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We need to keep on adjusting between the asset classes for desired risk.
First thing a portfolio manager should ask its cliet is what kind of risk he is
willing to take
Second question he should ask is what you want your portfolio size to
be? When and what amount an investor is going to put in and what
amount he will pull out are some of the factor a portfoilio manager should
be knowing before deciding on investment.
Market Timing: When we are sure that equity market is going to come down,
its better to come out of the equity investments, or atleast from the risky
investments in a portfoilios. And that is what a portfolio manager does. Its a
tricky task to do; alongside the management also requires other costs, like
consultancy charges, transaction costs etc.
Exaple is illustrated through the below diagram.
Stock selection: Its the process of selecting different assets for investment
depending on the risk willingness. At any given market risk, an investor can
choose among the investments which will bring them the desired yield. These
depends on the kind of risk premiums and beta.
Investors sometimes give freedom to the portfolio manager to diversify the stock
options as long he gets the expected returns from his portfolio.
Insurance portfolios are less actively managed. The reason is that the insurance
fund has specific purpose of some benefit in required circumstances.
The taxes are levied on selling of the stock. As long we keep reinvesting in the
market, no tax is levied.
Risk adjusted return = (rp - rf)/ riskp
rp = rf + p(Rm Rf)
rp = + rf + p(Rm Rf)
rp rp =
Alpha () = RAR RAR, i.e. the difference between the expected risk adjusted
return and actual risk adjusted return. Fund managers sometimes generate +ve
alpha and sometimes ve alpha, but consistently generating +ve alpha is very
difficult to maintain.
The efficiency frontier offers the highest expected return for a given risk or it
offers lowest risk for a given level of expected return. An investor always or
eventually have to the efficiency frontier for optimal return and any portfolio that
lies below the efficient frontier gives sub-optimal return.
A portfolio which is the mix of risk-free investment and risky investment will lie
on the tangent on the efficient frontier and passing through the risk-free point.
2 fund separation theorem: All portfolios are made of 2 kind of investments; riskfree and risky. The proportion of the investments in the portfolio can differ.