UNIT 1: Introduction to Portfolio Management
Meaning of an Investment & Security
Investment is an activity which commits funds in physical or financial form[i.e. financial
assets] with an expectation of receiving positive rate of return[[Link] ,Dividend,
Pension, Capital Appreciation etc.] and higher values in future.
The return is expected in future ,hence there is a possibility that the return actually
realized is different from what is expected. This possibility of variation/difference in
actual return is called Risk.
Thus every investment involves a return & risk.
Savings of the people are invested in assets depending on their risk & return.
Thus, Investment=employment of funds with the aim of achieving additional income or
growth in value.
[A] Attributes /Objectives /Characteristic features of Investments
The main characteristic features of investments are return risk, safety, & liquidity
[a] Return:
All investments are made with the primary aim of deriving/receiving a return. Return is
in the form of income/yield or capital appreciation (higher value on sale).
Dividend ,Interest Received from an investment is the yield and difference between
Selling Price & Purchase Price is Capital Appreciation.
This return depends on the nature of investment ,maturity period ,market demand, etc.
[b] Risk:
Risk relates to loss of capital, non-payment of interest, or variation of interest, delay in
repayment of capital.
Some investments such as Government securities are almost riskfree, others have an
element of risk.
Risk depends on maturity period, borrower’s repayment capacity, nature of
commitment of investment etc.
Ownership Securities such as equity shares have higher risk compared to Debt
Instruments
Thus, risk and return are related. Normally, Higher the risk, higher the expected return.
[c] Safety:
It means certainty of return of capital without loss of time or money
It depends on the capacity and reputation of the borrower .
[d] Liquidity:
Liquidity of an investment means that it is easily saleable without any loss of time &
money. A well-established trading mechanism [a stock exchange] helps in trading
listed securities with ease ,subject to their demand and supply .Certain government
securities have very poor liquidity[e.g. NSC]
[B] Investment Categories/Avenues
The following are the main categories of Investment:
i]Equity Shares
These are issued by companies . Equity Shares are highly risky ,due to variations in its
returns,but they are most liquid due to their tradability on Stock Exchange .
Preference Shares & Debentures have fixed returns ,hence lowerrisk
ii]Debentures and Bonds
Debentures/Bonds have a fixed Stream of Cash flows i.e Fixed Interest/Coupon
payments receivable in future years.
The level of risk involved in them depends on the issuer of these debentures/bonds i.e
A Govt. Bond is almost risk free ,however debentures /bonds issued by companies
have a risk depending on the type of company issuing these debentures.
Iii] Preference Shares
Pref..Shareholders receive a fixed percentage of dividend ,hence more safer than
equity shares which may receive fluctuating or no dividend. However ,in event of
liquidation , debenture holders are paid before [Link] holders.
Iv] Deposits
Banks issue Fixed Deposits, Savings account interest, recurring deposits. Periodical
Interest is paid & Principle is paid on maturity to the investors.
Companies also accept fixed deposits from public with different maturities .They have
high risk ,hence higher interest is paid on them by companies to investors.
Deposits with NBFC’s such as Leasing Cos., Investment Cos.,etc also accept deposits
,and considered high risk compared to bank Deposits.
v]Mutual Funds
A mutual fund is a professionally managed investment scheme, run a asset
management co. .
Its biggest advantage is that it gives small investors access to professionally managed,
diversified portfolios of Equity ,Bonds etc which otherwise would have been difficult.
UTI is the oldest Mutual Fund of [Link] are other mutual funds set up by Private
Sector,Banks & Financial Institutions also
vi]Post Office Deposits & Certificates
Post Office Investments are generally non-marketable ,hence not [Link] ,they
usually enjoy tax benefits. Eg. Post Office Fixed Deposits & Recurring Deposits ,6 year
NSC,Kisan Vikas Patra, Indira Vikas Patra
vii]LIC Policies
LIC offers many investment schemes to their investors. [Link] life
Policies,Endowment Policies,
viii]Provident Fund Schemes
Provident Fund Schemes are compulsory deposit schemes applicable to employees in
public & private sectors. Main types of Provident Fund Schemes are Statutory
Provident Fund,Recognised Provident Fund ,& Unrecognised Provident Fund
PPF i.e Public Provident Fund is a voluntary Provident Fund ,is open to all,whether
employed or not.
ix]Gold
Investment in Gold is considered an hedge against Inflation. Gold can be purchased in
physical form as well as in dematerialized form. Gold Bonds & Gold ETFs are popular
for investment in [Link] is one of the top consumers of gold in the world
x ]Real Estate
Real Estate is a very popular mode of investing in India.
It also requires a huge sum for investment.
REITs are also now gaining popularity as a mode of investment
[Note : There are many other Investment Avenues apart from above mentioned
such as Silver ,Antiques, Commodity, Futures,Options etc. ]
Tax Saving Investments in India
Section 80C is the most widely used section for claiming Income Tax deductions The
maximum deduction that can be claimed under sec 80C is Rs.1,50,000.
This deduction of Rs.1,50,000 can be claimed either in a single instrument or for
multiple investments, where total cumulative deduction is limited to Rs.1,50,000
Foll. Are some of the most popular investments which can be claimed as a deduction
under Section 80C
[Link][Equity linked savings scheme ] Mutual Funds
This is a specific category of Mutual funds, there is a lock-in period of 3 years, after
which the amount can be withdrawn
[Link] Premium
Premium paid for insuring life of yourself, spouse and children can claimed as
deduction, however premium paid for parents is not allowed
[Link] Provident Fund[PPF]
Any person, salaried or non-salaried can invest in PPF account.
These accounts are opened for 15 years with a 5 year lock-in period. You can
withdraw a certain amount from this account after 5th year of penalty.
[Link] Provident Fund [EPF]
It is a retirement benefit scheme available only for Salaried Employees. In this scheme,
both employer and employee invest a certain amount each month, interest is paid
regularly on the amount in this account
[Link] Duty paid on purchase of house
The amount paid on Stamp duty and Registration can be claimed as deduction in the
year of purchase.
6. 5 Year Tax Saving Fixed Deposit
Investment in 5-year fixed deposit is allowed for deduction under this section
Imp. Point is that the tenure of fixed deposit should be 5 years or more, and the banker
should be informed of the tax saving purpose for the same.
[C] Investment Goals & Objectives
Ideally ,every Investment targets a goal .The objective/purpose & risk tolerance of the
investor ,together form the Investment Goal. These goals may differ from individual to
individual and also depends on the different stages in their life.
Some of the different types of goals are :
i]Short Term High Priority Goals
Individuals have high emotional involvement with the achievement of such goals. For
People whose savings are low, cost of non-achievement of these goals proves costly.
Investments for these goals are made in highly safe & liquid investments.
Eg. Saving for basic studies,EMIs for home etc.
ii] Long Term High Priority Goals
These goals are Long Term,the investments for these goals are generally made in
risky assets with long maturity & in a diversified portfolio
Eg. Planning for education of a small child,saving for retirement etc.
iii] Lower Priority Goals
These goals are generally not affordable. Investors are generally not too serious about
these goals & are mostly for hobbies, fun, thrill ,status symbol etc. Investments for
these goals are made in speculative investments.
Eg. Purchase of a Luxury Car/Home, Top Brands, Foreign Trips etc.
iv]Money Making Goals
Many times, individuals want to acquire substantial wealth. Their risk tolerance is very
high, hence they invest in upcoming companies, and wait till these companies grow
,and they get their profits & then move on to next company.
Types of Investors
[Link] Investor
-Seeks to protect the capital
-Seek moderate returns and take a very low level of risk
[Link] Conservative
-Seek to partially protect from Inflation and Tax
-Prepared to accept moderate level of risk
-Focused on possible losses and also possible gains
[Link]
-Adopt a diversified portfolio to protect from inflation and tax
-Moderate risk taker and can accept moderate levels of investment risk and volatility
[Link] Growth
-Invest mostly in quality investments and mostly in growth assets to achieve higher
growth
-investment horizon is longterm, 7 years or more
-They can accept higher levels of investment risk
-They seek reasonably high rate of growth on their investments
[Link]
-They are interested in accumulating wealth more quickly
-They always focus on possible gains
-They accept very high levels of variability in investment returns
[Link]
-They are experienced in all major investment markets and are aware of the factors
that may affect investment performance in investment markets.
-They accept very high levels of variability in investment returns
[D]Investment Process/Portfolio Management Process
It outlines the steps in creating a Portfolio. It can be broken down into 3 steps
namely:
[Link]/Specification of Investment Objectives & Priorities/Investment
Policy
Most common objectives of investors are stability of income, capital appreciation,
safety
Constraints arise from liquidity, maturity, tax considerations etc.
An investor should be able to create an Emergency Fund, and have an element of
liquidity i.e quick convertibility of securities into cash.
[Link] of Portfolio
Portfolio means a group of securities eg. Shares,Debentures,Govt. Securitites etc.
The process of actual construction of Portfolio is divided into 3 parts :
Part A: Asset allocation= It is the decision on how to allocate the portfolio across
different asset classes such as Equity,Fixed Income Securities, etc.
When an individual has arranged a logical order of the types of investments that he
requires on his portfolio, he must make a comparative analysis of the different
[Link] do Investment Analysis
Part B: Asset Selection = At this stage, individual assets are selected eg .Which
Share/Debenture etc by Valuation of securities
Investment Value is their present worth of future benefits.
Comparison should be made of the Value with the current market price, if favourable ,
then those can be selected for the portfolio.
Part C: Execution =It involves actual purchase /sale of securities selected
[Link] Evaluation and Monitoring Portfolio Performance
At this step ,the portfolio’s performance is compared with its benchmark in order to
evaluate whether the portfolio has outperformed or underperformed . In case of
underperforming securities ,they can be sold & thus portfolio can be re-balanced .
However ,every purchase/sale involves various expenses [transaction/brokerage
costs,capital gains/loss, tax impact etc]
[E]Investment Constraints
Investment Constraints are factors which restrict the investment options available to
an investor.
Following are different Investment Constraints :
i]Liquidity – It means asset’s ability to be converted into cash without loss of time or
money. This is applicable to cash outflows required at a specific time or in case of any
emergency.
ii]Time Period- This time period refers to the period within which the portfolio is
expected to generate the said returns in order to meet the specific requirement [Link]
Education
iii]Tax –Different securities are taxed differently .The gains/incomes generated from
the portfolio are affected by tax. Hence ,tax impact has to be considered.
iv]Legal –They sometimes specify/dictate the asset classes ,their proportions in a
portfolio especially holdings by Trusts,HUFs,.These legal specifications have to be
followed .
v]Investor’s Personal Choices & Preferences- eg .some investors do not invest in
liquor & tobacco stocks
[F] Portfolio Management
Portfolio is a group of securities. The main objective of a portfolio is to reduce Risk by
diversification & maximize Returns.
Portfolio Management includes Portfolio planning, selection & construction ,review &
evaluation of securities. The skill in Portfolio Management lies in achieving a sound
balance between the objectives of safety, liquidity, profitability, and timing of the
activities.
Objectives/Principles of Portfolio Management
The main objectives are:
i] Maximising Returns & Minimising Portfolio Risk
-A good rate of return is the most important aim of any portfolio
-Returns may be annual return[i.e. dividends,interest etc] or Capital Gains [i.e Higher
value on sale than purchase price]
-Actual return becoming less than expected return is risk
-Any variability in return is a risk
-Generally,higher the risk ,higher is the return,However,how much risk is to be taken
,depends on the investor’s risk taking capacity and willingness
-Diversification is also a way to reduce risk .By investing in different types of
securities,risk can be reduced. It is simply not putting all eggs in one basket.
ii]Liquidity & Marketability
-Portfolio should be flexible to accommodate changes. For this, the portfolio should
consist of easily marketable/saleable securities
-For easily marketable securities, it is recommended to invest in those shares which
are listed on major stock exchanges and actively traded
-Liquidity refers to the ability of an investment to be converted to cash without much
loss of time or value
-Liquidity helps take care of any emergencies
iii] Capital Growth
A large capital appreciation by way of Bonus, Rights, Price Appreciation etc. are all
important for a successful portfolio.
iv]Stability of Income
It is necessary to determine the amount of income the portfolio must provide
considering investor’s standard of living & other sources of income in addition to the
portfolio income.
While doing so, impact of inflation has to be considered.
v] Safety
-Safety implies the certainty of return of capital without loss of money or time
-Every investor expects to get back his capital on maturity without loss and delay
-The motive of portfolio is to ensure that the investment is safe .Other factors such as
income, growth etc. come after safety
vi]Taxation
Some investments should be made in those avenues which will help the investor to
save tax & thereby increase the returns
[Link],ELSS schemes of Mutual funds
[G]Asset Allocation
Asset Allocation means investing your money across various asset classes i.e.
apportionment of assets to different asset classes based on investor’s goals
,preferences & risk profile.
Asset Allocation is based on the principle of diversification ,which helps in reducing
risks & maximizing returns.
According to Modern Portfolio Theory, to maximize returns for a given level of risk, it is
wise to invest in multiple asset classes.
Asset Allocation helps to determine which asset to buy ,in what proportion. It attempts
to balance risk & reward
Factors to Consider For Asset Allocation
i]Age:
Young investors could take high risk,hence major part of their portfolio can be equity
.Middle age investors can take moderate risk,hence a portfolio mix of equities & debt
can be made. Investors approaching retirement may safeguard their capital by
investing major part in fixed income securities.
Note: Above mentioned portfolio can change depending on other factors mentioned
below
ii]Income :
Higher income gives higher investible surplus. Also ,regularity of income has to be
considered.
iii]Time Horizon
If the funds are required within a short period , they can be invested in debt securities
whereas for longer periods ,investments can be in equities & some in debt
Iv]Risk Tolerance
Investor’s willingness & ability to take risks plays an important role .Investors ready to
take higher risks may invest in equities whereas investors with low risk appetite may
invest in fixed income securities.
[H] Processs of Asset Allocation
Diversification of assets to minimize risk & maximize returns is the most important
benefit of Asset Allocation
It is important to know the risk tolerance & investment goals of the investor prior to
deciding on Asset Allocation
Asset Allocation once achieved should be periodically reviewed ,re-balanced
depending upon its performance & changing circumstances.
It is important in choosing investment avenues according to goals & timeline of these
goals for eg. A long term goal can be achieved by having more aggressive assets
such as equities & short term goals can be achieved by investing in fixed income
[Link] these investment avenues are not selected correctly, it will lead to an
imbalance in Asset Allocation,and can upset our finances.
Approaches to Asset Allocation
Our portfolio’s asset mix should reflect our goals at any point of time .Hence ,having an
appropriate asset mix is a dynamic process
Following are some different strategies for establishing asset allocations:
i] Strategic Asset Allocation:[Traditional Approach]
-It is a traditional approach to building a portfolio
-This method follows a “Base Policy Mix” which is a proportional combination of assets
based on expected rates of return for each asset class
It generally implies a buy-and- hold Strategy
-It begins by investor determining how much money should be invested in different
categories. This decision depends on factors such as investor’s age, risk tolerance,
objective, time horizon, need for income, taxation etc. Once decided,this allocation is
carried on for many years ,unless required to be altered.
-This approach aims to create an asset mix which gives a balance between risk &
reward over long term i.e. Buy a few stocks & offset the risk with buying some bonds .
-By adding this disciplined approach, investor can avoid rash decisions basd on
current market trends.
-Strategic Asset Allocation involves sticking with original allocation over long periods of
time
-Regular re-balancing your portfolio helps in minimizing risk, and helps achieve your
targets
ii]Tactical Asset Allocation
-In Tactical asset allocation ,the main/primary asset classes namely ,stocks & bonds
are actively balanced
-Main intention is maximizing returns and minimizing risk with respect to a benchmark
index.
-Main difference in this style of investing is that the allocation will change depending
upon the expected market & economic conditions.
-Tactical Asset Allocation is different from timing the [Link] the market is
frequent & speculative trading, whereas ,tactical asset allocation is slow & systematic.
- Tactical asset allocation is a mix of active & passive investing ,i.e. Buy & hold quality
stocks ,but change the percentage of asset [Link] Index Funds, Gold ETFs
Eg : Original Allocation 70% Equity & 30% Bonds. If it is expected that economy will
fall, then shift to 50% stock & 50% bonds
-Strategic Asset Allocation Strategy is rigid over the long [Link] flexibility is
required to capitalize on unusual /exceptional investment opportunities
This flexibility requires market timing, to participate in favourable market conditions
Tactical asset allocation is a moderately active strategy ,and requires to recognize
short term opportunities
iii] Insured Asset Allocation
-In this strategy, you establish a base portfolio value under which the portfolio value
should not drop
-If the value of the portfolio drops below the base value, invest in risk free assets thru
re-balancing the portfolio
-If the value of the portfolio is above the base value, active management of portfolio is
done to increase the returns as much as possible
-It creates a secured benchmark below which , its value should not fall
-Insured Asset Allocation is suitable for risk free investors who desire a certain level of
active portfolio management but also want some guaranteed returns
iv] Dynamic Asset Allocation
-In this type of asset allocation,investor sells the assets that are declining & purchase
the assets that are increasing.
-Investor constantly re-balances his mix of assets as markets rise or fall.
v]Core-Satellite Asset Allocation
-This strategy is a hybrid/mix of Strategic & Tactical Allocations.
-The portfolio is made up of 2 components,namely Core & [Link] includes
stocks,bonds, etc. which are the major proportion in the portfolio, It may be 50%-80%
of the Total Portfolio. The remaining part of the portfolio is called Satellite i.e remaining
50%- 20% . Core will not change much, they are held for long [Link]
component will allow the investor to gain from market opportunities.
-For Core-Satellite allocation certain factors should be kept in mind such as Risk
Profile of investor,asset class for Core Allocation,Core Size & Satellite size in each
asset class,invest in the satellite useful to support Core.
Conclusion/Overview
-Change in goals can require a change in Asset Allocation
-With time,Asset Allocation changes i.e. asset allocation is different in mid-age group &
changes when they retire.
-Risk Capacity & Risk tolerance changes.
Hence ,asset allocation should be reviewed & re-aligned from time-to-time & when
necessary.
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