Portfolio Management: Construction,

Revision and Evaluation

¾ Introduction
¾ Preferences of Investors
¾ Tax Provisions
¾ Portfolio Management Objectives
¾ Risk Return Analysis
¾ Time Horizon of Strategy
¾ Efficient Portfolio
¾ Market Efficiency Theorem
¾ Objectives for Portfolio Construction
¾ Portfolio Revision
¾ Criteria for Evaluation of Portfolio Performance
 Introduction
This chapter throws lights on different aspects in
management of portfolio. The portfolio theory is relates
to the efficient portfolio investment in financial and
physical assets. The portfolio of individual or corporate
unit is consisting of securities and investment in assets.
Such investment is result of individual preferences and
decisions of the holders, regarding risk, return and
number of other considerations.
Let’s start by looking some of the preferences of
the investors.
 Preferences of Investors
Preferences of Investors

Income and Saving Decision

Asset Preference Profile

Investors Objectives, Constraints

Tax Brackets

Time Horizon.

The above chart represents some of the

important preferences of investors. This will
constitute the data base of the investor or client.
 Objectives of Investors
The objectives of investors may be income,
capital appreciation, future provision for contingencies
such as marriage, birth, death, retirement etc. Some
amount of savings must be kept in most liquid form,
such as cash or FD’s to meet day to day needs. Though
the cash earn no interest and FD’s would earn 4% to
6% of interest. The same is nullified by inflation rate.
That is why the amount kept in cash or FD’s is bare
minimum.
 Motives of Investments

After seeing preferences and objectives of investors,

now let’s look at the different motives of investment.
Following are different motives of investments.
1. Capital Appreciation.
2. Income.
3. Liquidity or Marketability.
4. Safety or Security.
5. Hedge against Inflation.
 Tax Provisions

While investing one should not forget these

important terms. Tax and Capital gain. Income from some
of the securities is tax exempted. For e.g. PSU Bonds,
Central Government Securities, N.S.C. etc. This
exemptions however not applicable to N.S.C. VIII issue,
Kisan Vikas Patra, etc. Investor has to look after the
return from each investment to ensure maximum return
with minimum liability.
 Capital Gain

The other income source in this context is Capital

Gain. This refers to profit earned by way of transfer, sale,
or exchange of capital assets. These gains are long term
gains. Under Section 54E and 54F of Income-Tax Act,
long term capital gains are exempted, if these funds are
invested in Central Government securities, UTI or CGI
Schemes and other specified semi-government bodies.
 Objectives for Portfolio Construction
The basic objective of portfolio management is
to maximise the return while minimising the risk.
Although there are other ancillary objectives as per the
needs of investors. Those are as below;
1. Stable or Regular Return
2. Appreciation of Capital
3. Safety of Investment
4. Marketability and Liquidity
5. Minimising of Tax Liability
 Risk Return Analysis
Every investments have some risks. Investment in
equity has larger risk. These risks are arise out of
number of factors. There are two types of risks.
i] Market Risk ii] Company Risk. The former can be
reduced by using Beta values of companies, while later
are handled by diversifying the securities. There is
direct relationship between risk and return. This
analysis helps investors or portfolio managers in
managing portfolio to the optimum level.
 Time Horizon of Strategy
Every investment strategy should have a time
horizon from a short period of one year to a few years.
Capital gains is considered long-term if equity
investment is for at least one year and other types of
investment for at least three years.
Below mentioned are three major categories of
activities which Portfolio management encompasses.
1. Asset Allocation.
2. Review and shift between classes of assets.
3. Security Selection within each Asset class.
 Risk and Types
Till now we have seen the major types of risk. Those are
Market Related and Company Related. But there are other risks
also, which are elaborated with brief explanations by chart below.

Types of Risks

Liquidity Premium Risk

Related to time period of holding

Default Premium Risk

Related to repayment of principal

Group Related Risk

Pertaining to a group of industries

Specific Risk
Related to specific company
 Efficient Portfolio
Every portfolio manager tries hard to make his
portfolio an efficient portfolio. For that he has to adopt
different techniques of combinations of assets. Then he
has to worked out the expected returns from these
portfolios. The risk part is to be estimated by measuring
standard deviation of different portfolio returns.
The efficient portfolio can be estimated by
presenting the various portfolios in terms of expected
return and standard deviations as shown in the tabular
format next slide.
 Efficient Portfolio
Portfolio Expected Return (Risk) Standard
From the along side table No. In % Deviation
if we compare portfolio Nos. 4
and 5, we see that for the same 1 5 1
standard deviation of 5, portfolio 2 7 2
No.5 gives an expected return of
3 8 3
11% higher than that on No. 4,
thereby making it an efficient 4 10 5

portfolio. If we compare 5 11 5
portfolio Nos. 6 and 7, we see
6 12 5
that with the same return of 12%
7 12 7
in both the portfolios, standard
deviation is lower in portfolio 8 14 10
No. 6. Thus, portfolio No. 6 is an 9 18 12
efficient portfolio.
 Market Efficiency Theorem
The market behaviour is outside of investor’s control, he can only
reduce the specific components of risk by choosing the individual scrips with
proper Betas to achieve desire result of lower risk. In the real world, there are
three different levels of efficiency of the stock market. Those are represented
by chart with brief descriptions.

Efficiency of Market

Weak Form
The successive changes in stock prices are independent of each other

Semi-strong Form
Stock prices adjust rapidly to all new public information

Strong Form
Stock prices fully reflect public and privately-held information
 Portfolio Management
Portfolio Management is the process
encompassing many activities of investment in assets
and securities. The objective of this service is help to the
novices and unintended investors with the expertise of
professionals in portfolio management. It involves
firstly, construction of a portfolio, based upon the fact
sheet of the investor. Secondly, the portfolio is reviewed
and adjusted from time to time in tune with the market
conditions. Thirdly, the evaluation of the same is to be
done by manager in terms of targets set for risk and
return.
 Elements of Portfolio Management
Portfolio management is continuous process
which involves following elements.
1. Identification of investor’s objectives.
2. Strategies according to investment policy.
3. Review and monitoring of performance.
4. Evaluation of portfolio for the result.
Let’s look each of these in brief.

1. The collection of data on the investors preferences,

objectives etc. is the foundation of portfolio
management.
 Execution of Strategy

2. The next stage is implementation and

execution of this investment process. This is the
most critical process in the portfolio management.
Because, the research, analysis of manager are key
inputs in the process. His initiative, innovation and
judgment would be the basis of his success in
management.
 Monitoring

Reviewing and monitoring of portfolios is third

step in portfolio management. This has to be done
because to take the advantage of the market conditions
and industry performance. This is again a continuous
process which involves, assess with current portfolio
goals, changes in investors preferences, capital market
conditions etc.
 Investment Alternative
The investment alternatives for portfolio management are stated below;

Alternatives
Asset Class
Equity, Preference Shares, Debentures, PSU Bonds, Govt.
Securities, Company Deposits, etc.

Industry Groups
Textiles, Cement, Aluminium, Fertilizers, Paper etc.

High Income Yield Securities

Blue chips companies and growth stock.

Companies with Export Orientation

Mutilocational Companies

Type of Management
Family type, Professional type etc.
 Building of Portfolio
The portfolio construction, as referred to earlier, is
made on the basis of the investment strategy, set out for
each investor. It is done through different assets classes,
specific scrips, instruments of investments, for e.g.
bonds or equities of different risks and return
characteristics, the choice of tax characteristics, risk
level and other features of investment. Combining all
together with judgment of market conditions a
successful portfolio is built.
 Portfolio Revision
Revision refers to change in original pattern.
Portfolio revision thus refers to change in selection of
scrips and bonds etc. this is due to changes in market
price and reassessment of companies and the portfolio
Beta. A change in interest rate will also affect the
portfolio through change in duration.
Thus, any portfolio requires constant monitoring
and revision. Operation on a portfolio will takes place on
a daily basis, keeping in mind the target Beta, duration
and most importantly return.
Security Pricing and Portfolio Management
Portfolio Management is based upon Security
Analysis, which is an analysis of shares prices.
Theories Explaining this Analysis are as below;
1. Fundamentalist Theory
2. Chartist School
3. Random Walk School
Out of these three first two deals with Investment
Decision-Making. And the third one’s assumption is
Price move Independent of past trends and hence return.
 Evaluation of Portfolio Performance
As seen earlier portfolio managers and investment
analysts continuously monitor and evaluate the result of
their performance. The ability of managers to out
perform the market depends on their expertise and
experience. The two major factors which influence his
performance are the return achieve and the level of risk
that the portfolio is exposed to. The manager has to
make proper diversification into different industries,
assets classes to reduce the unsystematic risk to
minimum level.
 Criteria for Evaluation
To review the performance of portfolio, investors
who manages their own portfolios constantly monitor
market trend, Betas of companies and accordingly they
take decision to alter the scrips or diversify the assets.
In this context. Evaluation has to take into account
whether the portfolio secured above average return,
average or below average return as compared to market
return.
Superior timing and superior stock selection may
result in above average return.