CHAPTER SEVEN

PORTFOLIO SELECTION, MANAGEMENT AND EVALUATION

DEFINITION OF PORTFOLIO
 Portfolio is the combination of different assets with different risk and return class.
 Portfolio management is the process of allocation of resources in to various assets so as to
reduce the risk to achieve the expected return on the portfolio. Portfolio management
primarily involves reducing risk rather than increasing return.
 Life wasn’t designed to be risk-free. The key is not to eliminate risk, but to estimate it
accurately and manage it wisely.
THE PORTFOLIO MANAGEMENT PROCESS
There are four general steps in the portfolio management process.
The process of managing an investment portfolio never stops. Once the funds are initially
invested according to the plan, the real work begins in monitoring and updating the status of the
portfolio and the investor’s needs.
This process can be presented in the graph below:

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1. Construct a policy statement:
The first step in the portfolio management process is for the investor, either alone or with the
assistance of an investment advisor, to construct a policy statement.
The policy statement is a road map; in it, investors specify the types of risks they are willing to
take and their investment goals and constraints. All investment decisions are based on the policy
statement to ensure they are appropriate for the investor. Because investor needs change over
time, the policy statement must be periodically reviewed and updated.
The process of investing seeks to peer into the future and determine strategies that offer the best
possibility of meeting the policy statement guidelines.
2. Study current financial and economic conditions and forecast future trends:
In the second step of the portfolio management process, the manager should study current
financial and economic conditions and forecast future trends. The investor’s needs, as reflected
in the policy statement and financial market expectations will jointly determine investment
strategy. Economies are dynamic; they are affected by numerous industry struggles, politics, and
changing demographics and social attitudes. Thus, the portfolio will require constant monitoring
and updating to reflect changes in financial market expectations.
3. Construct the portfolio:
The third step of the portfolio management process is to construct the portfolio. With the
investor’s policy statement and financial market forecasts as input, the advisors implement the
investment strategy and determine how to allocate available funds across different countries,
asset classes, and securities. This involves constructing a portfolio that will minimize the
investor’s risks while meeting the needs specified in the policy statement. Financial theory
frequently assists portfolio construction.
Asset allocation is the process of deciding how to distribute an investor’s wealth among
different countries and asset classes for investment purposes. An asset class is comprised of
securities that have similar characteristics, attributes, and risk/return relationships. The asset
allocation decision is not an isolated choice; rather, it is a component of a portfolio management
process.
In general, four decisions are made when constructing an investment strategy:
 What asset classes should be considered for investment?
 What normal or policy weights should be assigned to each eligible asset class?

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  What is the allowable allocation ranges based on policy weights?
 What specific securities should be purchased for the portfolio?
4. Continual monitoring:
The fourth step in the portfolio management process is the continual monitoring of the
investor’s needs and capital market conditions and, when necessary, updating the policy
statement.
Based upon all of this, the investment strategy is modified accordingly. A component of the
monitoring process is to evaluate a portfolio’s performance and compare the relative results to
the expectations and the requirements listed in the policy statement.

Investment Objectives
Investment objectives must be stated in terms of both risk and return.
Return objectives may be stated in absolute terms (dollar amounts) or percentages. But it may
also be stated in terms of a general goal: capital preservation, capital appreciation, current
income needs, and total returns.
Risk tolerance is a function of the investor's psychological makeup and personal factors such as
age, family situation, existing wealth, insurance coverage, current cash reserves, and income.
 Capital preservation: is the objective of earning a return on an investment that is at least
equal to the inflation rate with little or no chance of loss. This is an appropriate goal when the
funds will be needed in the near future. This is a strategy for strongly risk-averse investors or
for funds needed in the short-run, such as for next year’s tuition payment or a down payment
on a house.
 Capital appreciation: is the objective of earning a nominal return that exceeds the rate of
inflation over some period of time. Achieving this goal means that, the purchasing power of
the initial investment increases over time, usually through capital gains. This is an
appropriate goal when the need for the funds is further in the future, such as for retirement.
Under this strategy, growth mainly occurs through capital gains. This is an aggressive
strategy for investors willing to take on risk to meet their objective. Generally, longer-term
investors seeking to build a retirement or college education fund may have this goal.
 Current income: is the objective when the primary purpose of an account is to produce
income as opposed to capital appreciation. The current income objective is usually

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 appropriate when an investor wants or needs to supplement other sources of income to meet
living expenses or some other planned spending need, as in retirement. This strategy
sometimes suits investors who want to supplement their earnings with income generated by
their portfolio to meet their living expenses. Retirees may favor this objective for part of their
portfolio to help generate spendable funds.
 Total return is the objective of having a portfolio grow in value to meet a future need
through both capital gains and the reinvestment of current income. The total return objective
is riskier than the income objective but less risky than the capital appreciation objective. This
would be an appropriate objective for an investor with a longer-term investment horizon but
only moderate risk tolerance.
In addition to the investment objective that sets limits on risk and return, certain other constraints
also affect the investment plan. Investment constraints include liquidity needs, an investment
time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences.
 Liquidity: refers to the ability to quickly convert investments into cash at a price close to their
fair market value. Liquidity, from the investor's view, is the potential need for ready cash. This
may necessitate selling assets at unfavorable terms if adequate liquidity is not provided in the
portfolio. Treasury bills are a highly liquid security; real estate and venture capital are not.
Investors may have liquidity needs that the investment plan must consider. For example,
although an investor may have a primary long-term goal, several near-term goals may require
available funds. Wealthy individuals with sizable tax obligations need adequate liquidity to pay
their taxes without upsetting their investment plan.
 Time horizon (investment horizon): refers to the time between making an investment and
needing the funds. There is a relationship between an investor's time horizon, liquidity needs,
and ability to handle risk. Since losses are harder to overcome in a short time frame, investors
with shorter time horizons usually prefer lower-risk investments. Investors with long investment
horizons generally require less liquidity and can tolerate greater portfolio risk: less liquidity
because the funds are not usually needed for many years; greater risk tolerance because any
shortfalls or losses can be overcome by returns earned in subsequent years. Investors with shorter
time horizons generally favor more liquid and less risky investments because losses are harder to
overcome during a short time frame.

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 Tax concerns: play an important role in investment planning because after-tax returns are what
investors should be concerned with. Tax Concerns Investment planning is complicated by the tax
code; taxes complicate the situation even more if international investments are part of the
portfolio. Taxable income from interest, dividends, or rents is taxable at the investor’s marginal
tax rate. Capital gains or losses arise from asset price changes. They are taxed differently than
income. Income is taxed when it is received; capital gains or losses are taxed only when the asset
is sold and the gain or loss is realized. Unrealized capital gains reflect the price appreciation of
currently held assets that have not been sold; the tax liability on unrealized capital gains can be
deferred indefinitely. Capital gains only become taxable after the asset has been sold for a price
higher than its cost, or basis. If appreciated assets are passed on to an heir upon the investor’s
death, the basis of the assets is considered to be their value on the date of the holder’s death.
 Legal and regulatory factors: are more of concerns for institutional investors than individuals,
but the investment strategies of both may be restricted due to these constraints. , the investment
process and financial markets are highly regulated. At times, these legal and regulatory factors
constrain the investment strategies of individuals and institutions.
 Unique needs and preferences are constraints that investors may have that address special
needs or place special restrictions on investment strategies for personal or socially conscious
reasons. This is a catch-all constraint category for those "special" circumstances that don't fit
nearly into one of the other constraint areas.
PORTFOLIO EVALUATION
Investors always are interested in evaluating the performance of their portfolios. It is both
expensive and time consuming to analyze and select securities for a portfolio, so an individual,
company, or institution must determine whether this effort is worth the time and money invested
in it. Investors managing their own portfolios should evaluate their performance as should those
who pay one or several professional money managers.
For now, however, we can catalog some possible risk-adjusted performance measures and
examine the circumstances in which each measure might be most relevant.

1. Sharpe’s portfolio performance measure: (RP-RF)/SD portfolio

Sharpe’s measure divides average portfolio excess return over the sample period by the
standard deviation of returns over that period. It measures the reward to (total) volatility trade-
off.

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The Sharpe measure of portfolio performance (designated S) is stated as follows:

R i−RFR
St¿ σi

Where:
Ri = the average rate of return for portfolio i during a specified time period
RFR = the average rate of return on risk-free assets during the same time period
σi = the standard deviation of the rate of return for portfolio I during the time period

This composite measure of portfolio performance clearly is similar to the Treynor measure;
however, it seeks to measure the total risk of the portfolio by including the standard deviation of
returns rather than considering only the systematic risk summarized by beta. Because the
numerator is the portfolio’s risk premium, this measure indicates the risk premium return earned
per unit of total risk. In terms of capital market theory, this portfolio performance measure uses
total risk to compare portfolios to the CML, whereas the Treynor measure examines portfolio
performance in relation to the SML. Finally, notice that in practice the standard deviation can be
calculated using either total portfolio returns or portfolio returns in excess of the risk-free rate.

Example: The following examples use the Sharpe measure of performance. Assume that RM =
0.14 and RFR = 0.08. Suppose you are told that the standard deviation of the annual rate of
return for the market portfolio over the past 10 years was 20 percent (σM = 0.20). Now you want
to examine the performance of the following portfolios:

Portfoli Average annual rate of return Standard deviation of return

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D 0.13 0.18
E 0.17 0.22
F 0.16 0.23

The Sharpe measures for these portfolios are as follows:

0.14−0.08
SM = 0.2
=0.300
0.13−0.08
SD = 0.18
=0.278

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 0.17−0.08
SE = 0.22
=0.409
0.16−0.08
SF = 0.23 =0.348
The D portfolio had the lowest risk premium return per unit of total risk, failing even to perform
as well as the aggregate market portfolio. In contrast, Portfolios E and F performed better than
the aggregate market: Portfolio E did better than Portfolio F.

Treynor versus Sharpe Measure: The Sharpe portfolio performance measure uses the standard
deviation of returns as the measure of total risk, whereas the Treynor performance measure uses
beta (systematic risk). The Sharpe measure, therefore, evaluates the portfolio manager on the
basis of both rate of return performance and diversification.
For a completely diversified portfolio, one without any unsystematic risk, the two measures give
identical rankings because the total variance of the completely diversified portfolio is its
systematic variance. Alternatively, a poorly diversified portfolio could have a high ranking on
the basis of the Treynor performance measure but a much lower ranking on the basis of the
Sharpe performance measure. Any difference in rank would come directly from a difference in
diversification.
Therefore, these two performance measures provide complementary yet different information,
and both measures should be used. If you are dealing with a group of well-diversified portfolios
the two measures provide similar rankings.

2. Treynor’s portfolio performance measure: (RP-RF)/βp

Treynor developed the first composite measure of portfolio performance that included risk. He
postulated two components of risk: (1) risk produced by general market fluctuations and (2) risk
resulting from unique fluctuations in the portfolio securities. To identify risk due to market
fluctuations, he introduced the characteristic line, which defines the relationship between the
rates of return for a portfolio over time and the rates of return for an appropriate market portfolio.
He noted that the characteristic line’s slope measures the relative volatility of the portfolio’s
returns in relation to returns for the aggregate market the slope is the portfolio’s beta coefficient.
A higher slope (beta) characterizes a portfolio that is more sensitive to market returns and that
has greater market risk.

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Deviations from the characteristic line indicate unique returns for the portfolio relative to the
market. These differences arise from the returns on individual stocks in the portfolio. In a
completely diversified portfolio, these unique returns for individual stocks should cancel out. As
the correlation of the portfolio with the market increases, unique risk declines and diversification
improves. Because Treynor was not concerned about this aspect of portfolio performance, he
gave no further consideration to the diversification measure.
The slope of this portfolio possibility line (designated T) is equal to:

R i−RFR
T¿ βi

Where:
Ri = the average rate of return for portfolio i during a specified time period
RFR = the average rate of return on a risk-free investment during the same time period
βi = the slope of the fund’s characteristic line during that time period (this indicates the
portfolio’s relative volatility)

As noted, a larger T value indicates a larger slope and a better portfolio for all investors
(regardless of their risk preferences). Because the numerator of this ratio (Ri – RFR) is the risk
premium and the denominator is a measure of risk, the total expression indicates the portfolio’s
risk premium return per unit of risk. All risk-averse investors would prefer to maximize this
value. Note that the risk variable beta measures systematic risk and tells us nothing about the
diversification of the portfolio. It implicitly assumes a completely diversified portfolio, which
means that systematic risk is the relevant risk measure.
Like Sharpe’s, Treynor’s measure gives excess return per unit of risk, but it uses systematic
risk instead of total risk.
Example: To understand how to use and interpret this measure of performance, suppose that
during the most recent 10-year period, the average annual total rate of return on an aggregate
market portfolio was 14 percent (RM = 0.14) and the average nominal rate of return on
government T-bills was 8 percent (RFR = 0.08). Assume that, as administrator of a large pension
fund that has been divided among three money managers during the past 10 years, you must
decide whether to renew your investment management contracts with all three managers. To do
this, you must measure how they have performed.

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Assume you are given the following results:

Portfolio Average annual rate of return Beta

W 0.12 0.90
X 0.16 1.05
Y 0.18 1.20

You can compute T values for the market portfolio and for each of the individual portfolio
managers as follows:

0.14−0.08
TM = 1
=0.060

0.12−0.08
TW = 0.90
=0.044

0.16−0.08
TX = 1.05
=0.076

0.18−0.08
TY = 1.20
=0.083

These results indicate that Investment Manager W not only ranked the lowest of the three
managers but did not perform as well as the aggregate market. In contrast, both X and Y beat the
market portfolio, and Manager Y performed somewhat better than Manager X.

3. Jensen’s measure: RP -[RF + βp (rm- rf)]

Jensen’s measure is the average return on the portfolio over and above that predicted by the
CAPM, given the portfolio’s beta and the average market return. Jensen’s measure is the
portfolio’s alpha value. The Jensen measure is similar to the measures already discussed
because it is based on the capital asset pricing model (CAPM). All versions of the CAPM
calculate the expected one-period return on any security or portfolio by the following
expression:
E (Rj) = RFR + βj [E (RM) – RFR]
Where:
E (Rj) = the expected return on security or portfolio j

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 RFR = the one period risk-free interest rate
βj = the systematic risk (beta) for security or portfolio j
E (RM) = the expected return on the market portfolio of risky assets
The expected return and the risk-free return vary for different periods. Consequently, we are
concerned with the time series of expected rates of return for Security or Portfolio j. Moreover,
assuming the asset pricing model is empirically valid; you can express the Equation above in
terms of realized rates of return as follows:
Rjt = RFRt + βj [Rmt – RFRt ] + ejt
This equation states that the realized rate of return on a security or portfolio during a given time
period should be a linear function of the risk-free rate of return during the period, plus a risk
premium that depends on the systematic risk of the security or portfolio during the period plus a
random error term (ejt). Subtracting the risk-free return from both sides, we have
Rjt – RFRt = βj[Rmt – RFRt] + ejt
This shows that the risk premium earned on the jth portfolio is equal to βj times a market risk
premium plus a random error term. In this form, an intercept for the regression is not expected if
all assets and portfolios were in equilibrium.
Alternatively, superior portfolio managers who forecast market turns or consistently select
undervalued securities earn higher risk premiums than those implied by this model. Specifically,
superior portfolio managers have consistently positive random error terms because the actual
returns for their portfolios consistently exceed the expected returns implied by this model. To
detect and measure this superior performance, you must allow for an intercept (a nonzero
constant) that measures any positive or negative difference from the model. Consistent positive
differences cause a positive intercept, whereas consistent negative differences (inferior
performance) cause a negative intercept. With an interceptor nonzero constant, the earlier
equation becomes
Rjt – RFRt = αj + βj[Rmt – RFRt] + ejt
The αj value indicates whether the portfolio manager is superior or inferior in market timing
and/or stock selection. A superior manager has a significant positive α (or “alpha”) value because
of the consistent positive residuals. In contrast, an inferior manager’s returns consistently fall
short of expectations based on the CAPM model giving consistently negative residuals. In such a
case, α is a significant negative value.

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The performance of a portfolio manager with no forecasting ability but not clearly inferior equals
that of a naive buy-and-hold policy. In the equation, because the rate of return on such a portfolio
typically matches the returns you expect, the residual returns generally are randomly positive and
negative. This gives a constant term that differs insignificantly from zero, indicating that the
portfolio manager basically matched the market on a risk-adjusted basis. Therefore, the α
represents how much of the rate of return on the portfolio is attributable to the manager’s ability
to derive above-average returns adjusted for risk. Superior risk-adjusted returns indicate that the
manager is good at either predicting market turns, or selecting undervalued issues for the
portfolio, or both.

Calculating Portfolio Risk

While there may be different definitions of risk, one widely-used measure is called variance.
Variance measures the variability of realized returns around an average level. The larger the
variance the higher the risk in the portfolio will be.
Variance is dependent on the way in which individual securities interact with each other. This
interaction is known as covariance. Covariance essentially tells us whether or not two securities
returns are correlated. Covariance measures by themselves do not provide an indication of the
degree of correlation between two securities. As such, covariance is standardized by dividing
covariance by the product of the standard deviation of two individual securities. This
standardized measure is called the correlation coefficient.
Example: Oliver’s portfolio holds security A, which returned 12.0% and security B, which
returned 15.0%. At the beginning of the year 70% was invested in security A and the remaining
30% was invested in security B. Given a standard deviation of 10% for security A, 20% for
security B and a correlation coefficient of 0.5 between the two securities, calculate the portfolio
variance.
σ2p = w2A σ2A + w2B σ2B + 2wAwB σA σ B rAB

Portfolio Variance = (.72x102) + (.32x202) + (2x.7x.3x10x20x.5) = 127

Portfolio standard deviation is the square root of the portfolio variance.

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 σΡ = √ 127 = 11 .27 %
Correlation Coefficients
COV AB
rAB¿ σA σB

Correlation is the covariance of security A and B divided by the product of the standard
deviation of these two securities. It is a pure measure of the co-movement between the two
securities and is bounded by –1 and +1.
 A correlation of +1 means that the returns of the two securities always move in the same
direction; they are perfectly positively correlated.
 A correlation of zero means the two securities are uncorrelated and have no relationship to
each other.
 A correlation of –1 means the returns always move in the opposite direction and are
negatively correlated.
Portfolio risk can be effectively diversified (reduced) by combining securities with returns that
do not move in tandem with each other.
Example:
What happens to the portfolio standard deviation (risk) when the two securities are negatively
correlated rather than positively correlated? Using the same data as in Example above but now
with negative correlation equal to -.5:
Portfolio Variance = (.72x102) + (.32x202) + (2x.7x.3x10x20x (-.5)) = 43
Portfolio Standard Deviation = (43) .5 = 6.55%
The portfolio’s risk is reduced from 11.27% to 6.55% when securities that are negatively
correlated are combined.

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