CHAPTER 1

INTRODUCTION TO PORTFOLIO
MANAGEMENT

Table of Contents

INTRODUCTION TO PORTFOLIO MANAGEMENT ................................................................ 1

Table of Contents ........................................................................................................................ 1
Chapter Overview ........................................................................................................................ 2
Learning Objective: ..................................................................................................................... 2
Introduction ................................................................................................................................. 2
1.2 Portfolio Management Process ............................................................................................ 4
Portfolio Management Process ................................................................................................ 4
1.3 The Development of Modern Portfolio Theory ................................................................... 6
1.4 Traditional Portfolio Management vs Modern Portfolio Management .............................. 6
1.5 Asset Allocation .................................................................................................................. 6
1.5.1 Approaches to Asset Allocation .................................................................................. 7
Checklist ...................................................................................................................................... 8
Study Questions ........................................................................................................................... 8
Chapter 1 Introduction to Portfolio Management

Chapter Overview

Introduction To Portfolio Management

Introduction

Portfolio Management Process

The Development of Modern

Portfolio Theory

Traditional Management versus

Modern Portfolio Management

Asset Allocation

Learning Objectives:
After learning this chapter, you will be able to:

1. Discuss the basic concept of portfolio management process.

2. Identify the various steps in portfolio management process.
3. Describe the role of asset allocation and asset classes for portfolio management.

1.1 Introduction
For most of our life, we will be earning and spending. Sometime we have more money than what
we want to spend. Sometime we may want to spend more than what we can afford. This
imbalances will lead us to borrow or to save to maximize our long run benefits from our income.
When our current income exceeds current consumption desires, we tend to save the excess. What
we do with the savings to make them increase over time is investment.

According to Reilly and Brown (2000), investment is the current commitment of dollars for a
period of time in order to derive future payments that will compensate the investor for:

i. the time the funds are committed,

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ii. the expected rate of inflation,

iii. the uncertainty of the future payments.

The investor can be an individual (types of investment: stock, bonds, commodities or real estate),
a government or a corporation (types of investment: plant, equipment). Lets emphasizes
investments by individual investors where the investors are trading a known dollar amount today
for some expected future stream of payments that will be greater than the current outlay. Every
investor hope for some positive return from their investment such as price appreciation, dividend
payment, interest income or certain tax benefits.

The investors always select investments that will give them their required rates of return.
However, investors faced a real risk that their actual return might fall short of their expectation.
Therefore, an investor must be able to determine the best combination of risk and return. In
making investment decisions, an investor should be able to measure the risk and return of an
investment and be able to choose investment with the most favorable combination of risk and
return to suit their financial situation. We will discuss return and risk measurement in the later
section.

What is portfolio? Portfolio is a set of securities (holding more than one security at a time), are
thought of as helping to spread risk over many securities. Traditional portfolio planning called for
the selection of those securities that best fit the personal needs and desires of the investor.
Modern portfolio looking for optimum results based on estimates of risk and return of the
portfolio and the attitudes of the investor toward a risk-return trade-off stemming from analysis of
the individual securities.

Why portfolio? Individual securities carry some degree of risk. Risk was defined as the standard
deviation around the expected return. More dispersion or variability about a security’s expected
return meant the securities more risky than one less dispersion. The simple fact that securities
carry differing degree of expected risk lead most investors to the notion of holding more than one
security at a time, in an attempt to spread risk by not putting all their eggs into one basket.

Effort to spread and minimize risk takes the form of diversification. Diversify means invest in
more than one securities which have different risk characteristics.

What is Portfolio Management?

Portfolio Management refer to the handling of a pool of investible funds so that it yields an
appropriate return consistent with the risk associated with the portfolio.

The goal of portfolio management is to assemble various securities (assets) into portfolio that
address investor needs and then to manage those portfolio so as to achieve investment objectives.

The word portfolio is the collection of investment or a group of assets. It stresses the
importance of the total collection of asset held an appropriate measures of investor welfare,
emphasizes the importance of diversification and the balancing of risk and return from a
total portfolio viewpoint. In other words portfolio help investor decide on realistic
investment goals about financial market and financial risk.

Portfolio management consists of three major activities:

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1. asset allocation
2. shifts in weighting across major asset classes
3. security selection within asset classes

Asset allocation can be described as the blending together of major asset classes to obtain return
at lowest risk. The weighting asset classes have to shift in order to improve return prospects over
the longer-term objective. Also, return prospect can be improved by selecting securities that have
above-average expected return within the individual asset classes.

1.2 Portfolio Management Process

Portfolio management is a dynamic continuous and systematic one, which involves with the
following elements:

i. set objectives
ii. develop and implements strategies
iii. monitors market and investor conditions
iv. review and adjust the portfolio.

Effect of Diversification.

The primary objective of constructing an investment portfolio is to spread investment risks by

diversifying into more than one type of assets which carry different degree of expected risk of
return as discuss in chapter two. However, in the portfolio management process, it involved with
five steps.
Portfolio Management Process

Objectives

Security Analysis

Portfolio Analysis

Portfolio Selection

Portfolio Performance Evaluation

Step 1: Objectives
Objective is like a road map for traveler. This objective provides a basic, useful framework for
selecting individual investment vehicles for the portfolio. The investors have to set their
objective. Their objectives based on policy statement in which specify the type of risks they are
willing to take and their investment goals and constraints.

Step 2: Security Analysis

Security analysis is the process to identify which security should be bought and include in the
portfolio. The focus of the security analysis is to develop and analyze the probability return

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distribution for investment that the investor is considering purchasing. From these data, measures
of risk and expected return for each security are computed. Risk and expected return measures
generated from the security analysis are then used as inputs for the next step, portfolio analysis.

Step 3: Portfolio Analysis

In the portfolio analysis, the measures of risk and expected return of individual securities are used
to construct optimal portfolios. An optimal portfolio dominates all other portfolios as its level of
risk and expected return. Specifically, an optimal portfolio is defined as a portfolio that either: 1)
maximizes expected return for a given level of risk or (2) minimizes risk for a given level of
return. The set of portfolio combinations that produces the lowest possible levels of risk at each
possible level of expected return is called the efficient frontier. The efficient frontier is the set of
optimal or dominant portfolios that provide the lowest levels of risk at a given level of expected
return. Because different investors may choose different levels of desired returns, there is an
infinite number of optimal portfolios that can be constructed from a given set of investments and
their risks and expected returns. There are several techniques that can be used to identify this set
of optimal portfolios.

Step 4: Portfolio Selection

Once the efficient set, or the set of optimal portfolios, is identified, investors need to pick the one
portfolio that matches their preference for expected return and their dislike of risk. Investor
preference can be measured by what is called utility, and each investor has a somewhat different
utility or preference function. That is, one investor may like a portfolio with high expected return
and high risk, whereas another individual may feel more comfortable with a lower expected
return , lower risk portfolio. Regardless of their risk/expected return preferences, they will
maximize their trade-off between expected return and risk as long as they select a portfolio from
optimal, or efficient, set of portfolios.

Step 5: Portfolio Performance Evaluation

Once an investor has chosen an optimal portfolio, it should be evaluated periodically to determine
if it still meets the risk and expected return objectives. If it does not, then a restructuring of the
portfolio may be required. Portfolio management is a dynamic process. This is in respond to: 1)
unsatisfactory performance, 2) a change in investor’s preferences, 3) a change in market
conditions, and 4) changes in the characteristics of the assets themselves.

According to Reilly and Brown (2000), there are four steps in the portfolio management process.

Once the funds are initially invested according to plan, the real work begins in monitoring and
updating the status of the portfolio and the investor’s needs. The are four steps involve in the
portfolio management process. Step one: Policy Statement that focus: investor’s short-term and
long-term needs, familiarity with capital market history, and expectations. Step two: Examine
current and projected financial, economic, political, and social conditions. Focus: Short-term and
intermediate-term expected conditions to use in constructing a specific portfolio. Step three.
Implement the plan by constructing the portfolio. Focus: Meet the investor’s needs at minimum
risk levels. Step four: Feedback loop: Monitor and update investor needs, environmental
conditions, evaluate portfolio performance.

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. The evaluation of portfolio
performance will be discussed in the later section (chapter 27 of Reilly & Brown).

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1.3 The Development of Modern Portfolio Theory

The beginnings of modern portfolio theory dated 1952 when Harry Markowitz , the father of
modern portfolio theory, published a paper entitled “Portfolio Selection” . In it, he showed how
to create a frontier of investment portfolios, such that each of them had the greatest possible
expected rate of return, given their level of risk. A student of Markowitz named William Sharpe
(1963) developed a simplified version of technique which is now referred to as the single-index
model. This simplified version made portfolio theory practical even when managing large
numbers of securities. Prior to the dessemination of portfolio theory into the real world, Sharpe
(1964), Litner (1965) and Mossin (1966) developed a model known as the Capital Asset Pricing
Model.This model reigned as the premier model in the field of finance. However, this model
become controversial and still heated debate today. An alternative to the CAPM was being
developed by Steve Ross (1976). This model was called the arbitrage pricing theory. This theory
argued that expected return must be related to risk in such a way that no single investor could
create unlimited wealth through arbitrage. As researchers were attempting to determine the nature
of the pricing structure in the securities markets, the issue of how efficient the market was in
pricing to its structure was called into question. In 1965, the Ph.D. dissertation of Eugene Fama
was published and so called Efficient Market Hypothesis. Of Fama’s dissertation, securities
prices reflect less than the complete set of information available to the diligent investor.

1.4 Traditional Portfolio Management vs Modern Portfolio

Management
Traditional security analysis differs in emphasis from modern security analysis. The former
emphasizes the calculation of an intrinsic value. The intrinsic value is used to compare with the
security’s current market price. If the current market price is below the intrinsic value, a purchase
is recommended. Conversely, if the current market price is above this intrinsic value, a sale is
recommended. While the latter emphasizes risk-and-return estimates. Portfolio management is
also characterized by an old and new way of solving the portfolio problem.

Traditional portfolio planning called for the selection of securities that best fit the personal needs
and desires of the investors. For example, a young, aggressive, single adult, would be advised to
buy stocks in newer, dynamic, rapidly growing firms. A retired widow would be advised to
purchase stocks and bonds in old-line, established, stable companies, such as utilities.

Modern portfolio theory suggests that the traditional approach to portfolio analysis, selection and
management may yield less than optimal results- that a more scientific approach is needed, based
on estimates of risk and return of the portfolio and the attitudes of the investor toward a risk-
return trade-off stemming from the analysis of the individual securities.

1.5 Asset Allocation

Once an investor’s needs are converted into specific portfolio objectives, a portfolio designed to
achieve this goal can be constructed. Before buying any asset, the investor must develop asset
allocation scheme. Asset allocation involves dividing one’s portfolio into various asset classes,
such as common stocks, bonds, foreign securities, short-term securities, and other asset like real
estate. The emphasis of asset allocation is on preservation of capital – protecting against negative

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developments while taking advantage of positive development. Asset allocation although similar
to diversification in its objective, it is bit different: Its focus is on investment in various asset
classes, whereas diversification tends to focus more on investing in various asset within an asset
class.

Asset allocation is based upon the belief that the total return of a portfolio is influenced more by
the division of investment into asset classes than by the actual investments.

1.5.1 Approaches to Asset Allocation

There are three basic approaches to asset allocation:

i) Fixed Weightings
ii) Flexible Weightings
iii) Tactical Asset Allocation

i) Fixed Weighting

Under this approach, a fixed percentage of the portfolio is allocated to each of asset categories, of
which there typically are three to five. Assuming four categories – common stocks, bonds,
foreign securities and short-term securities, a fixed allocation might be:

Category Allocation
Common Stock 35%
Bonds 50%
Foreign Securities 10%
Short-term securities 5%
Total Portfolio 100%

Generally, the fixed weighting do not change over time. Because of shifting market values, the
portfolio may have to be adjusted annually or after major market moves to maintain the desired
fixed percentage allocation.

ii) Flexible Weighting

This approach involves the periodic adjustment of the weights for each asset category based on
market analysis (i.e. market timing) The use of a flexible weighting scheme is often called
strategic asset allocation. For example, the initial and new allocation based on a flexible
weighting scheme may be:

Category Initial Allocation New Allocation

Common Stock 35% 40%
Bonds 50% 30%
Foreign Securities 10% 15%
Short-term securities 5% 15%
Total Portfolio 100% 100%

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The allocation may have resulted from an expectation of lower inflation, which was expected to
result in increased common stock and bond prices and a decline in foreign and short-term
securities. The weighting were therefore changed to captured greater returns in changing market.

iii) Tactical Asset Allocation

The third approach uses stock-index futures and bond futures to change a portfolio’s asset
allocation. When stock seem less attractive than bonds, this strategy involves selling stock-index
futures and buying bond futures. Conversely, when bonds seem less attractive than stock, the
strategy results in buying stock-index futures and selling bond futures.

Checklist
After going through this chapter you should be able to:

Discuss the basic concept of portfolio management process.

Identify the various steps in portfolio management process.

Describe the role of asset allocation and asset classes for portfolio management.

Study Questions

1. Discuss the overall purpose of portfolio management. Define Portfolio Management.

2. Briefly discuss the various steps involved in portfolio management process.

3. What are the basic approaches used in asset allocation? Briefly explain each approach
used.