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Portfolio Construction
Objectives
To determine the objectives in the traditional approach To select the securities to be included in the portfolio
To learn the basics of modern approach
Portfolio
Portfolio is a combination of securities such as stocks, bonds and money market instruments. The process of blending together the asset classes so as to obtain optimum return with minimum risk is called portfolio construction. Diversification of investments helps to spread risk over many assets.
Traditional Approach
The traditional approach basically deals with two major decisions:
Bond
Common stock
Analysis of Constraints
Income needs
Need
Need
Tax consideration
Temperament
Determination of Objectives
The common objectives are stated below:
Current income
Growth in income Capital appreciation Preservation of capital
Selection of Portfolio
Objectives and asset mix Growth of income and asset mix Capital appreciation and asset mix Safety of principal and asset mix Risk and return analysis
Diversification
According to the investors need for income and risk tolerance level portfolio is diversified. In the bond portfolio, the investor has to strike a balance between the short term and long term bonds.
Stock Portfolio
Selection of Industries Selection of Companies in the Industry Determining the size of participation
Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, by carefully choosing the proportions of various assets.
Modern Approach
Modern approach gives more attention to the process of selecting the portfolio. The selection is based on the risk and return analysis.
MPT is a mathematical formulation of the concept of diversification in investing, Aim of selecting a collection of investment assets that has collectively lower risk than any individual asset.
Different types of assets often change in value in opposite ways. For example, when prices in the stock market fall, prices in the bond market often increase, and vice versa A collection of both types of assets can therefore have lower overall risk than either individually. diversification lowers risk.
The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on their own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price.
Investing is a trade-off between risk and expected return. In general, assets with higher expected returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the highest-returning available security, of course, unless negative holdings of assets are possible.)
MPT is therefore a form of diversification. Under certain assumptions and for specific quantitative definitions of risk and return, MPT explains how to find the best possible diversification strategy.
B 30% 10%
MATHEMATICAL MODEL
Risk and expected return
If given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns.
an investor wants higher expected returns must accept more risk. The exact trade-off will be the same for all investors, but different investors will evaluate the trade-off differently based on individual risk aversion characteristics.
The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favourable risk-expected return profile i.e., if for that level of risk an alternative portfolio exists which has better expected returns. The theory uses standard deviation of return as a proxy for risk.
Ri = return on assets I
Portfolio risk
the risk involved in individual securities can be measured by standard deviation or variance When two securities are combined we need to consider their - Interactive risk or covariance If rates of return of two securities move together -Interactive risk or covariance is positive -If rates are independent- covariance is zero -Inverse movement - covariance is negative
RETURN
STOCK X STOCK Y 7 13
EXPECTED RETURN
9 9
DIFFERNCES
-2 4 PRODUCT - 8
STOCK X
STOCK Y
11
5
9
9
2
-4 PRODUCT - 8
COV= (7-9)(13-9)+(11-9)(5-9)
=1/2(-8)+(-8)=-16/2 =8
The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on their own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price. Investing is a trade off between risk and expected return.
In general, assets with higher expected returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return.
MPT assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk. The exact trade-off will be the same for all investors, but different investors will evaluate the trade-off differently based on individual risk aversion characteristics.
The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-expected return profile i.e., if for that level of risk an alternative portfolio exists which has better expected returns. Theory uses standard deviation of return as a proxy for risk. Under the model: Portfolio return is the proportion-weighted combination of the constituent assets' returns. Portfolio volatility is a function of the correlations ij of the component assets, for all asset pairs (i, j).
Portfolio volatility is a function of the correlations ij of the component assets, for all asset pairs (i, j).
Rp = return on portfolio
Ri = return on assets I
W
i 2
+ WiWj rij
rij = Correlation coefficient between the returns on assets i and j (Between assets A & B & C..N)
p2
w + w w r
2 2 i i i j
ij
Portfolio return :
wA E(RA)+ WB E(RB)
Portfolio variance :
Portfolio variance :
p2 = 2 2 2 2 wA A + wB B +2 wAwB A B rAB + 2 wAwC A C rAC + 2 wBwC B C rBC
Diversification
An investor can reduce portfolio risk simply by holding combinations of instruments which are not perfectly positively correlated
In other words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets. Diversification may allow for the same portfolio expected return with reduced risk. If all the asset pairs have correlations of 0they are perfectly uncorrelatedthe portfolio's return variance is the sum over all assets of the square of the fraction held in the asset times the asset's return variance (and the portfolio standard deviation is the square root of this sum).
p p2
Risk Return
Individual securities has risk return characteristics PORTFOLIO is combination of securities May or may not take aggregate risk return characteristics of Individual securities Consists various blend of risk return characteristics of Individual securities
Traditional portfolio analysis recognizes Key importance of Risk Return to investors Each security ends up with some rough measurement of likely return and potential downside risk for the future
Portfolio or combination of securities Helpful spreading the risk over many securities However the interrelationship between securities may be specified. Example Auto stocks are Risk interrelated with Tire stocks Utility stock display defensive movement relative to steel etc.
Why portfolio
Expected return from individual security will carry Some degree of risk Risk is defined as standard deviation around the expected return (risk surrogate not synonyms for risk) We equated securitys risk with variability of its return
Since security carries different degree of expected risk Investors hold more than one security Attempt to spread risk
Diversification
Effort to spread risk takes the form of Diversification Most traditional type holding a number of security type Utility, mining, banking ,pharma, manufacturing group To inherent differences in bonds and equity
Although holding two types of securities is better than holding only one type Is it possible to reduce the risk of portfolio by incorporating in to it a security whose risk is greater than that of any of the investment initially?
Y is more riskier than X A portfolio consist of some of X & some of Y Is better than Holding exclusively X or Y
9 4
2
9 16
4
Expected Return
X= (.5)(7) +(.5)(11)=9 Y= (.5)(13)+(.5)(5)=9 X= (.5)(7) +(.5)(11)=9 Y= (.5)(13)+(.5)(5)=9
Since X & Y have similar return Y is riskier (SD is 4 in Y) Is a portfolio of some of X and some of Y is superior than holding exclusively X ?
Rp = Xi Ri
i=1
Rp =expected return of portfolio Xi= proportion of total portfolio invested in security i Ri = EXPECTED RETURN TO security I N= total number of securities in portfolio
Rp
Rp = (2/3)(9)+(1/3)+(9)=9 In a period when X is better as an investment we have (2/3)(11)+(1/3)( 5)=9 When y is remunerative We have (2/3)(7)+(1/3)( 13)=9
Thus by putting part of money in riskier stock like Y We are able to reduce risk also
The crucial question is how to achieve the proper proportion of X and y Finding two securities each of which tends to perform whenever other does poorly Makes more certain and reasonable return of the portfolio as a whole Even if one of its component happens to be quite risky.
RETURN
STOCK X STOCK Y 7 13
EXPECTED RETURN
9 9
DIFFERNCES
-2 4 PRODUCT - 8
STOCK X
STOCK Y
11
5
9
9
2
-4 PRODUCT - 8
COV= (7-9)(13-9)+(11-9)(5-9)
=1/2(-8)+(-8)=-16/2 =8
MEASUREMENT OF RISK
Measurement of risk
100 lakhs
100 lakhs
Rate of return %
Pessimistic Most likely 10 12 6 12
Optimistic
Range
14
4
18
12
Probability distribution
Probability of an event represents the changes of its occurrences If change of occurrences = 3 out of 5 the Probability of the event = 60% or .6
E(R)= PiRi
i=1
Pi
1 2 3 .25 .50 .25
Ri
10 12 14
6 12 18
? ? ?
Standard deviation
Most common quantitative measure of risk It considered every possible event and weight equal to its Probability is assigned to each event
The greater the SD of return of an assets , the greater is the risk of the assets Investor prefers higher rate of return with lower ?????????.
Coefficient of variation
Cv =
E(R)
Portfolio return :
wA E(RA)+ WB E(RB)
Portfolio variance :
Modern portfolio theory (MPT) is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets.
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. That this is possible can be seen intuitively because different types of assets often change in value in opposite ways. For example, when prices in the stock market fall, prices in the bond market often increase, and vice versa
A collection of both types of assets can therefore have lower overall risk than either individually. But diversification lowers risk.
The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on their own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price.
Investing is a trade-off between risk and expected return. In general, assets with higher expected returns are riskier. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the highest-returning available security, of course, unless negative holdings of assets are possible.)
MPT is therefore a form of diversification. Under certain assumptions and for specific quantitative definitions of risk and return, MPT explains how to find the best possible diversification strategy.
Mathematical model
MPT assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk.
The exact trade-off will be the same for all investors, but different investors will evaluate the trade-off differently based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favourable risk-expected return profile i.e., if for that level of risk an alternative portfolio exists which has better expected returns.
Note that the theory uses standard deviation of return as a proxy for risk. There are problems with this, however; Under the model: Portfolio return is the proportion-weighted combination of the constituent assets' returns. Portfolio volatility is a function of the correlations ij of the component assets, for all asset pairs (i, j).
Expected return:
Markowitz Diversification
Combining assets that are less than perfectly positively correlated in order to reduce portfolio risk without sacrificing portfolio returns. It is more analytical than simple diversification and considers assets correlations. The lower the correlation among assets, the more will be risk reduction through Markowitz diversification
A weighted average of the expected returns of individual securities in the portfolio. The weights are the proportions of total investment in each security n E(Rp) = wi x E(Ri) i=1 Where n is the number of securities in the portfolio
Portfolio Risk
Measured by portfolio standard deviation Not a simple weighted average of the standard deviations of individual securities in the portfolio. Why? How to compute portfolio standard deviation?
Markowitz Diversification
Combining assets that are less than perfectly positively correlated in order to reduce portfolio risk without sacrificing portfolio returns. It is more analytical than simple diversification and considers assets correlations. The lower the correlation among assets, the more will be risk reduction through Markowitz diversification Example of Markotwitzs Diversification The emphasis in Markowitzs Diversification is on portfolio expected return and portfolio risk
A weighted average of the expected returns of individual securities in the portfolio. The weights are the proportions of total investment in each security n E(Rp) = wi x E(Ri) i=1 Where n is the number of securities in the portfolio Example:
Portfolio Risk
Measured by portfolio standard deviation Not a simple weighted average of the standard deviations of individual securities in the portfolio. Why? How to compute portfolio standard deviation?
Significance of Covariance
An absolute measure of the degree of association between the returns for a pair of securities. The extent to which and the direction in which two variables co-vary over time Example:
Why Correlation?
The returns have a perfect direct linear relationship Knowing what the return on one security will do allows an investor to forecast perfectly what the other will do
Zero correlation
Combining securities with perfect positive correlation or high positive correlation does not reduce risk in the portfolio Combining two securities with zero correlation reduces the risk of the portfolio. However, portfolio risk cannot be eliminated Combining two securities with perfect negative correlation could eliminate risk altogether