ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTEMENT OF ACCOUNTING AND FINANCE

INVESTEMENT ANALYSIS
GROUP ASSIGNMENT ON
PORTFOLIO ANALYSIS AND MODERN PORTFOLIO
THEORY

Prepared by: ID No
1. Aberash Tibebe GSE/9966/13
2. Alem Berhe GSE/5078/13
3. Bethlehem Negussie GSE/5809/13
4. Bulcha Tasissa GSE/0129/13
5. Feysel Faris GSE/7761/13

Submitted to: Dr. Sewale Abate

June 2021
 Chapter Four

Portfolio Analysis And

Modern Portfolio Theory
4.1 Introduction


4.1.1 What is portfolio

Portfolio is a group of investments held by an investor, investment company, or financial
institution

A portfolio is the total collection of all investments held by an individual or institution. provides
the highest return for a given level of risk
Cont…..

A portfolio is a combination of a number of

securities.

Markowitz was the first person to show

quantitatively why and how diversification
reduces risk.
4.1.2 Portfolio Management
•Isthe process of managing investments with the help of
right tools and strategy to generate optimum return
downsizing risk within a given time horizon.

•Isthe art and science of selecting and overseeing a

group of investments.

•Portfolio management entails managing a group of

investments under an overall umbrella called a
portfolio.
Portfolio management is important because it
covers a certain amount of risk through
diversification and shuffling of funds among
different assets according to the returns they are
generating. It also helps in planning regarding
tax obligations. Moreover, it helps in arranging
funds in times of emergencies.
What are the requirement of portfolio management
Portfolio management requires the ability to
weigh strengths and weaknesses, opportunities
and threats across the full spectrum of
investments.

The ultimate goal of portfolio manager is to

maximize the investments' expected return
within an appropriate level of risk exposure
 What are the Cont’d …..

•Understanding the dynamics of market is the

essence of Portfolio Management.

•Portfolio Management basically deals with three

critical questions of investment planning.

1. Where to Invest?
2. When to Invest?
3. How much to Invest?
Objectives of portfolio management

Capital appreciation
Investment goals
Portfolio efficiency
Risk mitigation
Asset allocation
Liquidity diversification
Tax planning
4.1.3 The key elements of portfolio
management
The key to effective portfolio management is the long-
term mix of assets.
Asset Allocation
is based on the understanding that different
types of assets do not move in concert, and some
are more volatile than others.

A mix of assets provides balance and protects

against risk.
 The key elements Cont’d....

Investors with a more aggressive profile weight

their portfolios toward more volatile investments
such as growth stocks.

Investors with a conservative profile weight their

portfolios toward stabler investments such as
bonds.
The key elements Cont’d …

Diversification

refers to having a mix of investments that are

not all highly correlated to one another.

Rebalancing

Asset allocation is a good start, but a key part of

portfolio management is rebalancing the
portfolio periodically back to the target asset
allocation.
The key elements Cont’d …

Portfolio rebalancing is a reallocation of the

weight of portfolio assets and includes
buying and selling of existing assets either
fully or partially from time to time to
maintain the desired level of return.

The investor or fund manager shuffles the

stocks in the portfolio so that the desired level
of return and risk is maintained. This shuffling
is done after careful analysis of stocks, and a lot
of decision making and experience is required.
 4.1.4 Need for portfolio management
•Portfolio management presents the best
investment plan to the individuals as per their
income, budget, age and ability to undertake
risks.
•It minimizes the risks involved in investing
and also increases the chance of making
profits.
•Portfolio management enables the portfolio
managers to provide customized investment
solutions to clients as per their needs and
requirements.
Need for Cont’d…

Portfolio management is important in

business because there are factors to consider
that affect the success of the investment.
when moving to a portfolio management
approach: there are some benefits
 Strategic Alignment
Resource Management
Planning and Reporting
4.1.5 Types of portfolio management

.Active portfolio management

An actively managed investment fund has an
individual/ portfolio manager actively making
investment decisions for the fund.

.Passive portfolio management

Managers generally tend to invest in index fund
that provides low but consistent return in
longer period.
 Types of portfolio Cont’d…….
Discretionary portfolio management
In this type, the portfolio managers are
entrusted with the authority to make
decision and invest as per their discretion
on behalf of investors.
Non discretionary portfolio management
Under this management the managers act
as financial counselor who provide advice
on investment. It is up to investors
whether to accept the advice or reject it.
4.1.6 Who is a portfolio manager?
•A portfolio manager is an individual who
develops and implements investment strategies
for individuals or organizations.
•Portfolio managers may be called investment
managers, wealth managers, asset managers, or
financial advisors.
•primarily responsible for creating and
managing investment allocations for private
clients.
•The manager should know goals and objectives
of the clients.
4.2 PORTFOLIO ANALYSIS

•Portfolio Analysis is one of the areas of

investment management that enables market
participants to analyze and assess the
performance of a portfolio (equities, bonds,
alternative investments etc) with the objective of
measuring performance on a relative and
absolute basis along with its associated risks.

•A portfolio is a combination of a number of

securities.
Portfolio analysis cont..
•Portfolio
analysis is a quantitative method for selecting an
optimal portfolio that can strike a balance between
maximizing the return and minimizing the risk in various
uncertain environments.

•Portfolio analysis involves quantifying the operational and

financial impact of the portfolio.

•Theanalysis of a portfolio extend to all classes of

investments such as bonds, equities, indexes, commodities,
funds, options and securities.
 4.2.2 What is involved portfolio
analysis
Risk aversion
Risk aversion: This method analyzes the portfolio
composition while considering the risk appetite of an
investor. Some investors may prefer to play safe and accept
low profits rather than invest in risky assets that can generate
high returns.

Analyzing returns:
4.3 MEASURING EXPECTED
PORTIFOLIO RETURN AND RISK
For the purpose of portfolio construction, the financial
assets are primarily looked at from the perspective of
risk and returns.

Based on the analysis of risk and returns we analyze

thousands of securities and portfolio combinations
before making the right selection for our own portfolio.

Therefore, it is important that we have a deeper

understanding of the risk and return and how these are
calculated.
To calculate a portfolio's expected return, an
investor needs to calculate the expected return
of each of its holdings, as well as the overall
weight of each holding.

The basic expected return formula involves

multiplying each asset's weight in the portfolio
by its expected return, then adding all those
figures together.
The expected return is usually based on historical
data and is therefore not guaranteed.
4.3.1 Measuring expected portfolio return
The expected return is the profit or loss that
an investor anticipates on an investment that
has known historical rates of return

The expected return of a portfolio is the

anticipated amount of returns that a portfolio
may generate.
The expected return of a portfolio is calculated
by multiplying the weight of each asset by
its expected return and adding the values for
each investment.
The expected return measures the mean, or expected
value, of the probability distribution of investment
returns. The expected return of a portfolio is calculated by
multiplying the weight of each asset by its expected
return and adding the values for each investment.

The expected return on portfolio, kp, is the weighted

average of the expected returns on the individual stocks
in the portfolio.
Given any set of risky assets and a set of weights
that describe how the portfolio investment is
split, the general formulas of expected return for
n assets is:

E(Rp)=W1(R1)+W2(R2)+W3(R3) +W4(R4) +--------------+Wn(Rn)

E(Rp) =
Example of expected return of a portfolio

Example: A portfolio consists for four securities A, B& C

with expected returns of 12%, 15% & 20% respectively.
The portions of portfolio value invested in these
securities are 0.4, 0.3 & 03 respectively. Then the
expected return on portfolio will be:

Ra is the return and Wa is the weight of asset A.

Rb is the return and Wb is the weight of asset B.
Rc is the return and Wc is the weight on asset C.
Wa + Wb + Wc = 1.
E(Rp)=Wa(Ra)+Wb(Rb)+Wc(Rc)

E(Rp) =0.4(12%) +0.3(15%) +0.3(20%)

The expected return of the portfolio E(Rp) is = 15.3%

The expected rate of return is always b/n the lower and the highest
asset of
 4.3.2 Measuring portfolio risk

Portfolio risks can be calculated, like calculating

the risk of single investments, by taking the
standard deviation of the variance of actual
returns of the portfolio over time.

The risk of a portfolio is measured using the

standard deviation of the portfolio.

the standard deviation of the portfolio will not be

simply the weighted average of the standard
deviation of the two assets.
Standard deviation, as applied to investment
returns, is a quantitative statistical measure of
the variation of specific returns to the average of
those returns. One standard deviation is equal to
the average deviation of the sample.

Standard Deviation  of a portfolio measures how

much the investment returns deviate from the
mean of the probability distribution of
investments.
One standard deviation is equal to the average
deviation of the sample.

-We also need to consider the

covariance/correlation between the assets.

-The covariance reflects the co-movement of the

returns of the two assets.

-The portfolio standard deviation can be

calculated as follows:-
σP = √(wA2 * σA2 + wB2 * σB2 + 2 * wA * wB * σA * σB * ρAB)

Where:
σP = portfolio standard deviation
wA = weight of asset A in the portfolio
wB = weight of asset B in the portfolio
σA = standard deviation of asset A
σB = standard deviation of asset B; and
ρAB = correlation of asset A and asset B
For example, consider a two-asset portfolio with
equal weights, standard deviations of 20% and
30%, respectively, and a correlation of 0.40.
Therefore, the portfolio standard deviation is:

σP = √(w12 * σ12 + w22 * σ22 + 2 * w1 * w2 * σ1 * σ2 * ρ12)

[√(0.5² * 0.22 + 0.5² * 0.32 + 2 * 0.5 * 0.5 * 0.2 * 0.3 * 0.4)] = 21.1%
4.3.3 Variance and standard Deviation as a measure of risk

Portfolio Variance is a measure of a

portfolio’s volatility, and is a function of
two variables.
variance and covariance
 A positive covariance means the asset’s
returns move up or down together.
 A negative covariance means the asset’s
return move in opposite directions. 
According to modern portfolio theory, investors
bundle different types of investments together so
that the portfolio assets are inversely correlated.

As a result the securities counter-balance one

another such that when some of the securities fall
in value, other securities rise an equal amount.

Finally this diversification reduces risk for the

overall portfolio.
Portfolio variance looks at the co-variance or
correlation coefficient for the securities in the
portfolio.

Portfolio variance is calculated by multiplying

the squared weight of each security by its
corresponding variance and adding two times
the weighted average weight multiplied by the
co-variance of all individual security pairs.
The equation for variance of the expected return
for asset i ,denoted σ2(Ri)

Example: Portfolio Variance

Data on both variance and covariance may be

displayed in a covariance matrix. Assume the
following covariance matrix for our two-asset
case:
 Types variance Weight covariance  

Stock 350 50 % 80%

Bond 150 50 %

From this matrix, we know that the variance on

stocks is 350 (the covariance of any asset to itself
equals its variance), the variance on bonds is 150
and the covariance between stocks and bonds is
80. Given our portfolio weights of 0.5 for both
stocks and bonds, we have all the terms needed
to solve for portfolio variance.
Portfolio variance

σ2(RP)= w2A*σ2 (RA) + w2B*σ2 (RB) + 2*(WA)*(WB)*Cov (RA, RB)

σ2(RP) = (0.5)2*(350) + (0.5)2*(150) + 2*(0.5)*(0.5)*(80)

σ2(RP) = 87.5 + 37.5 + 40 = 165.

A measure of the dispersion of a set of data
from its mean.

Standard deviation is calculated as the

square root of variance.

The higher the variance or standard

deviation, the greater the investment risk.

Standard deviation is a statistical

measurement that sheds light on historical
volatility.
if an asset is riskless, it has expected return dispersion
of zero, in other word the asset return is certain
4.4 PORTFOLIO RISK-RETURN
ANALYSIS OF TWO SECURITIES
Grouping Individual Assets into Portfolios
 The riskiness of a portfolio that is made of

different risky assets is a function of three

different factors:
1. the riskiness of the individual assets that
make up the portfolio
2. the relative weights of the assets in the
portfolio
3. the degree of co movement of returns of the
assets making up the portfolio
 The standard deviation of a two-asset portfolio
may be measured using the Markowitz model:

 p   w   w  2wA wB  A,B A B
2 2
A A
2 2
B B

Where : ρ A,B = COVAB /δ A δB

Example

Suppose Asset A has an expected return of 10 percent and a

standard deviation of 20 percent. Asset B has an expected return of
16 percent and a standard deviation of 40 percent. If the correlation
between A and B is 0.6, what are the expected return and standard
deviation for a portfolio comprised of 30 percent Asset A and 70
percent Asset B?
Portfolio Expected Return
r̂P  w A r̂A  (1  w A ) r̂B
 0.3( 0.1)  0.7( 0.16 )
 0.142  14.2%.
Portfolio Standard Deviation

 p  WA2 A2  (1  WA ) 2  B2  2WA (1  WA )  AB  A  B
 0.32 (0.2 2 )  0.7 2 (0.4 2 )  2(0.3)( 0.7)(0.6)( 0.2)(0.4)
 0.309
4.5 PORTFOLIO RISK-RETURN ANALYSIS
of N SECURITIES
As we add more assets, co-variances become a
more important determinant of the portfolio’s
variance (diversification).

The variance and standard deviation of the

return of n security portfolio are:-

σp2= ∑∑WiWjPijσiσj
 
σp= [∑∑WiWjPijσiσj]
The extension for many securities Variance is a
bit more complicated.
The extension for three securities look as
follows:

σp2 =w21*σ2(R1) + w22*σ2(R2) + w23*σ2(R3) +

2*(w1)*(w2)*Cov (R1, R2) +2*(w1)*(w3)*Cov (R1,

R3) + 2*(w2)*(w3)*Cov (R2, R3)

The above equation states that the variance of the
portfolio return is the sum of the squared
weighted variances of the individual assets plus
two times the sum of weighted pair wise co
variances of the asset.
Where:
W1, W2 and W3are weights of securities in the portfolio,
σ2 (R1),σ2(R2) and σ2(R3) are variances
Cov (R1,R2,R3) is the covariance
 
Example:-
A portfolio consists of 3 securities 1,2 and [Link]
proportions of these securities are
w1=0.5,w2=0.3 and w3=[Link] standard
deviation of returns of these securities are :-
σ1=10 σ2=15 σ3=20.
The correlation coefficient among security
returns are:-
p12=0.3 p13 =0.5 and p23 =0.6.

What is the standard deviation of portfolio

returns?
 Example cont…

Correlation coefficient
P12= Cov(1,2)Implies▬►Cov (R1,R2)=P12*σ1σ2

σp2 =w21*σ12+ w22*σ22+ w23*σ32+

2*(w1)*(w2)*P12*σ1σ2+2*w1*w3)*P13*σ1σ3+ 2*(wB)*(wc)*P23*σ2σ3

σp=[0.52*102+0.32*152+0.22*202+2*0.5*0.3*0.3*10*15+2*0.5*0.2
*0.5*10*20+2*0.3*0.2* 0.6*15*20]1/2
σp=10.79
4.6 DIVERSIFICATION AND PORTFOLIO
RISK