PORT FOLIO MANAGEMENT

MEANING:
A portfolio is a collection of assets. The assets may be physical or financial
like Shares, Bonds, Debentures, Preference Shares, etc. The individual investor or
a fund manager would not like to put all his money in the shares of one company
that would amount to great risk. He would therefore, follow the age old maxim
that one should not put all the eggs into one basket. By doing so, he can achieve
objective to maximize portfolio return and at the same time minimizing the
portfolio risk by diversification.

 Portfolio management is the management of various financial assets which

comprise the portfolio.
 Portfolio management is a decision – support system that is designed with a
view to meet the multi-faced needs of investors.
 According to Securities and Exchange Board of India Portfolio Manager is
defined as: “portfolio means the total holdings of securities belonging to any
person”.
 PORTFOLIO MANAGER means any person who pursuant to a contract
or arrangement with a client, advises or directs or undertakes on behalf of
the client (whether as a discretionary portfolio manager or otherwise) the
management or administration of a portfolio of securities or the funds of the
client.
DISCRETIONARY PORTFOLIO MANAGER means a portfolio
manager who exercises or may, under a contract relating to portfolio
management exercises any degree of discretion as to the investments or
management of the portfolio of securities or the funds of the client.
IMPORTANCE OF PORTFOLIO MANAGEMENT:

 Emergence of institutional investing on behalf of individuals. A number of

financial institutions, mutual funds and other agencies are undertaking the
task of investing money of small investors, on their behalf.

 Growth in the number and size of investible funds – a large part of

household savings is being directed towards financial assets.

 Increased market volatility – risk and return parameters of financial assets

are continuously changing because of frequent changes in government‘s
industrial and fiscal policies, economic uncertainty and instability.

 Greater use of computers for processing mass of data.

 Professionalization of the field and increasing use of analytical methods (e.g.

quantitative techniques) in the investment decision – making

 Larger direct and indirect costs of errors or shortfalls in meeting portfolio

objectives – increased competition and greater scrutiny by investors.
3.6 STEPS IN PORTFOLIO MANAGEMENT:

 Specification and qualification of investor objectives, constraints, and

preferences in the form of an investment policy statement.

 Determination and qualification of capital market expectations for the

economy, market sectors, industries and individual securities.

 Allocation of assets and determination of appropriate portfolio strategies for

each asset class and selection of individual securities.

 Performance measurement and evaluation to ensure attainment of investor

objectives.

 Monitoring portfolio factors and responding to changes in investor

objectives, constrains and / or capital market expectations.

 Rebalancing the portfolio when necessary by repeating the asset allocation,

portfolio strategy and security selection.
CRITERIA FOR PORTFOLIO DECISIONS:

 In portfolio management emphasis is put on identifying the collective

importance of all investors’ holdings. The emphasis shifts from individual
assets selection to a more balanced emphasis on diversification and risk-
return interrelationships of individual assets within the portfolio. Individual
 securities are important only to the extent they affect the aggregate portfolio.
In short, all decisions should focus on the impact which the decision will
have on the aggregate portfolio of all the assets held.

 Portfolio strategy should be moulded to the unique needs and characteristics

of the portfolio‘s owner.
 Diversification across securities will reduce a portfolio‘s risk. If the risk and
return are lower than the desired level, leverages (borrowing) can be used to
achieve the desired level.

 Larger portfolio returns come only with larger portfolio risk. The most
important decision to make is the amount of risk which is acceptable.

 The risk associated with a security type depends on when the investment
will be liquidated. Risk is reduced by selecting securities with a payoff close
to when the portfolio is to be liquidated.

Competition for abnormal returns is extensive, so one has to be careful in

evaluating the risk and return from securities. Imbalances do not last long
and one has to act fast to profit from exceptional opportunities.

PORTFOLIO BUILDING:

Portfolio decisions for an individual investor are influenced by a wide

variety of factors. Individuals differ greatly in their circumstances and therefore, a
financial programme well suited to one individual may be inappropriate for
another. Ideally, an individual‘s portfolio should be tailor-made to fit one‘s
individual needs.
Investor‘s Characteristics:
An analysis of an individual‘s investment situation requires a study of
personal characteristics such as age, health conditions, personal habits, family
responsibilities, business or professional situation, and tax status, all of which
affect the investor‘s willingness to assume risk.

Stage in the Life Cycle:

One of the most important factors affecting the individual‘s investment
objective is his stage in the life cycle. A young person may put greater emphasis
on growth and lesser emphasis on liquidity. He can afford to wait for realization of
capital gains as his time horizon is large.

Family responsibilities:
The investor‘s marital status and his responsibilities towards other members of
the family can have a large impact on his investment needs and goals.

Investor‘s experience:
The success of portfolio depends upon the investor‘s knowledge and
experience in financial matters. If an investor has an aptitude for financial affairs,
he may wish to be more aggressive in his investments.
Attitude towards Risk:
A person‘s psychological make-up and financial position dictate his ability to
assume the risk. Different kinds of securities have different kinds of risks. The
higher the risk, the greater the opportunity for higher gain or loss.

Liquidity Needs:
Liquidity needs vary considerably among individual investors. Investors
with regular income from other sources may not worry much about instantaneous
liquidity, but individuals who depend heavily upon investment for meeting their
general or specific needs, must plan portfolio to match their liquidity needs.
Liquidity can be obtained in two ways:

1. by allocating an appropriate percentage of the portfolio to bank deposits, and

2. by requiring that bonds and equities purchased be highly marketable.

Tax considerations:
Since different individuals, depending upon their incomes, are subjected to
different marginal rates of taxes, tax considerations become most important factor
in individual‘s portfolio strategy. There are differing tax treatments for investment
in various kinds of assets.

Time Horizon:
In investment planning, time horizon becomes an important consideration. It is
highly variable from individual to individual. Individuals in their young age have
long time horizon for planning, they can smooth out and absorb the ups and downs
of risky combination. Individuals who are old have smaller time horizon, they
generally tend to avoid volatile portfolios.
Individual‘s Financial Objectives:
In the initial stages, the primary objective of an individual could be to
accumulate wealth via regular monthly savings and have an investment programme
to achieve long term capital gains.

Safety of Principal:
The protection of the rupee value of the investment is of prime importance to
most investors. The original investment can be recovered only if the security can
be readily sold in the market without much loss of value.

Assurance of Income:
`Different investors have different current income needs. If an individual is
dependent of its investment income for current consumption then income received
now in the form of dividend and interest payments become primary objective.

Investment Risk:
All investment decisions revolve around the trade-off between risk and
return. All rational investors want a substantial return from their investment. An
ability to understand, measure and properly manage investment risk is fundamental
to any intelligent investor or a speculator. Frequently, the risk associated with
security investment is ignored and only the rewards are emphasized. An investor
who does not fully appreciate the risks in security investments will find it difficult
to obtain continuing positive results.
 4. RISK AND EXPECTED RETURN

There is a positive relationship between the amount of risk and the amount
of expected return i.e., the greater the risk, the larger the expected return and larger
the chances of substantial loss. One of the most difficult problems for an investor is
to estimate the highest level of risk he is able to assume.
  Risk is measured along the horizontal axis and increases from the left to
right.

 Expected rate of return is measured on the vertical axis and rises from
bottom to top.

 The line from 0 to R (f) is called the rate of return or risk less investments
commonly associated with the yield on government securities.

 The diagonal line form R (f) to E(r) illustrates the concept of expected rate
of return increasing as level of risk increases.

4.1 TYPES OF RISKS:

Risk consists of two components. They are

1. Systematic Risk
2. Un-systematic Risk

1. Systematic Risk:

Systematic risk is caused by factors external to the particular company and

uncontrollable by the company. The systematic risk affects the market as a whole.
Factors affect the systematic risk are

 economic conditions
 political conditions
 sociological changes
The systematic risk is unavoidable. Systematic risk is further sub-divided into three
types. They are

a) Market Risk
b) Interest Rate Risk
c) Purchasing Power Risk

a). Market Risk:

One would notice that when the stock market surges up, most stocks post higher
price. On the other hand, when the market falls sharply, most common stocks will
drop. It is not uncommon to find stock prices falling from time to time while a
company‘s earnings are rising and vice-versa. The price of stock may fluctuate
widely within a short time even though earnings remain unchanged or relatively
stable.

b). Interest Rate Risk:

Interest rate risk is the risk of loss of principal brought about the changes in the
interest rate paid on new securities currently being issued.

c). Purchasing Power Risk:

The typical investor seeks an investment which will give him current income and /
or capital appreciation in addition to his original investment.
 2. Un-systematic Risk:

Un-systematic risk is unique and peculiar to a firm or an industry. The nature and
mode of raising finance and paying back the loans, involve the risk element.
Financial leverage of the companies that is debt-equity portion of the companies
differs from each other. All these factors Factors affect the un-systematic risk and
contribute a portion in the total variability of the return.
 Managerial inefficiently
 Technological change in the production process
 Availability of raw materials
 Changes in the consumer preference
 Labour problems

The nature and magnitude of the above mentioned factors differ from industry to
industry and company to company. They have to be analyzed separately for each
industry and firm. Un-systematic risk can be broadly classified into:
a) Business Risk
b) Financial Risk

a. Business Risk:

Business risk is that portion of the unsystematic risk caused by the operating
environment of the business. Business risk arises from the inability of a firm to
maintain its competitive edge and growth or stability of the earnings. The
volatibility in stock prices due to factors intrinsic to the company itself is known as
Business risk. Business risk is concerned with the difference between revenue and
earnings before interest and tax. Business risk can be divided into.
 i). Internal Business Risk

Internal business risk is associated with the operational efficiency of the

firm. The operational efficiency differs from company to company. The efficiency
of operation is reflected on the company‘s achievement of its pre-set goals and the
fulfillment of the promises to its investors.

ii).External Business Risk

External business risk is the result of operating conditions imposed on the

firm by circumstances beyond its control. The external environments in which it
operates exert some pressure on the firm. The external factors are social and
regulatory factors, monetary and fiscal policies of the government, business cycle
and the general economic environment within which a firm or an industry operates.

b. Financial Risk:

It refers to the variability of the income to the equity capital due to the debt capital.
Financial risk in a company is associated with the capital structure of the company.
Capital structure of the company consists of equity funds and borrowed funds.
 5. ANALYSIS AND INTERPRETATION

5.1 PORTFOLIO ANALYSIS:

Various groups of securities when held together behave in a different

manner and give interest payments and dividends also, which are different to the
analysis of individual securities. A combination of securities held together will
give a beneficial result if they are grouped in a manner to secure higher return after
taking into consideration the risk element.

There are two approaches in construction of the portfolio of securities. They

are

 Traditional approach
 Modern approach

TRADITIONAL APPROACH:

Traditional approach was based on the fact that risk could be measured on
each individual security through the process of finding out the standard deviation
and that security should be chosen where the deviation was the lowest. Traditional
approach believes that the market is inefficient and the fundamental analyst can
take advantage of the situation. Traditional approach is a comprehensive financial
plan for the individual. It takes into account the individual needs such as housing,
life insurance and pension plans. Traditional approach basically deals with two
major decisions. They are
a) Determining the objectives of the portfolio
b) Selection of securities to be included in the portfolio

MODERN APPROACH:
Modern approach theory was brought out by Markowitz and Sharpe. It is the
combination of securities to get the most efficient portfolio. Combination of
securities can be made in many ways. Markowitz developed the theory of
diversification through scientific reasoning and method. Modern portfolio theory
believes in the maximization of return through a combination of securities. The
modern approach discusses the relationship between different securities and then
draws inter-relationships of risks between them. Markowitz gives more attention to
the process of selecting the portfolio. It does not deal with the individual needs.

5.2 MARKOWITZ MODEL:

Markowitz model is a theoretical framework for analysis of risk and return
and their relationships. He used statistical analysis for the measurement of risk and
mathematical programming for selection of assets in a portfolio in an efficient
manner. Markowitz approach determines for the investor the efficient set of
portfolio through three important variables i.e.

 Return
 Standard deviation
 Co-efficient of correlation

Markowitz model is also called as a “Full Covariance Model“. Through this

model the investor can find out the efficient set of portfolio by finding out the trade
off between risk and return, between the limits of zero and infinity. According to
this theory, the effects of one security purchase over the effects of the other
security purchase are taken into consideration and then the results are evaluated.
Most people agree that holding two stocks is less risky than holding one stock. For
example, holding stocks from textile, banking and electronic companies is better
than investing all the money on the textile company‘s stock.

Markowitz had given up the single stock portfolio and introduced diversification.
The single stock portfolio would be preferable if the investor is perfectly certain
that his expectation of highest return would turn out to be real. In the world of
uncertainty, most of the risk adverse investors would like to join Markowitz rather
than keeping a single stock, because diversification reduces the risk.

ASSUMPTIONS:
 All investors would like to earn the maximum rate of return that they can
achieve from their investments.
 All investors have the same expected single period investment horizon.
 All investors before making any investments have a common goal. This is
the avoidance of risk because Investors are risk-averse.
 Investors base their investment decisions on the expected return and
standard deviation of returns from a possible investment.
 Perfect markets are assumed (e.g. no taxes and no transaction costs)
 The investor assumes that greater or larger the return that he achieves on his
investments, the higher the risk factor surrounds him. On the contrary when
risks are low the return can also be expected to be low.
 The investor can reduce his risk if he adds investments to his portfolio.
 An investor should be able to get higher return for each level of risk “by
determining the efficient set of securities“.

 An individual seller or buyer cannot affect the price of a stock. This

assumption is the basic assumption of the perfectly competitive market.
 Investors make their decisions only on the basis of the expected returns,
standard deviation and co variances of all pairs of securities.
 Investors are assumed to have homogenous expectations during the decision-
making period
 The investor can lend or borrow any amount of funds at the risk less rate of
interest. The risk less rate of interest is the rate of interest offered for the
treasury bills or Government securities.
 Investors are risk-averse, so when given a choice between two otherwise
identical portfolios, they will choose the one with the lower standard
deviation.
 Individual assets are infinitely divisible, meaning that an investor can buy a
fraction of a share if he or she so desires.
 There is a risk free rate at which an investor may either lend (i.e. invest)
money or borrow money.
 There is no transaction cost i.e. no cost involved in buying and selling of
stocks.
 There is no personal income tax. Hence, the investor is indifferent to the
form of return either capital gain or dividend.