PORTFOLIO MANAGEMENT

TYBBA STOCK EXCHANGE & PORTFOLIO MANAGEMENT

Risk
Risks are caused by the following factors: 1. Wrong decision of what to invest in 2. Wrong timing of investment 3. Risky instruments of investment from the unorganised sector due to uncertainty of payment of principal and interest 4. Creditworthiness of the issuer 5. Maturity period or length of investment 6. Amount of investment 7. Method of investment 8. Terms of lending such as periodicity of servicing, redemption periods etc. 9. Nature of Industry or business 10. National and international factors, acts of God, etc.

Categories of Risks
Systematic Risks : External and uncontrollable factors arising out of the market, nature of industry and the state of the economy and a host of other factors Unsystematic Risks : They emerge out of the known and controllable factors internal to the issuer of the securities or companies Examples of Systematic Risks Market Risks : This arise out of changes in demand and supply pressures in the markets, following the changing flow of information or expectations Interest Rate Risk : The return on an investment depends on the interest rate promised on it and changes in market rates of interest from time to time. These interest rates depend on nature of instruments, stocks, bonds, loans etc., maturity of the periods and the creditworthiness of the issuer of securities. Purchasing Power Risk : Inflation or rise in prices lead to rise in costs of production, lower margins, wage rises and profit squeezing etc. The return expected by investors will change due to change in real value of returns

Examples of Unsystematic Risks : Business Risk : This relates to the variability of the business, sales, income, profits etc. which in turn depend on the market conditions for the product mix, input supplies, strength of competitors. This business risk is sometimes external to the company due to changes in govt. policy or strategies of competitors or unforeseen market conditions. They may be internal due to fall in production, labour problems, raw materials or inadequate supply of electricity etc. It can be corrected by certain changes in companys policies Financial Risk : This relates to the method of financing, adopted by the company, high leverage leading to larger debt servicing problems or short term liquidity problems due to bad debts, delayed receivables and fall in current assets or rise in current liabilities. Proper financial planning and financial adjustments can be used to correct this risk and is controllable Default or Insolvency Risk : The borrower or issuer of securities may become insolvent or may default, or delay the payments due, such as interest instalments or principal repayments. In such cases, the investor may get no return or negative returns.

Other Risks Political Risks following changes in the govt or its policy shown in fiscal or budgetary aspects Management Risks due to errors or inefficiencies of management causing losses to the company Marketability Risks involving loss of liquidity or loss of value in conversions from one asset to another say from stocks to bonds Market risk Political and social risk International risk such as currency risk Management risk Liquidity and solvency risk Callability risk Convertibility risk Acts of God like earthquakes etc

Return on a Portfolio
Return Each security in a portfolio contributes returns in the proportion of its investment in security. Thus, the portfolio expected return is the weighted average of the expected returns from each of the securities, with weights representing the proportionate share of the security in the total investment __________________________________________________________________________________ Security Proportion of Funds Expected Contribution Invested in Each Return of of each security Security holding period to return (1) (2) (3) = (1) x (2) __________________________________________________________________________________ A 30 15% (30 x 0.15) = 4.50 B 25 20% (25 x 0.20) = 5.00 C 25 25 % (25 x 0.25) = 6.25 D 20 10 % (20 x 0.10) = 2.00 __________________________________________________________________________________ Weights = 100 Weighted Return = 17.75 %

Risk on Portfolio
Risk Risk on a portfolio is different from the risk on individual securities. This risk is reflected in the variability of the returns from zero to infinity. The expected return depends on the probability of the returns and their weighted contribution to the risk of the portfolio. There are two measure of risk one is the absolute deviation and the other standard deviation

________________________________________________
Event Probability X Absolute Deviation _______________________________________________________________________________ (1) (2) (3) (4) (5) (6) (2) x (3) (5) x (2) _______________________________________________________________________________
1. 2. 3. 4. 0.20 0.30 0.40 0.10 -10 20 25 10 - 2.0 + 6.0 + 10.0 + 1.00 -25 5 10 -5 + 5.0 + 1.5 + 4.0 + 0.5

Probability

Return

Probability x Return

Absolute deviation

_______________________________________________________________________________ Expected Return 15.00 Average 11.0 absolute deviation

BETA
Beta is the measure of non-diversifiable risk (Systematic Risk). It shows how the price of a security responds to changes in market prices. The equation for calculation of Beta is Ri = a + i Rm Ri = estimated return on i stock a = expected return when market return is zero i = Beta measuring stocks sensitivity to the market index Rm = return on market index Using the Beta concept, the capital asset Pricing Model will help to define the required return on a security. Normally the higher is the risk we take, the higher should be the return, as otherwise we avoid risk. So, the higher the , the higher should be the return Ri = Rf + i (Rm Rf) Ri is the required return Rf is the risk free return Rm is the average market return i is the measure of systematic risk which is non-diversifiable

BETA
Beta describes the relationship between stocks return and market index return. It can be +ve or ve

= % Price Change of a Scrip Return % Price change of the market index return
Beta is thus a measure of Systematic Risk of the market only and does not represent the unsystematic risk. If is 1, 1% increase in market index will lead to 1% increase in the If is 0, stock price is unrelated to market index If is -1, it indicates ve relationship ie if the market goes up by 1% the stock price will fall by 1% Beta measure the systematic market related risk which cannot be eliminated by diversification.

Alpha
Alpha is the distance between the horizontal axis and lines intersection with y axis. It measure the unsystematic risk of the company. If a is positive return, then that scrip will have higher returns. If a =o, then the regression line goes through the origin and its return simple depends on the Beta times the market return.

Stock return

Beta

Beta

Alpha

Market return(OR Market Index)

DIVERSIFICATION
Diversification is a technique of reducing the risk involved in investment and portfolio management. This is the process of conscious selection of assets, instruments and scrips of companies or government securities to reduce the level of risk (unsystematic risk) and promotes the optimisation of returns for a given level of risks in portfolio management. Forms of diversification :
Into different types of assets, like gold, real estate, Government securities, corporate securities etc. Into different instruments or security type bonds, stocks, debentures, Government securities etc. Into different industry lines, namely , plastics, chemicals, engineering, cement, steel, fertilisers etc. Into different scrips of companies viz.,new companies, growing companies, new product companies etc.

Principles / Ways of Diversification

The traditional belief is that diversification involves not putting all eggs in one basket. This policy involves as many baskets as possible; carried to the extreme it is good to have as many companies as possible in ones portfolio. But this is a misconception as economies of scale operate in reverse direction (involving diseconomies) with the result that monitoring and review of the portfolio become inefficient, costly and cumbersome and outweigh the benefits of diversification. There are some accepted methods of effecting diversification : 1. Randomness in Selection of Companies and Industries :The probability of reducing risk is more with a random selection as the statistical error of choosing wrong companies will come down due to randomness of selection which is a statistical technique. This involves placing of companies in any order and picking them up in random manner.

Principles / Ways of Diversification

2. Optimisation of Selection Process : Given thye amount of money to be invested there is optimum number of companies, where money can be invested. If the number is too small, risk cannot be reduced adequately and if the number is too big, there will be diseconomies and difficulty of supervision, analysis and monitoring will increase risk again. There is thus an optimum number of companies to be chosen for a given amount of investment. Adequate Diversification : Many traditional approaches emphasise on the need for adequate diversification. This involves as many industries and companies or securities as possible to get the best results. This principle believes in the possibilities of reducing risk to even zero, if there are adequate number of companies and industries. Markowitz emphasised however that what is needed is not only the number of securities to be chosen but the right kind of securities to be chosen. Thus even if there are a number of companies they may not reduce risk adequately if they are positively correlated with each other and the market, in which case, they all move in the same direction and many risks will not be reduced and may even increase.

3.

Principles / Ways of Diversification

4. Markowitz Diversification :

Markowitz emphasised on right number of securities which are negatively correlated or not correlated at all The purpose is to reduce unsystematic risk by a proper choice of companies and industries For an individual a number of around 10 to 16 companies can secure reduction of risk to optimum level For mutual funds or finance companies this number may be higher Systematic risk cannot be reduced by diversification but to a large extent unsystematic risk can be reduced by a right choice of companies and to a limited number.

Phases / Process of Portfolio Management

Portfolio means a bundle of things. Investors tend to invest in a group of securities or different investment avenues such as group of securities or bunch of investment avenues is called portfolio. Portfolio Management is managing the portfolio in efficient manner which serves maximum returns, minimum risk and hedge against the risk. Phases / Process of Portfolio Management 1. Security Analysis : Analyse different investment avenues with innovative features.
Risk return characteristics of individual securities or investment avenues. Fundamental Analysis Technical Analysis Efficient Market hypothesis

2.

Portfolio Analysis
Diversification to reduce risk Combination of different securities & investment avenues Calculation of risk and return mathematically.

Phases / Process of Portfolio Management

3. 4. 5. Portfolio Selection Efficient Portfolio Harry Markowitz Determining optimum portfolio Portfolio Revision To reduce the portfolio on the basis of new developments in the market It could be due to availability of additional funds, change in risk attitude, need of cash Portfolio Evaluation To identify the relative performance It provides feedback for improvement for superior performance in future.