What is a Financial Portfolio?

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).

Portfolio management is the process of managing individuals' investments so that they

maximize their earnings within a given time horizon. Furthermore, such practices ensure that
the capital invested by individuals is not exposed to too much market risk.

1. Selection: This initial activity involves choosing the most suitable investments to align
with your overall goals and risk tolerance.
 Example: An investor with a long-term investment horizon and a high-risk tolerance
might select a mix of growth stocks and growth mutual funds. These investments have
the potential for high returns but also carry greater risk of price fluctuations.
2. Management: Once you've selected your investments, the management phase involves
actively monitoring their performance and making adjustments as needed. This could
involve rebalancing your portfolio to maintain your target asset allocation or selling
underperforming assets.
 Example: An investor who owns a portfolio of stocks and bonds might monitor market
conditions and economic news. If the stock market experiences a downturn, they might
rebalance their portfolio by selling some stocks and buying more bonds to reduce overall
risk.
3. Evaluation: This ongoing activity involves assessing the effectiveness of your chosen
investments in meeting your financial goals. You'll regularly measure the performance of
your portfolio and compare it to your initial objectives.
 Example: An investor aiming for a specific retirement goal might evaluate their portfolio
performance annually. They'd track the return on their investments and adjust their
strategy if needed to ensure they stay on track to reach their target retirement corpus.

By following these steps, you can create a more structured and goal-oriented approach to
managing your assets and investments. Remember, this is a continuous process, and you'll need
to adapt your strategy based on market conditions and your evolving financial needs.
FOUR TRADITIONAL OBJECTIVES OF PORTFOLIO MANAGEMENT
1. Stability of principal: This objective prioritizes protecting the initial amount you
invested. It focuses on minimizing losses and ensuring your principal remains intact.
Example: An investor nearing retirement might prioritize stability of principal by
allocating a larger portion of their portfolio to safe haven assets like government bonds.
These bonds offer lower returns but are generally considered less volatile than stocks.
2. Income: This objective aims to generate regular cash flow from your investments. This
income can be used to supplement your lifestyle or reinvest for further growth.
Example: An investor relying on their portfolio for income might invest in dividend-
paying stocks or interest-bearing bonds. These investments provide regular payouts that
can help meet their ongoing financial needs.
3. Growth of income: This objective builds upon the income objective by seeking
investments that have the potential to increase their payouts over time.
Example: An investor with a long-term investment horizon might invest in dividend-
growth stocks. These companies have a history of raising their dividends regularly,
offering the potential for increasing income over the years.
4. Capital appreciation: This objective focuses on growing the overall value of your
portfolio through asset price increases. This strategy targets long-term growth for your
principal investment.
Example: An investor with a high-risk tolerance might invest in growth stocks. These
companies have the potential for significant stock price appreciation but also come with
greater volatility.

It's important to remember that these objectives often work together, and the ideal
balance will vary depending on your individual circumstances and financial goals. You might
prioritize a combination of these objectives depending on your age, risk tolerance, and
investment timeline.
Portfolio Performance Measures (Risk Adjusted Performance Measures)
1. Sharpe Ratio

Purpose: The Sharpe Ratio measures the risk-adjusted return of an investment by considering
both the return and the volatility (risk) of the investment. It helps investors assess whether the
return of an investment is worth the risk taken.

Difference: It uses the standard deviation of returns as a measure of risk and compares the excess
return over the risk-free rate to the riskiness of the investment.

2. Treynor Ratio

Purpose: The Treynor Ratio also measures the risk-adjusted return of an investment, but it
specifically focuses on systematic risk, which is the risk that cannot be diversified away. It helps
investors assess whether the return of an investment adequately compensates for its systematic
risk.

Difference: It uses beta (systematic risk) as a measure of risk instead of standard deviation,
making it particularly useful for evaluating the performance of diversified portfolios relative to
the market.

3. Jensen’s Alpha

Purpose: Jensen’s Alpha measures the risk-adjusted performance of an investment by comparing

its actual return to the return predicted by the Capital Asset Pricing Model (CAPM), which
considers the systematic risk of the investment. It helps investors determine whether a portfolio
manager has added value beyond what would be expected given the level of systematic risk.

Difference: It explicitly considers the relationship between the investment's return and its
systematic risk as predicted by CAPM, providing insight into the manager's skill in generating
excess returns.

4. Information Ratio:

Purpose: The Information Ratio measures the risk-adjusted return of an investment relative to a
specific benchmark, focusing on the active (non-market) risk taken by the portfolio manager. It
helps investors evaluate the manager's ability to outperform a benchmark after adjusting for
active risk.

Difference: It compares the excess return of the portfolio to the benchmark to the standard
deviation of the portfolio's excess returns over the benchmark, providing a measure of the
manager's skill in selecting securities or making active investment decisions.