Investment Analysis and

Portfolio Management

Introduction
Portfolio Management: The management of a group of investment.
Ideally the investment should have different patterns of returns over
time.
Phases of Portfolio Management:
1. Security Analysis
2. Portfolio Analysis
3. Portfolio Selection
4. Portfolio revision
5. Portfolio evaluation

Investors make two major steps or decisions in

constructing their own portfolios
Portfolio is simply collection of investment assets
The asset allocation decision is the choice among
broad asset classes such as stocks, bonds, real
estate, commodities, and so on.
The security selection decision is the choice of
which particular securities to hold within each
asset class.
3

Stock Selection Philosophy

Fundamental analysis
Technical analysis

Fundamental Analysis
A fundamental analyst tries to discern the
logical worth of a security based on its
anticipated earnings stream
The fundamental analyst considers:
Financial statements
Industry conditions
Prospects for the economy
5

Technical Analysis
A technical analyst attempts to predict the supply
and demand for a stock by observing the past
series of stock prices
Financial statements and market conditions are of
secondary importance to the technical analyst

Security Analysis
A three-step process
1) The analyst considers prospects for the
economy, given the state of the business
cycle
2) The analyst determines which industries are
likely to do well in the forecasted economic
conditions
3) The analyst chooses particular companies
within the favored industries
7

An understanding of the risk/return trade-off

Assets with higher expected returns have greater
risk.
Higher risk assets offer higher expected returns
than lower-risk assets.
Risk tolerance: The investors willingness to accept
higher risk to attain higher expected returns.
Risk aversion: The investor is also reluctant to
accept risk
An investors objectives can be classified as return
requirement and risk tolerance
8

Investors Constraints
Constraints are the kind of financial circumstances
imposed on an investors choice.
Five common types of constraints are:
1. Liquidity: refers to how easy an asset can be
converted to cash
2. Investment horizon: is the planned liquidation
duration of investment.
3. Regulations: Professional and institutional
investors are constrained by regulations- investors
who manage other peoples money have fiduciary
responsibility to restrict investment to assets that
would have been approved by a prudent investor.
9

Investors Constraints
4.Tax considerations: special considerations
related to tax position of the investor. The
performance of any investment strategy are
always measured by its rate of return after tax.
5.Unique needs: often centre around the
investors stage in the life cycle such as
retirement, housing and childrens education.

10

Portfolio Management (contd)

Market efficiency and portfolio
management
A properly constructed portfolio achieves a
given level of expected return with the least
possible risk
Portfolio managers have a duty to create the
best possible collection of investments for each
customers unique needs and circumstances
11

Purpose of Portfolio Management

Portfolio management primarily involves
reducing risk rather than increasing
return
Consider two $10,000 investments:
1) Earns 10% per year for each of ten years (low
risk)
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, 12%, and 10% in the ten years, respectively
(high risk)
12

Low Risk vs. High Risk Investments

(contd)
1) Earns 10% per year for each of ten years (low risk)

Terminal value is $25,937

2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%, 12%, and 10% in the ten years, respectively (high
risk)

Terminal value is $23,642

The lower the dispersion of returns, the greater the

terminal value of equal investments

13

Portfolio Management
Passive management has the
following characteristics:
Follow
a
predetermined
investment strategy that is
invariant to market conditions or
Do nothing
14

Portfolio Management (contd)

Active management:
Requires the periodic changing of
the portfolio components as the
managers outlook for the market
changes

15

Risk Versus Uncertainty

Uncertainty involves a doubtful outcome
What you will get for your birthday
If a particular horse will win at the track

Risk involves the chance of loss

If a particular horse will win at the track if
you made a bet

16

Risk and Return

Risk and return are the two
most important attributes
of an investment.
Research has shown that the
two are linked in the
capital markets and that
generally, higher returns
can only be achieved by
taking on greater risk.
Risk isnt just the potential
loss of return, it is the
potential loss of the
entire investment itself
(loss of both principal and
interest).

Return
%
Risk Premium

RF

Real Return
Expected Inflation Rate

Risk

17

Why Do Individuals Invest ?

By saving money (instead of spending it), individuals tradeoff
present consumption for a larger future consumption.
Characteristics of Investment: All investments are characterized by
certain features which include inter alia:
1. Return
2. Risk
3. Safety
4. Liquidity

Objectives of Investment
1. Maximization of return
2. Minimization of risk
3. Hedge against inflation
Investment Vs. Speculation: Investment is distinguished from
speculation with respect to three factors, viz. (1) Risk; (2) Capital Gain;
(3) Time period.

An investor generally commits his/her funds to low risk investment, whereas a

speculator commits funds to a higher risk investment.
The speculators motive is to achieve profits through price changes, i.e., he/she
is interested in capital gains rather than income from investment.
Investment is long-term in nature, whereas speculation is short-term.

Cont

Investment vs Gambling: Gambling consist in taking

high risks not only for high returns, but also for thrill
and excitement. It is unplanned and non scientific,
undertaken without the knowledge of the nature of the
risk involved.
Investment is an attempt to carefully plan, evaluate and
allocate funds to various investment outlets which offer
safety of principal and moderate and continuous return
over a long period of time. Gambling is quite opposite
of investment.

Cont..
Investment Avenues:
1.
2.
3.
4.
5.
6.
7.

Corporate securities
Deposits in banks and non-banking companies
Mutual funds schemes
Post office deposits and certificates
Life insurance policies
Provident fund schemes
Government securities

How Do We Measure The Rate Of

Return On An Investment ?
The pure rate of interest is the
exchange rate between future
consumption
and
present
consumption.
Market forces
determine this rate.

$1.00 4% $1.04

How Do We Measure The Rate Of

Return On An Investment ?
Peoples willingness to pay the
difference for borrowing today and
their desire to receive a surplus on
their savings give rise to an interest
rate referred to as the pure time
value of money.

How Do We Measure The Rate Of

Return On An Investment ?
If the future payment will be
diminished in value because of
inflation, then the investor will
demand an interest rate higher than
the pure time value of money to also
cover the expected inflation expense.

How Do We Measure The Rate Of

Return On An Investment ?
If the future payment from the
investment is not certain, the
investor will demand an interest
rate that exceeds the pure time
value of money plus the inflation
rate to provide a risk premium to
cover the investment risk.

Defining an Investment
A current commitment of $ for a
period of time in order to derive
future payments that will
compensate for:
the time the funds are committed
the expected rate of inflation
uncertainty of future flow of funds.

Measures of
Historical Rates of Return
Holding Period Return
Ending Value of Investment
HPR
Beginning Value of Investment
$220

1.10
$200

1.1

Measures of
Historical Rates of Return
1.2

Holding Period Yield

HPY = HPR - 1
1.10 - 1 = 0.10 = 10%

Measures of
Historical Rates of Return
Annual Holding Period Return
Annual HPR = HPR 1/n
where n = number of years investment is held

Annual Holding Period Yield

Annual HPY = Annual HPR - 1

Measures of
Historical Rates of Return
Arithmetic Mean
where :

AM HPY/ n

HPY the sum of annual

holding period yields

1.4

Measures of
Historical Rates of Return
1.5

Geometric Mean
GM HPR

where :

the product of the annual

holding period returns as follows :

HPR 1 HPR 2 HPR n

A Portfolio of Investments
The mean historical rate of return for
a portfolio of investments is
measured as the weighted average
of the HPYs for the individual
investments in the portfolio.

Computation of Holding
Period Yield for a Portfolio
#
Stock Shares
A
100,000
B
200,000
C
500,000
Total

HPY =

Begin
Price
$ 10
$ 20
$ 30

Beginning Ending
Ending
Market
Mkt. Value Price Mkt. Value HPR HPY Wt.
$ 1,000,000
$ 12 $ 1,200,000 1.20 20% 0.05
$ 4,000,000
$ 21 $ 4,200,000 1.05 5% 0.20
$ 15,000,000
$ 33 $ 16,500,000 1.10 10% 0.75
$ 20,000,000
$ 21,900,000

HPR =

$ 21,900,000
$ 20,000,000

1.095

1.095

-1

0.095

9.5%

Wtd.
HPY
0.010
0.010
0.075
0.095

Exhibit 1.1

Expected Rates of Return

Risk is uncertainty that an
investment will earn its expected
rate of return
Probability is the likelihood of an
outcome

Expected Rates of Return

Expected Return E(R i )

1.6

(Probabilit y of Return) (Possible Return)

i 1

[(P1 )(R 1 ) (P2 )(R 2 ) .... (Pn R n )

n

(
P
)(R
)
i i
i 1

Risk Aversion
The assumption that most investors
will choose the least risky
alternative, all else being equal and
that they will not accept additional
risk unless they are compensated in
the form of higher return

Measuring the Risk of

Expected Rates of Return

1.7

Variance ( )
n
2
(
Probabilit
y)

(Possible
Return
Expected
Return)

i 1

(
P
)[R

E(R
)]
i i
i
i 1

Measuring the Risk of

Expected Rates of Return
Standard Deviation is the square
root of the variance

1.8

Measuring the Risk of

Expected Rates of Return
Coefficient of variation (CV) a measure of
relative variability that indicates risk per unit
of return
Standard Deviation of Returns
Expected Rate of Returns

E(R)

1.9

Measuring the Risk of

Historical Rates of Return

1.10

n
2

[HPYi E (HPY)
2

HPYi
E(HPY)
n

2/n

i 1
variance of the series
holding period yield during period I
expected value of the HPY that is equal
to the arithmetic mean of the series
the number of observations

Determinants of
Required Rates of Return
Time value of money
Expected rate of inflation
Risk involved

The Real Risk Free Rate (RRFR)

Assumes no inflation.
Assumes no uncertainty about
future cash flows.
Influenced by time preference for
consumption of income and
investment opportunities in the
economy

Adjusting For Inflation

1.12

Real RFR =

(1 Nominal RFR)

1
(1 Rate of Inflation)

Nominal Risk-Free Rate

Dependent upon
Conditions in the Capital Markets
Expected Rate of Inflation

Adjusting For Inflation

Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1

1.11

Facets of Fundamental Risk

Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk

Business Risk
Uncertainty of income flows caused by
the nature of a firms business
Sales volatility and operating leverage
determine the level of business risk.

Financial Risk
Uncertainty caused by the use of debt
financing.
Borrowing requires fixed payments which
must be paid ahead of payments to
stockholders.
The use of debt increases uncertainty of
stockholder income and causes an increase
in the stocks risk premium.

Liquidity Risk
Uncertainty is introduced by the secondary
market for an investment.
How long will it take to convert an investment
into cash?
How certain is the price that will be received?

Exchange Rate Risk

Uncertainty of return is introduced by
acquiring securities denominated in a
currency different from that of the investor.
Changes in exchange rates affect the
investors return when converting an
investment back into the home currency.

Country Risk
Political risk is the uncertainty of returns
caused by the possibility of a major change
in the political or economic environment in
a country.
Individuals who invest in countries that
have unstable political-economic systems
must include a country risk-premium when
determining their required rate of return

Risk Premium
f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk,
Country Risk)

or
f (Systematic Market Risk)

Risk Premium
and Portfolio Theory
The relevant risk measure for an
individual asset is its co-movement
with the market portfolio
Systematic risk relates the variance of
the investment to the variance of the
market
Beta measures this systematic risk of
an asset

Fundamental Risk
versus Systematic Risk
Fundamental risk comprises business
risk, financial risk, liquidity risk, exchange
rate risk, and country risk
Systematic risk refers to the portion of an
individual assets total variance attributable
to the variability of the total market
portfolio

Relationship Between
Risk and Return

Exhibit 1.7

Rateof Return (Expected)

Low
Risk

RFR

Average
Risk

High
Risk

Security
Market Line

The slope indicates the

required return per unit of risk

Risk
(business risk, etc., or systematic risk-beta)

Changes in the Required Rate of Return

Due to Movements Along the SML
Expected
Rate

Exhibit 1.8

Security
Market Line

RFR

Movements along the curve

that reflect changes in the
risk of the asset

Risk
(business risk, etc., or systematic risk-beta)

Changes in the Slope of the SML

1.13

RPi = E(Ri) - NRFR

where:
RPi = risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free asset

Market Portfolio Risk

1.14

The market risk premium for the market

portfolio (contains all the risky assets in the
market) can be computed:
RPm = E(Rm)- NRFR where:
RPm = risk premium on the market portfolio
E(Rm) = expected return on the market portfolio
NRFR = expected return on a risk-free asset