An Introduction to

Portfolio
Management
What is a portfolio?

 A portfolio is a collection of financial

investments like stocks, bonds,
commodities, cash, and cash equivalents,
including mutual funds. People generally
believe that stocks, bonds, and cash
comprise the core of a portfolio. Though this
is often the case, it does not need to be the
rule. A portfolio may contain a wide range
of assets including real estate, art, and
private investments.
 One of the key concepts in
portfolio management is the wisdom of
diversification—which simply means not putting
all of your eggs in one basket. Diversification
tries to reduce risk by allocating investments
among various financial instruments, industries,
and other categories.

 It aims to maximize returns by investing in

different areas that would each react differently
to the same event. There are many ways to
diversify.
 Regardless of your portfolio's asset mix, all
portfolios should contain some degree of
diversification, and reflect the investor's
tolerance for risk, return objectives, time
horizon, and other pertinent constraints,
including tax position, liquidity needs, legal
situations, and unique circumstances.
A Portfolio Investment
When you use a portfolio for investment
purposes, you expect that the stock, bond,
or another financial asset will earn a return
or grow in value over time, or both. A
portfolio investment may be either strategic
—where you buy financial assets with the
intention of holding onto those assets for a
long time; or tactical—where you actively
buy and sell the asset hoping to achieve
short-term gains.
Types of Portfolios

 There can be as many different types of portfolios

and portfolio strategies.
 A Hybrid Portfolio
 The hybrid portfolio approach diversifies across
asset classes. Building a hybrid portfolio requires
taking positions in stocks as well as bonds,
commodities, real estate, and even art. Generally,
a hybrid portfolio entails relatively fixed proportions
of stocks, bonds, and alternative investments. This
is beneficial, because historically, stocks, bonds,
and alternatives have exhibited less than perfect
correlations with one another.
 An Aggressive, Equities-Focused Portfolio
The underlying assets in an aggressive portfolio generally
would assume great risks in search of great returns.
Aggressive investors seek out companies that are in the early
stages of their growth and have a unique value proposition.
Most of them are not yet common household names.

A Defensive, Equities-Focused Portfolio

A portfolio that is defensive would tend to focus on
consumer staples that are impervious to downturns.
Defensive stocks do well in bad times as well as in good
times. No matter how bad the economy is at a given time,
companies that make products that are essential to everyday
life will survive.
A Speculative, Equities-Focused
Portfolio
A speculative portfolio is best for investors
that have a high level of tolerance for risk.
Speculative plays could include
initial public offerings (IPOs) or stocks that
are rumored to be takeover targets.
Technology or healthcare firms in the
process of developing a single breakthrough
product also would fall into this category.
 One basic assumption of portfolio theory is that investors
want to maximize return from the total set of investments
for a given level of risks.

 Portfolio theory assumes that investors are basically risk

averse. Meaning given a chance between two assets with
equal rates of return , they will select the assets with the
lower level of risks.

 Similar to risk tolerance, investors

should consider how long they have to invest when building
a portfolio. In general, investors should be moving toward a
conservative asset allocation as their goal date approaches,
to protect the portfolio's earnings up to that point.
 For example, a conservative investor might favor a portfolio
with large-cap value stocks, broad-based market index
funds, investment-grade bonds, and a position in liquid,
high-grade cash equivalents.

 Take, for example, an investor saving for retirement who's

planning to leave the workforce in five years. Even if that
investor is comfortable investing in stocks and riskier
securities, they might want to invest a larger portion of the
portfolio in more conservative assets such as bonds and
cash, to help protect what has already been saved.
Conversely, an individual just entering the workforce may
want to invest their entire portfolio in stocks, as they may
have decades to invest, and the ability to ride out some of
the market's short-term volatility.
Alternative measure of risk
 Variance or S.D of expected return.
 It is a statistical measure of the dispersion of returns around
the expected value .

 The formula for expected return is

 E(Rport)=ΣwiRi

Where
 W=the weight of an individual asset in the portfolio, or the

percent of the portfolio in Asset

 R= expected rate of return

Weight Expecte Expected
(w) d portfolio
(perce Security return(wi*Ri)
nt of return(R
portfoli )
o
0.20 .10 0.0200
0.30 .11 0.0330
0.30 .12 0.0360
0.20 .13 0.0260
E(Rport ) = 0.1150
Variance of returns for a
portfolio
 Covariance of returns: Covariance is a
measure of the degree to which two variable
move together relative to their individual
mean value over time. In portfolio analysis
we usually are concerned with covariance of
rates of return rather than prices or some
other variables.
 The value of the covariance can be both
positive or negative.

 Covij= E{[Ri-E(Ri)][Rj-E(Rj)]}
Covariance and correlation
 rij= Covij/σiσj

 rij= Correlation coefficient of returns

 σi = the standard deviation of Rit

 σj = the standard deviation of Rjt

Covariance and correlation
 rij= Covij/ σiσj

 Rij = The correlation coefficient of returns.

σi = The standard deviation of Rit
σj = The standard deviation of Rjt
Two asset portfolio
A Three Asset Portfolio
Asset E(Ri) δi wi
classes
Stocks(s) 0.12 0.20 0.60
Bonds(B) 0.08 0.10 0.30
Cash 0.04 0.30 0.10
equivalents
(c)
The correlation are r s,B = 0.25; r s,c = -.08; r B,c =0.15
Markowitz portfolio theory
 The basic portfolio model was developed by
Harry Markowitz (1952,1959). Markowitz
showed that the variance of the rate of
return was a meaningful measure of
portfolio risk under a reasonable set of
assumption.
The efficient frontier
 The efficient frontier, also known as the portfolio frontier, is a set of
ideal or optimal portfolios expected to give the highest return for a
minimal risk or a lower risk for an equal rate of return than some
portfolio beneath the frontier. It manifests the risk-and return trade-off
of a portfolio. This frontier is formed by plotting the expected return
on the y-axis and the standard deviation as a measure of risk on the x-
axis. For building the frontier, there are three important factors to be
taken into consideration:

 Expected return

 Variance/ Standard Deviation as a measure of the variability of returns, also known

as risk and

 The covariance of one asset’s return to that of another asset.

 The American Economist Harry Markowitz established this model in 1952. After that,
he spent a few years researching the same, eventually winning the Nobel Prize in
1990.
Construction of efficient
frontier
 Assume two assets, A1 and A2, are in a
particular portfolio. Calculate the risks and
returns for the two assets whose expected
rate of return and standard deviation are as
follows:
particulars A1 A2
Expected 10% 20%
return
S.D 15% 30%
Correlation -.05
Coefficient
 Let us now give weights to the assets, i.e., a
few portfolio possibilities of investing in
such assets as given below:
Portfolio weights
A2 A1
1 100 0
2 75 25
3 50 50
4 25 75
5 0 100
 Using the formula for Expected Return and
Portfolio Risk i.e.
 Expected Return = (Weight of A1 *

Return of A1) + (Weight of A2 * Return

of A2)

 Portfolio Risk = √ [(Weight of A12 *

Standard Deviation of A12) + (Weight
of A22 * Standard Deviation of A22) + (2
X Correlation Coefficient * Standard
Deviation of A1 * Standard Deviation of
A2)],
 We can arrive at the portfolio risks and
returns as below.
Portfolio Risk Return
1 15 10
2 9.92 12.5
3 12.99 15
4 20.88 17.5
5 30 20
 Using the above table, if we plot the risk on
the X-axis and the Return on Y-axis, we get
a graph that looks as follows and is called
the efficient frontier, sometimes referred to
as the Markowitz bullet.
 In this illustration, we have assumed that the
portfolio consists of only two assets A1 and A2,
for simplicity and easy understanding. We can,
in a similar fashion, construct a portfolio for
multiple assets and plot it to attain the
frontier. In the above graph, any points outside
the frontier are inferior to the portfolio on the
efficient frontier because they offer the same
return with higher risk or lesser return with the
same amount of risk as those on the frontier.
 From the above graphical representation of
the efficient frontier, we can arrive at two
logical conclusions:
 It is where the optimal portfolios are.
 The efficient frontier is not a straight line. It

is curved. It is concave to the Y-axis.

 However, the efficient frontier would be a

straight line if we are constructing it for a

complete risk-free portfolio.
Assumptions of efficient
frontier model
 Investors are rational and know all the facts about the markets. This
assumption implies that all the investors are vigilant enough to
understand the stock movements, predict returns, and invest
accordingly. That also means that this model assumes all investors are
on the same page regarding knowledge of the markets.
 All investors have a common goal: avoid the risk because they are
risk-averse and maximize the return as far as possible and practicable.
 There are not many investors who would affect the market price.
 Investors have unlimited borrowing power.
 Investors lend and borrow money at a risk-free interest rate.
 The markets are efficient.
 The assets follow a normal distribution .
 Markets absorb information quickly and accordingly base the actions.
 The investors’ decisions are always based on expected return and
standard deviation as a measure of risk.
Merits
 This theory portrayed the importance of
diversification.
 This efficient frontier graph helps investors

choose the portfolio combinations with the

highest and least possible returns.
 It represents all the dominant portfolios in

the risk-return space.

Drawbacks/Demerits

 The assumption that all investors are rational and make sound
investment decisions may not always be true because not all
investors would have enough knowledge about the markets.
 The theory can be applied, or the frontier can be constructed
only when a concept of diversification is involved. If there is no
diversification, the theory would certainly fail.
 Also, the assumption that investors have unlimited borrowing
and lending capacity is faulty.
 The assumption that the assets follow a normal distribution
pattern might not always stand true. In reality, securities may
have to experience returns far from the respective standard
deviations, sometimes like three standard deviations away from
the mean.
 The real costs, like taxes, brokerage, fees, etc., are not
considered while constructing the frontier.