomes.

13. Speculative Investors

• Description: Speculators seek to profit from market volatility, price movements, and short-
term market events. They invest in high-risk assets, often leveraging their positions, to
make substantial profits from short-term price fluctuations.
• Characteristics:
o High risk tolerance, often using leverage or derivatives.
o Focus on assets with large price swings, such as options, futures, or
cryptocurrencies.
o Can experience significant gains or losses in a short period.
Principles of Portfolio Construction

Portfolio construction is the process of creating a diversified investment portfolio that aligns with
an investor's objectives, risk tolerance, and time horizon. The goal is to maximize returns while
managing risk. There are several key principles to follow when constructing a portfolio:

1. Diversification

• Definition: Spreading investments across various asset classes (stocks, bonds, real estate,
etc.) and within those classes (sectors, industries, regions) to reduce the impact of any
single asset's poor performance.
• Goal: To reduce unsystematic risk and smooth out returns by ensuring that the performance
of one asset does not significantly impact the overall portfolio.

2. Asset Allocation

• Definition: Determining the proportion of different asset classes (e.g., equities, fixed
income, cash, alternative investments) based on factors like risk tolerance, time horizon,
and investment goals.
• Goal: To balance risk and return. Stocks tend to offer higher returns but come with more
risk, while bonds are more stable but often offer lower returns.

3. Risk Management

• Definition: Identifying, assessing, and managing the risks associated with the portfolio,
such as market risk, credit risk, and liquidity risk.
• Goal: To align the portfolio's risk level with the investor's tolerance for risk and to avoid
overexposure to any particular risk.

4. Rebalancing

• Definition: Periodically adjusting the portfolio back to the target asset allocation by buying
or selling assets to ensure the portfolio remains aligned with the investor's goals and risk
profile.
• Goal: To maintain the desired level of risk and take advantage of changes in market
conditions. It helps lock in gains and prevents overexposure to any single asset class.

5. Investment Horizon

• Definition: The length of time the investor plans to hold the portfolio before needing to
access the funds.
• Goal: To align the portfolio with the time frame for achieving investment goals. Longer
horizons typically allow for more risk-taking, while shorter horizons require more stability
and liquidity.

6. Cost Control

• Definition: Minimizing the costs associated with managing and trading assets, such as
transaction fees, management fees, and tax implications.
 • Goal: To improve net returns by reducing unnecessary expenses. High fees can erode
portfolio growth over time.

7. Liquidity Considerations

• Definition: Ensuring the portfolio has enough liquid assets to meet any short-term financial
needs without incurring significant losses.
• Goal: To ensure that the investor can access cash when necessary, especially during market
downturns.

8. Tax Efficiency

• Definition: Structuring the portfolio in a way that minimizes the investor's tax burden, such
as by utilizing tax-advantaged accounts (IRAs, 401(k)s) or tax-efficient investment
strategies.
• Goal: To maximize after-tax returns, considering both short-term and long-term tax
implications.

9. Investment Objectives

• Definition: Clearly defining the financial goals of the portfolio (e.g., retirement, education,
wealth accumulation) and the time frame for achieving them.
• Goal: To ensure that the portfolio is designed to meet specific financial goals. Each
objective might require a different level of risk or return expectation.

10. Behavioral Factors

• Definition: Understanding the investor's psychological biases and emotional tendencies

(e.g., overreacting to market fluctuations or chasing performance).
• Goal: To avoid making decisions based on fear, greed, or short-term market movements,
which could undermine long-term performance.

11. Sustainability and Ethical Considerations

• Definition: Integrating environmental, social, and governance (ESG) factors or socially

responsible investing (SRI) into the portfolio.
• Goal: To invest in ways that align with personal values while achieving financial returns.
Investment Constraints

Investment constraints refer to the limitations or conditions that investors must consider when
constructing their portfolios. These constraints influence the investment strategy, asset allocation,
and risk management approach. Understanding and addressing investment constraints is critical for
aligning the portfolio with the investor’s objectives, preferences, and circumstances. Here are the
main categories of investment constraints:

1. Time Horizon

• Definition: The length of time over which an investor plans to invest before needing access
to the funds.
• Implication: A long time horizon (e.g., retirement in 20-30 years) allows for more risk-
taking (e.g., higher allocation to equities), while a shorter time horizon (e.g., saving for a
home in 2-3 years) requires more conservative investments (e.g., bonds or cash
equivalents).

2. Liquidity Needs

• Definition: The need for cash or liquid assets for short-term spending or emergencies.
• Implication: If an investor has a need for liquidity, they must ensure a portion of the
portfolio is easily tradable and accessible without significant loss in value (e.g., cash or
highly liquid assets like money market funds). This constraint may limit the investor’s
ability to take on illiquid or long-term investments, such as private equity or real estate.

3. Risk Tolerance

• Definition: The level of risk an investor is willing to take on, which can vary based on
personal preferences, financial situation, and psychological factors.
• Implication: Investors with high risk tolerance may be comfortable with higher volatility
and a larger portion of equities in their portfolio, whereas conservative investors may prefer
more stable, lower-risk assets like bonds or cash. Risk tolerance is often linked to the
investor's ability to withstand market fluctuations without panicking or making emotional
decisions.

4. Legal and Regulatory Constraints

• Definition: Legal or regulatory requirements that affect the portfolio construction, often
imposed by government, regulatory bodies, or investment contracts.
• Implication: Investors must be aware of rules that apply to their investments, such as
restrictions on certain asset classes, regulations governing pension funds or endowments,
and laws about fiduciary responsibilities. For example, certain funds may need to comply
with Social Security or ERISA regulations for retirement accounts.

5. Unique Circumstances or Preferences (Personal Preferences)

• Definition: Specific desires or values that an investor wants reflected in their portfolio,
such as ethical, social, or environmental preferences.
 • Implication: These preferences can result in the exclusion of certain investments or sectors
(e.g., avoiding tobacco or fossil fuel companies), or a focus on socially responsible
investing (SRI) or environmental, social, and governance (ESG) criteria. These preferences
may limit certain investment choices or require additional research and strategy to align
with values.

6. Tax Constraints

• Definition: The investor's tax situation, which can affect the investment strategy, especially
in terms of tax efficiency.
• Implication: Investors must consider the tax impact of their investment choices. For
instance, capital gains taxes, dividend taxes, and tax-advantaged accounts (IRAs, 401(k)s,
etc.) can influence the asset allocation. Certain investments may be more tax-efficient than
others, and tax considerations may lead to strategies like tax-loss harvesting or investing in
tax-exempt securities.

7. Size of the Portfolio

• Definition: The total value of the assets being managed.

• Implication: Smaller portfolios might face higher transaction costs and limited access to
certain investment opportunities (e.g., institutional funds, alternative investments). Larger
portfolios may have more flexibility and opportunities to diversify. Additionally, the
portfolio size may determine how often it is rebalanced or how granular the asset allocation
strategy can be.

8. Return Objectives

• Definition: The investor’s goal in terms of expected return, which may vary depending on
their financial objectives.
• Implication: If the investor is targeting high growth (e.g., doubling their capital over a
decade), the portfolio may be heavily weighted toward riskier assets, such as stocks or
alternatives. On the other hand, conservative return objectives will call for more
conservative asset choices that generate stable income or moderate capital appreciation.

9. Geographic Constraints

• Definition: Geographic limitations that investors might impose, such as limiting

investments to specific regions or countries.
• Implication: Some investors prefer to focus on domestic markets or avoid investing in
certain countries due to political risk, economic conditions, or ethical concerns.
International investments can offer diversification but may introduce foreign exchange
risks, geopolitical risks, and regulatory complexities.

10. Investment Horizon (for Specific Goals)

• Definition: The specific financial goals within a certain timeframe, such as saving for a
child’s education or a major purchase.
• Implication: Short-term goals (e.g., saving for a car or a wedding) may require a more
conservative, income-generating portfolio, while long-term goals (e.g., retirement) allow
 for more risk and growth potential. The timeline and amount needed for a particular goal
should dictate the investment approach.

11. Concentration Limits

• Definition: Restrictions on how much of the portfolio can be allocated to any single
investment or sector.
• Implication: Some investors or funds may limit the concentration of investments in any
one stock, sector, or asset class to avoid excessive risk. For example, the investment policy
may specify that no more than 10% of the portfolio should be in a single stock or industry.

Conclusion:

Investment constraints serve as critical guidelines in shaping the overall portfolio structure. By
understanding these limitations, an investor can build a portfolio that meets both their financial
goals and personal preferences while adhering to practical and regulatory boundaries. Balancing
these constraints with the desired return objectives helps ensure that the portfolio remains aligned
with the investor’s unique needs.

Asset Allocation

Asset allocation refers to the process of dividing investments among different asset categories, such
as stocks, bonds, real estate, cash, or alternative investments. The goal is to balance risk and reward
according to an individual’s or institution's financial goals, risk tolerance, and investment time
horizon. By diversifying investments across different asset classes, asset allocation helps reduce
risk and increase the potential for returns.

There are different types of asset allocation strategies:

1. Strategic Asset Allocation: This is a long-term approach, where the allocation mix remains
constant over time based on the investor's goals. For example, a portfolio might be set at
60% stocks, 30% bonds, and 10% cash.
2. Tactical Asset Allocation: This strategy involves taking a more active approach by making
short-term adjustments to the asset mix based on market conditions. It’s more flexible but
also riskier.
3. Dynamic Asset Allocation: In this approach, the asset mix is adjusted frequently, based on
changes in the market environment, economic conditions, or the investor’s financial
situation.
4. Core-Satellite Allocation: In this strategy, the core of the portfolio is composed of low-
cost, diversified investments (such as index funds or ETFs), while smaller satellite
investments are made in higher-risk, higher-return opportunities.
5. Lifestyle or Target-Date Asset Allocation: This is often used for retirement savings,
where the asset allocation becomes more conservative as the target date approaches. For
example, someone planning to retire in 30 years might have a higher allocation to stocks,
which gradually shifts towards bonds and cash as retirement gets closer.
Modern Portfolio Theory (MPT)

In 1952, Harry Markowitz published a paper called “Portfolio Selection” in The Journal
of Finance, setting out what he called the modern portfolio theory (MPT). It caught on,
inspired other groundbreaking research, and was eventually renamed Markowitz
portfolio theory in his honor. He won the Nobel Prize for his work in [Link] Modern
Portfolio Theory (also known as mean-variance analysis) is a portfolio allocation theory based on
two factors – risk and return. The theory states that a portfolio’s risk can be reduced through
diversification. Diversification works by holding many different assets with low or negative
covariance. The low/negative covariance reduces the volatility (risk) of the portfolio by eliminating
the idiosyncratic risk inherent in individual securities. The MPT takes an aggregate view in that
each asset is less important than its impact on the portfolio as a whole.

The theory assumes that investors are risk-averse, meaning that between two portfolios with the
same risk, investors prefer the one with a higher return. Because individual investors have different
risk tolerances, Markowitz developed the efficient frontier, where each point along the curve
represents the optimal asset weightings in a portfolio that gives the highest expected return for the
amount of risk. The graph depicts expected return as a function of risk.

Portfolios towards the right are weighted heavier on risky assets such as stocks and private equity.
Portfolios towards the left are weighted heavier on less risky assets such as bonds. The upwards
shape of the efficient frontier demonstrates the concept that higher risk comes with a higher return.
Any portfolios on the efficient frontier are better than those under it. In the illustration above,
portfolio B is objectively better than portfolio A because it has a higher expected return than
portfolio A for the same risk. Such portfolios on the efficient frontier are called the Markowitz
efficient set.

The best portfolio allocation on the efficient frontier depends on the level of risk tolerance of the
investor. Both portfolio B and portfolio C have the highest return for their given risk. Therefore, we
cannot say one is better than the other; investors with higher risk tolerance will like C better, while
more conservative investors will like B better.

Criticisms and limitations of MPT

Despite its profound impact on investment practice, MPT is not without criticism.
Detractors argue that the theory makes simplifying assumptions about market behavior,
such as the normal distribution of asset returns and constant correlations, which may not
hold in the real world.
One issue is using the standard deviation as a measure of risk. This benchmark
considers a return greater than expected to be as risky as getting a return that’s less than
expected, but most rational investors would disagree.

Many of the limitations reflect the revolutionary nature of Markowitz’s theory. Several
economists looked at MPT, saw the benefits of the basic framework, and used it as the
starting point for such fundamental financial concepts as the efficient market
hypothesis (EMH) and the capital asset pricing model (CAPM). Without MPT, their
work might have taken longer to emerge, if it emerged at all.
 Module 2

Portfolio Risk and Return

Historical Risk and Return
"Historical risk and return" refers to the analysis of past performance data of an investment, where
"risk" represents the potential for fluctuations in price or loss, and "return" is the profit gained from
an investment over a specific period, both measured using historical data to estimate future
potential performance.
Key points about historical risk and return:
Data-driven:

This analysis relies on past price movements and returns of a security, index, or portfolio to
understand the historical risk-return relationship.

Predictive tool:

While not a guarantee of future results, analyzing historical risk and return can help investors
make informed decisions about potential investments by providing insights into expected
volatility and potential returns.

Calculating risk:

Common metrics used to measure historical risk include:

Standard deviation: Measures the volatility of returns around the average return.

Beta: Indicates how much an investment moves relative to the overall market.

Calculating return:
Historical returns are simply calculated by taking the difference between the initial price and the
final price of an investment, then dividing by the initial price to express it as a percentage.
Important considerations:
Time period matters:

The time frame chosen for historical data can significantly impact the analysis.

Market conditions change:

Past performance is not necessarily indicative of future results, and market conditions can change
significantly over time.

Diversification:
Even with historical risk and return analysis, investors should still diversify their portfolios to
mitigate risk.
What Is the Capital Asset Pricing Model (CAPM)?

Capital asset pricing model or CAPM is a specialised model used in business finance to determine
the relationship between the expected dividends and the risk associated with investing in particular
equity. When assessing CAPM, one can understand that expected returns on specific security are
equal to the risk-free returns plus the addition of a beta factor.

Assessing the capital asset pricing model requires a proper understanding of systematic and
unsystematic risks. Systematic risks are general dangers, which are associated with the investment
of any form. Wars, inflation rates, recessions, etc. are some of the examples of systematic risks.

Unsystematic risks, on the other hand, refer to specific perils associated with investing in a
particular stock or equity. Thus, unsystematic risks are not perceived as threats, which are shared
by the general market.

CAPM deals mostly with systematic risks on securities, thereby predicting whether things can go
wrong with particular investments.

Capital Asset Pricing Model (CAPM) Formula

The formula for calculating the expected return of an asset, given its risk, is as follows:

Ra = Rf + Be x (Rm – Rf)

Example of CAPM

A CAPM example can assist in evaluating how this formula works. Consider the following when
trying to understand the various factors in CAPM calculation.

An investor is considering buying stocks priced at Rs. 367, which offer annual returns of 4%.
Assuming that a beta factor of 1.1 is associated with this particular stock, one can calculate the
expected dividend earnings by considering the risk-free premium as 3% and investor expectation of
market appreciation by 7% annually.

Arranging the various factors into the formula, one can arrive at the following conclusion –

Ra = 4% + 1.1 x (7% – 3%)

Ra = 8.4%

Consider another example of the CAPM model. In this next one, the investor is all set to buy stocks
worth Rs. 455. Annual returns from such an investment are expected to be around 9%. Beta factor,
in this case, is 0.8. Risk-free rate is 5%. This investor expects the market to increase in value by 8%
within this next year.

Ra = 9% + 0.8 x (8% – 5%)

Ra = 11.4%

Role of Beta in CAPM

Beta is an integral factor in CAPM. It reflects the volatility of given security against the volatility
of the stock market as a whole. For better understanding, consider that a share’s price appreciates
and depreciates in total sync with the market. In such a case, the beta factor would be one.

However, if the beta of a stock is 1.2, it is indicative of the stock prices rising by 12% when the
market appreciates by 10%. Similarly, a negative beta (say of 0.7) indicates that the stock prices
will rise by 7% when the market collectively grows by 10%.

The summation of beta and the risk premium of an investment is necessary when determining the
amount of compensation a particular investor is liable to receive for taking this additional risk.

How does CAPM Benefit Investors?

Listed below are some of the advantages of this model of risk-reward evaluation for investors –

• Assumption of a diversified portfolio

This model assumes that an investor maintains a diversified investment portfolio, which can
eliminate specific or unsystematic risks.

• Convenient and simple

This model is built around the fact that it is extremely easy to use. The results from such a
calculation are dependable and enable investors to decide one way or another when it comes to
choosing particular equities.

• Systematic risks can alter this calculation significantly

A beta factor in the capital asset pricing model considers any systematic risks associated with one’s
investment. Dividend discount model or DDM, which is another popular return predicting model,
disregards the effects of such risks on returns. Since market risk is unforeseen and unpredictable,
no investor can mitigate its effects in their entirety.

Drawbacks of CAPM

While CAPM is a dependable calculation model, followed by investors worldwide, it does present
some drawbacks as well –

• Risk-free rates tend to change frequently

Short-term government securities are responsible for generating the risk-free premium or rate used
in CAPM calculations. A major problem of this model is that this risk-free rate is highly volatile,
altering within a span of just a few days.

• Risk-free rate is not a realistic factor

Individual investors cannot borrow or lend at the same rates as the government. Therefore,
assuming a risk-free rate for calculation is not realistic. Thus, the actual return from an investment
may be lower than what this CAPM model reveals.

• Determining a beta can be challenging

Investors using this model of return calculation need to figure out a beta value, which reflects the
security in question. Unfortunately, evaluating an accurate beta can be time-consuming and
difficult. Therefore, in most cases, a proxy beta value is utilised. This ultimately accelerates return
calculations but also diminishes its accuracy.
Systematic and Unsystematic Risks

Systematic Risks

Systematic risks are inherent risks that exist in the stock market. They’re also called “non-
diversifiable risks” or “market risks” since they impact the entire asset class.

Non-diversifiable means that an organization can’t control, minimize, or avoid systematic

risks. These risks are typically due to external factors like ongoing geopolitical situations,
monetary policies, and natural disasters. For example, the COVID-19 pandemic was a
systematic risk because it impacted the entire stock market.

Types of Systematic Risks

• Interest rate risk. Interest rate risk results from a change in the market interest
rate. It mainly impacts fixed-income securities like bond prices and asset-backed
securities. The yield on these securities is inversely related to the interest rate. As
interest rates go up, investors find it more attractive to pull their money out of
fixed-income securities.

• Market risk. Market risk results from the general tendency of investors to behave
as per the market. For example, investors avoid investing in even the best-
performing companies during a financial crisis.

• Purchasing power risk. Also called inflation risk, purchasing power risk results
from the decline in the purchasing power of money due to inflation. For example, if
inflation is 5% per year, you’d need $10.50 to buy the pack of pens next year that
cost $10 today.

Unsystematic Risks

Unsystematic risks, also known as “nonsystematic risks,” “specific risks,” “diversifiable

risks,” or “residual risks,” are unique to a specific company or industry. These risks arise due
to various internal and external factors that affect only the particular organization but not the
entire market.
Some examples of unsystematic risk include labor unrest at a factory, regulatory changes, and
shortages of raw materials.

Unlike systematic risks, an organization can control, minimize, and possibly even avoid
unsystematic risks.

Types of Unsystematic Risks

Unsystematic risks occur as two types:

• Business risk: Business risk includes the internal factors that affect a company’s
revenue and performance. Business risks can also result from company-specific
external factors, such as the government banning a raw material that a company
uses.

• Financial risk: Financial risk relates to a company’s debt and equity. If a company
takes on too much debt, its debt-to-equity ratio may suffer. A negative debt-to-
equity ratio indicates that a company might be on the verge of bankruptcy.

Difference between Systematic and Unsystematic Risks

• Impact: Systematic risks can potentially affect the entire industry and the overall
economy, whereas unsystematic risks generally affect an organization. Systematic
risks are non-diversifiable, whereas unsystematic risks are diversifiable.

• Nature: Systematic risks are unavoidable and uncontrollable, whereas unsystematic

risks are avoidable and controllable.

• Factors: Systematic risks result from external factors that occur at a macroeconomic
level, which is why they’re unavoidable and uncontrollable. In contrast,
unsystematic risks result from internal factors occurring within an organization or
externally but in a closely related manner to the organization. They’re linked to
microeconomic factors and are avoidable and controllable.

• Protection: The effects of systematic risk can be mitigated through proper asset
allocation, whereas mitigating unsystematic risk relies on portfolio diversification.
• Avoidability: Systematic risks can’t be avoided; however, unsystematic risks can be
mitigated or avoided.

• Types: Systematic risks include interest, inflation, purchasing power, and market
risk, whereas unsystematic risks are financial and business-specific risks.