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SAPM Unit 3 Presentation-2

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akanshasingh2705
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© © All Rights Reserved
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Portfolio

Analysis
PRESENTED BY: TANAY MANGLANI

Tanay
M.

MONIRBA | MAN - 655 | 2023


Introduction

A portfolio is a collection of financial investments like stocks, bonds,


commodities, cash, and cash equivalents, including closed-end funds and
Exchange Traded Funds (ETFs). A portfolio may contain a wide range of
assets including real estate, art, and private investments.

Portfolio analysis is the process of evaluating and assessing a portfolio, to


understand its performance, risks, and potential returns.
Portfolio Theory - I

Investors seek to find a Balance between Risk and Return.


Towards this end, they tend to “Diversify” their investments.
This systematic body of knowledge that provides a normative approach to
investors to make decisions to invest their wealth in assets or securities under
conditions of risk is called “Portfolio Theory”.
It is based on the assumption that investors are “Risk Averse”.
Return

It is defined as “the benefit of undertaking investments.”


It has 2 components-:
1. Current Returns are the periodic cash flows generated by an investment.
2. Capital Returns are reflected by the price changes of the asset after
investment.
We can say that-:
Total Return = Current Return + Capital Return
Risk

It refers to the possibility that the actual outcome of an investment would differ
from its expected outcome.
The wider the range of possible outcomes (variability), the greater the risk.
It is of the following types-:
1. Unique Risk-: Stems from firm/asset/security specific factors.
2. Market Risk-: Attributed to greater, macro-economic factors.

Unique Risk is diversifiable, while Market Risk is non-diversifiable.


Need for Diversification

To reduce risk it is necessary to avoid a portfolio whose securities are all


highly correlated with each other. One hundred securities whose returns
rise and fall in near unison afford little protection than the uncertain
return of a single security.

- Harry Markowitz
Diversification

“Don’t put all your eggs in one basket.”


It is a risk management technique that mitigates risk by allocating investments
across different financial instruments, industries, and several other categories.
The purpose of this technique is to maximize returns by investing in different areas
that would yield higher and long term returns.
In a diversified portfolio, the unique risks of different securities would tend to
cancel each other out.
Note

Diversification does not provide any guarantee against loss, but remains
the most important component of achieving long-range financial goals
while reducing risk.
Portfolio Theory - II

Originally developed by Harry Markowitz, the Theory states that portfolio risk,
unlike portfolio return, is more than a simple aggregation of the risks of
individual assets.
It is dependent upon the interplay between the returns on assets comprising
the portfolio.
Portfolio Return is represented by a Weighted Average; while Portfolio Risk is
estimated by the Variance of its Return.
Portfolio Return

The expected return of a


portfolio represents
weighted average of the
expected returns on the
securities comprising that
portfolio.
Weights are the proportion
of total funds invested in
each security.
Portfolio Risk
The overall risk of a portfolio
includes the interactive risk
of assets in relation to each
other, measured by the
Standard Deviation and
Variance of returns.
Covariance represents the
correlation between returns
on the securities in the
portfolio.
Implications

Positive covariance shows that on an average the two variables move together. As the
proportion of high return and high risk assets is increased, higher returns on portfolio
come with higher risk.
Negative covariance suggests that, on an average, the two variables move in opposite
directions. This implies that it is possible to combine the two securities A and B in a
manner that will eliminate all risk.
Zero covariance means that the two variables do not move together; that is, returns on
the two securities are not related at all. Such situation does not exist in real world.
Risk Reduction
The Unique or Unsystematic risk
can be eliminated through
diversification because of
randomness.
Effects on individual securities
in a portfolio cancel out each
other.
systematic risk , however is
unavoidable and investors
expect to be compensated for
bearing it.
Limits of Diversification

As more and more securities are added, Portfolio Risk decreases, but at a
decreasing rate. Empirical studes suggest that maximum benefit from
diversification occurs at about 20 securities. Thereafter, the benefits of
diversification are negligible.
Markowitz Model

Harry Markowitz propounded the Mean-Variance (Return-Risk) Model and


provided a structured and mathematically sound method of measuring Risk and
Return.
He attempted to classify and quantify Risk and Return and developed a
methodology for constructing the Optimal Portfolio.
The Markowitz Model (or Markowitz Modern Portfolio Theory) is a Normative
Theory and is based on the assumptions of Efficient Markets and Rational
investors.
Assumptions

All investors have access to the same information


There are no restrictions on making investments.
There are no taxes.
Transaction costs are nil.
Market prices are not affected by any large buyer/seller.
All investors have the same expectations regarding the risks and returns of all
securities.
Efficient Frontier Concept

Premise-: The utility derived by an investor is a function of Mean or Expected Return


and Risk (measured by Variance (or Standard Deviation)) of Return.
Provided an option, any rational investor would prefer a higher return to a lower one;
and lower risk to higher risk. An investor would wish to move to a portfolio that provides
higher returns for the same level of risk or lower risk for the same level of returns.
The various weighted combinations of stocks that create this return-risk mmix constitute
the set of Efficient Portfolios.
This is represented by an eggshell shaped curve called the Efficient Frontier.
Efficient Frontier
Implications

Within the Efficient Frontier framework, the goal of the investor is to move
upwards and towards the left.
Moving downwards reduces Returns and moving towards the right increases
Risk.
As such, the upper left section of the curve represents the ideal combination
of stocks and securities that provides maximum returns with minimal risk.
Utility

Portfolio Y is inefficient
compared to Portfolios R &
X, as they offer higher
returns at equal (or lower)
Risk.
R lies on the frontier and
provides highest utility.
Above the frontier, Risk is
too high. Leftwards, Returns
are too low.
Critique

Assumes that all rational investors are Risk Averse.


Assumes that Variance is the most appropriate measure of Risk.
Does not mention investing in Risk-Free Assets (Standard Deviation and
Covariance are zero).
Does not mention short-selling.
Risk and Return measurements rely on past data and are probabilistic.
Conclusion

A good portfolio is more than a long list of good stocks


and bonds. It is a balanced whole, providing the investor
with protections and opportunities with respect to a wide
range of contingencies.
- Harry Markowitz
Further

Asset Pricing and Portfolio Management Principles have


been further refined by other, more recent theories; such
as Sharpe’s Optimization Model and CAPM.
Tanay
M.

Thank
you

MONIRBA | MAN - 655 | 2023

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