Chapter 6: Portfolio Management

"Investment in the securities such as bonds, debentures and shares etc. is lucrative as well as exciting for the investors. Though investment in these securities may be rewarding, it is also fraught with risk. Therefore, investment in these securities requires a good amount of scientific and analytical skills. As per the famous principle of not putting all eggs in the same basket, an investor never invests his entire investable funds in one security. He invests in a well diversified portfolio of a number of securities which will optimize the overall risk-return profile. Investment in a portfolio can reduce risk without diluting the returns. An investor, who is expert in portfolio analysis, may be able to generate trading profits on a sustained basis."
"Every investment is characterized by return and risk. The concept of risk is intuitively understood by investors. In general, it refers to the possibility of the rate of return from a security or a portfolio of securities deviating from the corresponding expected/average rate and can be measured by the"
standard deviation/variance of the rate of return.
How different type of Investors react in different situations
Source: www.missiassaugahsale.com
1.1 Activities in Portfolio Management
The following three major activities are involved in the formation of an Optimal Portfolio suitable for any given investor:
(a) Selection of securities.
(b) Construction of all Feasible Portfolios with the help of the selected securities.
(c) Deciding the weights/proportions of the different constituent securities in the portfolio so that it is an Optimal Portfolio for the concerned investor.
The activities are directed to achieve an Optimal Portfolio of investments commensurate with the risk appetite of the investor.
1.2 Objectives of Portfolio Management
Some of the important objectives of portfolio management are:
(i) Security/Safety of Principal Amount: Security not only involves keeping the principal sum intact but also its purchasing power.
(ii) Stability of Income: To facilitate planning more accurately and systematically the reinvestment or consumption of income.
(iii) Capital Growth: It can be attained by reinvesting in growth securities or through purchase of growth securities.
(iv) Marketability i.e. the case with which a security can be bought or sold: This is essential for providing flexibility to investment portfolio.
(v) Liquidity i.e. nearness to money: It is desirable for the investor so as to take advantage of attractive opportunities upcoming in the market.
(vi) Diversification: The basic objective of building a portfolio is to reduce the risk of loss of capital and/or income by investing in various types of securities and over a wide range of industries.
"(vii) Favourable Tax Status: The effective yield an investor gets from his investment depends on tax to which it is subjected to. By minimising the tax burden, yield can be effectively improved."

Portfolio management is a process and broadly it involves following five phases and each phase is an integral part of the whole process and the success of portfolio management depends upon the efficiency in carrying out each of these phases.
2.1 Security Analysis
"The securities available to an investor for investment are numerous in number and of various types. The securities are normally classified on the basis of ownership of securities such as equity shares, preference shares, debentures and bonds, In recent times a number of new securities with innovative features are available in the market e.g. Convertible Debentures, Deep Discount Bonds, Zero Coupon Bonds, Flexi Bonds, Floating Rate Bonds, Global Depository Receipts, Euro-currency"
"Bonds, etc. are some examples of these new securities. Among this vast group of securities, an"
investor has to choose those ones which he considers worthwhile to be included in his investment portfolio. This requires a detailed analysis of the all securities available for making investment.
Security analysis constitutes the initial phase of the portfolio formation process and consists of examining the risk-return characteristics of individual securities and also the correlation among them. A simple strategy in securities investment is to buy under-priced securities and sell overpriced securities. But the basic problem is how to identify under-priced and overpriced securities and this is what security analysis is all about.
"As discussed in the chapter of Security Analysis, there are two alternative approaches to analyse any security viz. Fundamental Analysis and Technical Analysis. They are based on different premises and follow different techniques. Fundamental analysis, the older of the two approaches, concentrates on the fundamental factors affecting the company such as"
"• the EPS of the company,"
"• the dividend pay-out ratio,"
"• the competition faced by the company,"
"• the market share, quality of management, etc."
• fundamental factors affecting the industry to which the company belongs.
"The Fundamental Analyst compares this intrinsic value (true worth of a security based on its fundamentals) with the current market price. If the current market price is higher than the intrinsic value, the share is said to be overpriced and vice versa. This mispricing of securities gives an opportunity to the investor to acquire the share or sell off the share profitably. An intelligent investor would buy those securities which are under-priced and sell those securities which are overpriced. Thus, it can be said that fundamental analysis helps to identify fundamentally strong companies whose shares are worthy to be included in the investor's portfolio."
"The second approach to security analysis is 'Technical Analysis'. As per this approach the share price movements are systematic and exhibit certain consistent patterns. Therefore, properly studied past movements in the prices of shares help to identify trends and patterns in security prices and efforts are made to predict the future price movements by looking at the patterns of the immediate past. Thus, Technical Analyst concentrates more on price movements and ignores the fundamentals of the shares."
"In order to construct well diversified portfolios, so that Unsystematic Risk can be eliminated or substantially mitigated, an investor would like to select securities across diverse industry sectors which should not have strong positive correlation among themselves."
"The Random Walk Theory holds that the share price movements are random and not systematic. Consequently, neither Fundamental Analysis nor Technical Analysis is of value in generating trading gains on a sustained basis. The Efficient Market Hypothesis (EMH) does not subscribe to the belief that it is possible to book gains in the long term on a sustained basis from trading in the stock market. Markets, though becoming increasingly efficient everywhere with the passage of time, are never perfectly efficient. So, there are opportunities all the time although their durations are decreasing and only the smart investors can look forward to booking gains consistently out of stock market deals."
2.2 Portfolio Analysis
"Once the securities for investment have been identified, the next step is to combine these to form a suitable portfolio. Each such portfolio has its own specific risk-return characteristics which are not just the aggregates of the characteristics of the individual securities constituting it. The return and risk of each portfolio can be computed mathematically based on the Risk-Return profiles for the constituent securities and the pair-wise correlations among them."
"From any chosen set of securities, an indefinitely large number of portfolios can be constructed by varying the fractions of the total investable resources allocated to each one of them. All such portfolios that can be constructed out of the set of chosen securities are termed as Feasible Portfolios. Detailed discussion on Risk- Return concept has been covered later in this chapter."
2.3 Portfolio Selection
The goal of a rational investor is to identify the Efficient Portfolios out of the whole set of Feasible Portfolios mentioned above and then to zero in on the Optimal Portfolio suiting his risk appetite. An Efficient Portfolio has the highest return among all Feasible Portfolios having same or lower Risk or has the lowest Risk among all Feasible Portfolios having same or higher Return. Harry Markowitz's portfolio theory (Modern Portfolio Theory) outlines the methodology for locating the Optimal Portfolio for an investor out of efficient portfolios. Detailed discussion on Markowitz's Portfolio Theory has been covered later in this chapter.
2.4 Portfolio Revision
"Once an optimal portfolio has been constructed, it becomes necessary for the investor to constantly monitor the portfolio to ensure that it does not lose it optimality. Since the economy and financial markets are dynamic in nature, changes take place in these variables almost on a daily basis and securities which were once attractive may cease to be so with the passage of time. New securities"
with expectations of high returns and low risk may emerge. In light of these developments in the
"market, the investor now has to revise his portfolio. This revision leads to addition (purchase) of some new securities and deletion (sale) of some of the existing securities from the portfolio. The nature of securities and their proportion in the portfolio changes as a result of the revision."
"This portfolio revision may also be necessitated by some investor-related changes such as availability of additional funds for investment, change in risk appetite, need of cash for other alternative use, etc."
"Portfolio revision is not a casual process to be taken lightly and needs to be carried out with care, scientifically and objectively so as to ensure the optimality of the revised portfolio. Hence, in the entire process of portfolio management, portfolio revision is as important as portfolio analysis and selection."
2.5 Portfolio Evaluation
This process is concerned with assessing the performance of the portfolio over a selected period of time in terms of return and risk and it involves quantitative measurement of actual return realized and the risk borne by the portfolio over the period of investment. The objective of constructing a portfolio and revising it periodically is to maintain its optimal risk-return characteristics. Various types of alternative measures of performance evaluation have been developed for use by investors and portfolio managers.
This step provides a mechanism for identifying weaknesses in the investment process and for improving these deficient areas.
"It should however be noted that the portfolio management process is an ongoing process. It starts with security analysis, proceeds to portfolio construction, and continues with portfolio -revision and ends with portfolio evaluation. Superior performance is achieved through continual refinement of portfolio management skill. Detailed discussion on the techniques of Portfolio Evaluation has been"
covered later in this chapter.

"Portfolio theory forms the basis for portfolio management. Portfolio management deals with the selection of securities and their continuous shifting in the portfolio to optimise returns to suit the objectives of an investor. This, however, requires financial expertise in selecting the right mix of securities in changing market conditions to get the best out of the stock market. In India as well as in a number of Western countries, portfolio management service has assumed the role of a"
specialised service and a number of professional investment bankers/fund managers compete
"aggressively to provide the best options to high net-worth clients, who have little time to manage their own investments. The idea is catching on with the growth of the capital market and an increasing number of people want to earn profits by investing their hard-earned savings in a planned manner."
A portfolio theory guides investors about the method of selecting and combining securities that will provide the highest expected rate of return for any given degree of risk or that will expose the investor to the lowest degree of risk for a given expected rate of return. Portfolio theory can be discussed under the following heads:
3.1 Traditional Approach
"The traditional approach to portfolio management concerns itself with the investor, definition of portfolio objectives, investment strategy, diversification and selection of individual investment as detailed below:"
(i) Investor's study includes an insight into his -
"(a) age, health, responsibilities, other assets, portfolio needs;"
"(b) need for income, capital maintenance, liquidity;"
(c) attitude towards risk; and
(d) taxation status;
"(ii) Portfolio objectives are defined with reference to maximising the investors' wealth which is subject to risk. The higher the level of risk borne, the more the expected returns."
(iii) Investment strategy covers examining a number of aspects including:
(a) Balancing fixed interest securities against equities;
(b) Balancing high dividend payout companies against high earning growth companies as required by investor;
(c) Finding the income of the growth portfolio;
(d) Balancing income tax payable against capital gains tax;
(e) Balancing transaction cost against capital gains from rapid switching; and
(f) Retaining some liquidity to seize upon bargains.
(iv) Diversification reduces volatility of returns and risks and thus adequate equity diversification is sought. Balancing of equities against fixed interest bearing securities is also sought.
(v) Selection of individual investments is made on the basis of the following principles:
"(a) Methods for selecting sound investments by calculating the true or intrinsic value of a share and comparing that value with the current market value (i.e. by following the fundamental analysis) or trying to predict future share prices from past price movements (i.e., following the technical analysis);"
(b) Expert advice is sought besides study of published accounts to predict intrinsic value;
"(c) Inside information is sought and relied upon to move to diversified growth companies, switch quickly to winners than loser companies;"
(d) Newspaper tipsters about good track record of companies are followed closely;
"(e) Companies with good asset backing, dividend growth, good earning record, high quality management with appropriate dividend paying policies and leverage policies are traced out constantly for making selection of portfolio holdings."
"In India, most of the share and stock brokers follow the above traditional approach for selecting a portfolio for their clients."
"The Traditional Approach suggests that one should not put all money in one basket, instead an investor should diversify by investing in different securities and assets. As long as an investor invests in different assets and securities, he shall get the advantage of diversification. Markowitz questioned this wisdom of the Traditional Approach and proved that putting money in particular kinds of securities or assets will give the investor advantage of diversification. Therefore, one should not go blindly picking up securities and assets to make portfolio."
3.2 Modern Approach (Markowitz Model or Risk-Return Optimization)
"Originally developed by Harry Markowitz in the early 1950's, Portfolio Theory - sometimes referred to as Modern Portfolio Theory - provides a logical/mathematical framework in which investors can optimise their risk and return. The central plank of the theory is that diversification through portfolio formation by adding securities whose returns are having low correlation or negative correlation into portfolio can reduce risk, and second, one can get higher return by taking higher risk."
"Harry Markowitz is regarded as the father of Modern Portfolio Theory. According to him, investors are mainly concerned with two properties of an asset: risk and return. The essence of his theory is that risk of an individual asset hardly matters to an investor. What really matters is the contribution it makes to the investor's overall risk. By turning his principle into a useful technique for selecting the right portfolio from a range of different assets, he developed the 'Mean Variance Analysis' in 1952."
We shall discuss this theory in detail later in this chapter.

"Before proceeding further it will be better if the concept of risk and return is discussed. A person makes an investment in the expectation of getting some return in the future, but the future is uncertain and so is the uncertain future return. It is this uncertainty associated with the returns from an investment that introduces risk for an investor."
"It is important here to distinguish between the expected return and the realized return from an investment. The expected future return is what an investor expects to get from his investment. On the other hand, the realized return is what an investor actually obtains from his investment at the end of the investment period. The investor makes the investment decision based on the expected return from the investment. However, the actual return realized from the investment may not correspond to the expected return. This possible variation of the actual return from the expected return is termed as risk. If actual realizations correspond to expectations exactly, there would be no risk. Risk arises where there is a probability of variation between expectations and realizations with regard to an investment."
"Thus, risk arises from the variability in returns. An investment whose returns are fairly stable is considered to be a low-risk investment, whereas an investment whose returns fluctuate significantly is considered to be a highly risky investment. Government securities whose returns are fairly stable and which are free from default are considered to possess low risk whereas equity shares whose returns are likely to fluctuate widely around their mean are considered risky investments."
The essence of risk in an investment is the variation in its returns. This variation in returns is caused by a number of factors. These factors which produce variations in the returns from an investment constitute different types of risk.
4.1 Types of Risk
Let us consider the risk in holding equity securities. The elements of risk may be broadly classified into two groups as shown in the following diagram.
The first group i.e. systematic risk comprises factors that are external to a company (macro in nature) and affect a large number of securities simultaneously. These are mostly uncontrollable in nature. The second group i.e. unsystematic risk includes those factors which are internal to companies (micro in nature) and affect only those particular companies. These are controllable to a great extent.
"The total variability in returns of a security is due to the total risk of that security. Hence,"
Total risk = Total Systematic risk + Total Unsystematic risk
4.1.1 Systematic Risk
"Due to dynamic nature of an economy, the changes occur in the economic, political and social conditions constantly. These changes have an influence on the performance of companies and thereby on their stock prices but in varying degrees. For example, economic and political instability adversely affects all industries and companies. When an economy moves into recession, corporate profits will shift downwards, and stock prices of most companies may decline. Thus, the impact of economic, political and social changes is system-wide and that portion of total variability in security returns caused by such macro level factors is referred to as systematic risk. Systematic risk can be further subdivided into interest rate risk, market risk and purchasing power risk."
"(i) Interest Rate Risk: This arises due to variability in the interest rates from time to time and its impact on security prices. A change in the interest rates establishes an inverse relationship with the price of security i.e. price of securities tends to move inversely with change in rate of interest, long term securities show greater variability in the price with respect to interest rate changes than short term securities."
"(ii) Purchasing Power Risk: It is also known as inflation risk, as it also emanates from the very fact that inflation affects the purchasing power adversely. Nominal return contains both the real return component and an inflation premium in a transaction involving risk of the above type to compensate for inflation over an investment holding period. Inflation rates vary over time and investors are caught unaware when rate of inflation changes unexpectedly causing erosion in the value of realised rate of return and expected return."
"Purchasing power risk is more in inflationary conditions especially in respect of bonds and fixed income securities. It is not desirable to invest in such securities during inflationary periods. Purchasing power risk is however, less in flexible income securities like equity shares or common stock where rise in dividend income off-sets increase in the rate of inflation and provides advantage of capital gains."
"(iii) Market risk: This is a type of systematic risk that affects prices of a share that moves up or down consistently for some time periods in line with other shares in the market. A general rise in share prices is referred to as a bullish trend, whereas a general fall in share prices is referred to as a bearish trend. In other words, the share market moves between the bullish phase and the bearish"
"phase. The market movements can be easily seen in the movement of share price indices such as the BSE Sensitive Index, BSE National Index, NSE Index etc."
4.1.2 Unsystematic Risk
"Also called 'idiosyncratic risk' the return from a security of any company may vary because of certain factors particular to that company. Variability in returns of the security on account of these factors (micro in nature), is known as unsystematic risk. It should be noted that this risk is in addition to the systematic risk affecting all the companies. Unsystematic risk can be further subdivided into business risk and financial risk."
"(i) Business Risk: Business risk emanates variability in the operating profits of a company - higher the variability in the operating profits of a company, higher is the business risk. Such a risk can be measured using operating leverage."
"(ii) Financial Risk: It arises due to presence of debt in the capital structure of the company. It is also known as leveraged risk and expressed in terms of debt-equity ratio. Excess of debt vis-à-vis equity in the capital structure indicates that the company is highly geared and hence, has higher financial risk. Although a leveraged company's earnings per share may be more but dependence on borrowings exposes it to the risk of winding-up for its inability to honour its commitments towards lenders/creditors. This risk is known as leveraged or financial risk of which investors should be aware of and portfolio managers should be very careful."
4.2 Diversion of Risk
"As discussed above, the total risk of an individual security consists of two risks systematic risk and unsystematic risk. It should be noted that by combining many securities in a portfolio the unsystematic risk can be avoided or diversified which is attached to any particular security. The"
following diagram depicts how the risk can be reduced with the increase in the number of securities.
"From the above diagram it can be seen that total risk is reducing with the increase in the number of securities in the portfolio. However, ultimately when the size of the portfolio reaches certain limit, it"
will contain only the systematic risk.
4.3 Risk & Return
It is very common that an intelligent investor would attempt to anticipate the kind of risk that he/she is likely to face and would also attempt to estimate the extent of risk associated with different investment proposals. In other words an attempt is made by him/her to measure or quantify the risk of each investment under consideration before making the final selection. Thus quantification of risk is necessary for analysis of any investment.
"As risk is attached with return its risk cannot be measured without reference to return. The return, in turn, depends on the cash inflows to be received from the investment. Let us take an example of purchase of a share. With an investment in an equity share, an investor expects to receive future dividends declared by the company. In addition, he expects to receive capital gain in the form of difference between the selling price and purchase price, when the share is finally sold."
"Suppose a share of X Ltd. is currently selling at ₹ 12.00. An investor who is interested in the share anticipates that the company will pay a dividend of ₹ 0.50 in the next year. Moreover, he expects to sell the share at ₹ 17.50 after one year. The expected return from the investment in share will be as follows:"
R = Forecasted dividend
 Forecasted end of the period stock price - 1 Initial investment
R = ₹ 0.50  ₹ 17.50 - 1
₹ 12.00
= 0.5 or 50 per cent
"It is important to note that here the investor expects to get a return of 50 per cent in the future, which is uncertain. It might be possible that the dividend declared by the company may turn out to be either more or less than the figure anticipated by the investor. Similarly, the selling price of the share may be less than the price expected by the investor at the time of investment. It may sometimes be even more. Hence, there is a possibility that the future return may be more than 50 per cent or less than 50 per cent. Since the future is uncertain the investor has to consider the probability of several other possible returns. The expected returns may be 20 per cent, 30 per cent, 50 per cent, 60 per cent or 70 per cent. The investor now has to assign the probability of occurrence of these possible"
alternative returns as given below:
"Possible returns (in per cent)
Xi" "Probability of occurrence
p(Xi)"
20 0.20
30 0.20
50 0.40
60 0.10
70 0.10
The above table gives the probability distribution of possible returns from an investment in shares. Such distribution can be developed by the investor with the help of analysis of past data and modifying it appropriately for the changes he expects to occur in a future period of time.
With the help of available probability distribution two statistical measures one expected return and the other risk of the investment can be calculated.
4.3.1 Expected Return
a. In case the data is given with probabilities: The expected return of the investment is the probability weighted average of all the possible returns. If the possible returns are denoted by Xi and the related probabilities are p(Xi) the expected return may be represented as X
and can be calculated as:
n
X = ∑
i=1
x i p(X i)
It is the sum of the products of possible returns with their respective probabilities.
The expected return of the share in the example given above can be calculated as shown below:
Example
Calculation of Expected Return
"Possible returns
Xi" "Probability
p(Xi)" Xi p(Xi)
0.20 0.20 0.04
0.30 0.20 0.06
0.40 0.40 0.16
0.50 0.10 0.05
0.60 0.10 0.06
n
∑ x i p(X i) 0.37
i=1
Hence the expected return is 0.37 i.e. 37%
b. In case the historical data is given:
x = 
i=1
x1+x2 +x3 xi
n
i.e. Simple average or Arithmetic Mean of the historical data series
Example
Suppose the total return from shares of X Ltd. for a period of last five years is as follows:
Year "Total Return
% (x)"
1 9.50
2 7.00
3 11.00
4 -6.00
5 2.50
xi = 24.00
The Average Return of the share will be = 24.00 = 4.80
5
4.3.2 Risk
As risk is attached with every return hence calculation of only expected return is not sufficient for decision making. Therefore risk aspect should also be considered along with the expected return. The most popular measure of risk is the variance or standard deviation of the probability distribution of possible returns.
Risk can be defined as deviation of actual/possible return from expected return i.e. Mean return. Variance of each security is generally denoted by σ2 and is calculated by using the following formula:
a. In case the data is given with probabilities:
n
σ2 = ∑ [(Xi - X)2 p(Xi )]
i=1
Continuing our earlier example the following table provides calculations required to calculate
the risk i.e. Variance or Standard Deviation (SD).
Possible returns Xi Probability p(Xi) Deviation (Xi - X ) Deviation squared (Xi - X )2 "Product
(Xi - X )2 p(Xj)"
0.20 0.20 -0.17 0.0289 0.00578
0.30 0.20 -0.07 0.0049 0.00098
0.40 0.40 0.03 0.0009 0.00036
0.50 0.10 0.13 0.0169 0.00169
0.60 0.10 0.23 0.0529 0.00529
Var (σ2) 0.0141
Variance = 0.0141
Standard Deviation of the return will be the positive square root of the variance and is
"generally represented by σ. Accordingly, the standard deviation of return in the above"
example will be = 0.1187 i.e. 11.87%.
b. In case the historical data is given:
2 n (x - x)2
σ = i
i=1 n
"Thus, keeping the above formulae same, instead of multiplying with probabilities, we need to divide it by no of observations."
Continuing our earlier example the following table provides calculations required to calculate the risk i.e. Variance or Standard Deviation (SD).
Year "Total Return
% (x)" "Deviation
(x i - x )" "Deviation squared
(x i - x )2"
1 9.50 4.70 22.09
2 7.00 2.20 4.84
3 11.00 6.20 38.44
4 -6.00 -10.80 116.64
5 2.50 -2.30 5.29
xi = 24.00 187.30
Mean 4.80
Variance = 187.30 = 37.46
5
Standard Deviation of the return will be the positive square root of the variance and is
"generally represented by σ. Accordingly, the standard deviation of return in the above"
example will be = 6.12 i.e. 6.12%.
"The basic purpose to calculate the variance and standard deviation is to measure the extent of variability of possible returns from the expected return. Several other measures such as range, semi- variance and mean absolute deviation can also be used to measure risk, but standard deviation has been the most popularly accepted measure."
"For example, if a security has a return of 11% and Standard Deviation i.e. risk of 3%, then it can be concluded that as per the given conditions, the return's range can be expected from 8% to 14% i.e. 11% - 3% would be the lower range and 11% + 3% would be the upper range."
The method described above is widely used for assessing risk.
"The standard deviation or variance, however, provides a measure of the total risk associated with a security. As we know, the total risk comprises two components, namely systematic risk and unsystematic risk. Unsystematic risk is the risk specific or unique to a company. Unsystematic risk associated with the security of a particular company can be eliminated/reduced by combining it with another security having negative correlation. This process is known as diversification of unsystematic risk. As a means of diversification the investment is spread over a group of securities with different characteristics. This collection of diverse securities is called a Portfolio."
"As unsystematic risk can be reduced or eliminated through diversification, it is not very important for an investor to consider. The risk that is relevant in investment decisions is the systematic risk because it is not diversifiable. Hence, the main interest of the investor lies in the measurement of systematic risk of a security."
4.3.3 Measurement of Systematic Risk
"As discussed earlier, systematic risk is the variability in security returns caused by changes in the economy or the market and all securities are affected by such changes to some extent. Some securities exhibit greater variability in response to market changes and some may exhibit less response. Securities that are more sensitive to changes in factors are said to have higher systematic risk. The average effect of a change in the economy can be represented by the change in the stock market index. The systematic risk of a security can be measured by relating that security's variability vis-à-vis variability in the stock market index. A higher variability would indicate higher systematic"
risk and vice versa.
"The systematic risk of a security is measured by a statistical measure which is called Beta (β). The main input data required for the calculation of beta of any security are the historical data of returns of the individual security and corresponding return of a representative market return (stock market index). There are two statistical methods i.e. correlation method and the regression method, which can be used for the calculation of Beta."
"4.3.3.1 Correlation Method : Correlation measures the extent to which two variables are related. In respect to Beta, it means how market returns and security returns are related. Using this method beta (β) can be calculated from the historical data of returns by the following formula:"
β = rimσi
i
m
Where
rim = Correlation coefficient between the returns of the stock i and the returns of the market
index.
σi = Standard deviation of returns of stock i
σm = Standard deviation of returns of the market index.
"4.3.3.2 Regression Method : The regression model is based on the postulation that there exists a linear relationship between a dependent variable and an independent variable. The model helps to calculate the values of two constants, namely alfa (α) and beta (β). β measures the change in the dependent variable in response to unit change in the independent variable, while α measures the value of the dependent variable even when the independent variable has zero value. The formula of the regression equation is as follows:"
Y = α + βX
where
Y = Dependent variable X = Independent variable
α and β are constants.
α = Y - βX
The formula used for the calculation of α and β are given below.
  nXY (X)(Y) nX2 (X)2
where
n = Number of items.
Y = Dependent variable scores. X = Independent variable scores.
"For the purpose of calculation of β, the return of the individual security is taken as the dependent variable and the return of the market index is taken as the independent variable."
"Here it is very important to note that a security can have betas that are positive, negative or zero."
 Positive Beta- indicates that security's return is dependent on the market return and moves in the direction in which market moves.
 Negative Beta- indicates that security's return is dependent on the market return but moves in the opposite direction in which market moves.
 Zero Beta- indicates that security's return is independent of the market return.
"Further as beta measures the volatility of a security's returns relative to the market, the larger the beta, the more volatile the security."
 A beta of 1.0 indicates that a security has risk as that of the market.
" A stock with beta greater than 1.0 has above average risk i.e. its returns would be more volatile than the market returns. For example, when market returns move up by 6%, a stock with beta of 2 would find its returns moving up by 12% (i.e. 6% x 2). Similarly, decline in market returns by 6% would produce a decline of 12% (i.e. 6% x 2) in the return of that security."
 A stock with beta less than 1.0 would have below market risk. Variability in its returns would be less than the market variability.
"Beta is calculated from historical data of returns to measure the systematic risk of a security. It is a historical measure of systematic risk. In using this beta for investment decision making, the investor is assuming that the relationship between the security variability and market variability will continue to remain the same in future also."
4.4 Portfolio Analysis
Till now we have discussed the risk and return of a single security. Let us now discuss the return and risk of a portfolio of securities.
4.4.1 Portfolio Return
For a portfolio analysis an investor first needs to specify the list of securities eligible for selection or inclusion in the portfolio. Then he has to generate the risk-return expectations for these securities. The expected return for the portfolio is expressed as the mean of its rates of return over the time horizon under consideration and risk for the portfolio is the variance or standard deviation of these rates of return around the mean return.
The expected return of a portfolio of assets is simply the weighted average of the returns of the individual securities constituting the portfolio. The weights to be applied for calculation of the portfolio return are the fractions of the portfolio invested in such securities.
Let us consider a portfolio of two equity shares A and B with expected returns of 16 per cent and 22 per cent respectively.
The formula for the calculation of expected portfolio return may be expressed as shown below:
n
rp =∑xi r i
i=1
rp = Expected return of the portfolio.
Xi = Proportion of funds invested in security i
r i = Expected return of security i.
n = Number of securities in the portfolio.
"If 40 per cent of the total funds is invested in share A and the remaining 60 per cent in share B, then the expected portfolio return will be:"
Return on the portfolio = (0.40 x 16) + (0.60 x 22) = 19.6 per cent
4.4.2 Portfolio Risk
"As discussed earlier, the variance of return and standard deviation of return are statistical measures that are used for measuring risk in investment. The variance of a portfolio can be written down as the sum of 2 terms, one containing the aggregate of the weighted variances of the constituent securities and the other containing the weighted co-variances among different pairs of securities."
Covariance (a statistical measure) between two securities or two portfolios or a security and a portfolio indicates how the rates of return for the two concerned entities behave relative to each other.
The covariance between two securities A and B may be calculated using the following formula:
COVAB = 
where
[RA - RA ][RB - RB ]
N
COVAB = Covariance between A and B RA = Return of security A
RB = Return of security B
RA = Expected or mean return of security A
RB = Expected or mean return of security B
N = Number of observations.
The calculation of covariance can be understood with the help of following table:
Calculation of Covariance
Year RX "Deviation
Rx - R x" RY "Deviation
RY - R Y" [R x - R x ][R y - Ry ]
1 11 -4 18 5 -20
2 13 -2 14 1 -2
3 17 2 11 -2 -4
4 19 4 9 -4 -16
Rx = 15 Ry =13 -42
n
∑ [R x - Rx ][Ry - Ry ]
Cov
= i=1 = - 42 = -10.5
xy n 4
"From the above table it can be seen that the covariance is a measure of how returns of two securities move together. In case the returns of the two securities move in the same direction consistently the covariance is said to be positive (+). Contrarily, if the returns of the two securities move in opposite directions consistently the covariance would be negative (-). If the movements of returns are"
"independent of each other, covariance would be close to zero (0)."
The coefficient of correlation is expressed as:
rAB =
CovAB
AB
where
rAB = Coefficient of correlation between A and B CovAB = Covariance between A and B
σA= Standard deviation of A
σB = Standard deviation of B
It may be noted on the basis of above formula the covariance can be expressed as the product of
correlation between the securities and the standard deviation of each of the securities as shown below:
CovAB = σA σB rAB
It is very important to note that the correlation coefficients may range from -1 to 1.
 A value of -1 indicates perfect negative correlation between the two securities' returns.
 A value of +1 indicates a perfect positive correlation between them.
 A value of zero indicates that the returns are independent.
The calculation of the variance (or risk) of a portfolio is not simply a weighted average of the variances of the individual securities in the portfolio as in the calculation of the return of portfolio. The variance
of a portfolio with only two securities in it can be calculated with the following formula.
2  x22  x22  2x x r   
where
p 1 1 2 2
1 2 12 1 2
2 = Portfolio variance.
x1 = Proportion of funds invested in the first security.
x2 = Proportion of funds invested in the second security (x1+x2 = 1).
2 = Variance of first security.
2 = Variance of second security.
1 = Standard deviation of first security.
2 = Standard deviation of second security.
r12 = Correlation coefficient between the returns of the first and second securities.
As the standard deviation is the square root of the variance the portfolio standard deviation can be obtained by taking the square root of portfolio variance.
"Let us take an example to understand the calculation of portfolio variance and portfolio standard deviation. Two securities A and B generate the following sets of expected returns, standard deviations and correlation coefficient:"
A B
r = 20% 25%
σ = 50% 30%
rab= -0.60
Now suppose a portfolio is constructed with 40 per cent of funds invested in A and the remaining 60 per cent of funds in B (i.e. P = 0.4A + 0.6B).
Using the formula of portfolio return the expected return of the portfolio will be: RP= (0.40 x 20) + (0.60 x 25) = 23%
And the Variance and Standard Deviation of the portfolio will be:
Variance
σp 2 = (0.40)2 (50)2 + (0.60)2 (30)2 + 2(0.40)(0.60)(- 0.60)(50)(30) = 400 + 324 - 432 = 292
Standard deviation
σp = = 17.09 per cent.
The return and risk of a portfolio depends on following two sets of factors:
(a) Returns and risks of individual securities and the covariance between securities forming the portfolio
(b) Proportion of investment in each of securities.
"As the first set of factors is parametric in nature for the investor in the sense that he has no control over the returns, risks and co-variances of individual securities. The second set of factors is choice factor or variable for the investors in the sense that they can choose the proportions of each security"
in the portfolio.
4.4.3 Reduction or Dilution of Portfolio Risk through Diversification
"The process of combining more than one security in to a portfolio is known as diversification. The main purpose of this diversification is to reduce the total risk by eliminating or substantially mitigating the unsystematic risk, without sacrificing portfolio return. As shown in the example mentioned above, diversification has helped to reduce risk. The portfolio standard deviation of 17.09% is lower than the standard deviation of either of the two securities taken separately which were 50% and 30% respectively. Incidentally, such risk reduction is possible even when the two constituent securities are uncorrelated. In case, however, these have the maximum positive correlation between them, no reduction of risk can be achieved."
"In order to understand the mechanism and power of diversification, it is necessary to consider the impact of covariance or correlation on portfolio risk more closely. We shall discuss following three cases taking two securities in the portfolio:"
"(a) Securities' returns are perfectly positively correlated,"
"(b) Securities' returns are perfectly negatively correlated, and"
(c) Securities' returns are not correlated i.e. they are independent.
4.4.3.1 Perfectly Positively Correlated : In case two securities returns are perfectly positively correlated the correlation coefficient between these securities will be +1 and the returns of these securities then move up or down together.
The variance of such portfolio can be calculated by using the following formula:
2  x22  x22  2x x r  
p 1 1 2 2
"As r12 = 1, this may be rewritten as:"
1 2 12 1 2
2  x22  x22  2x x  
p 1 1 2 2 1 2 1 2
or
2  x   x  2
p
Hence Standard Deviation will become
1 1 2 2
p  x11  x2 2
In other words this is simply the weighted average of the standard deviations of the individual securities.
Taking the above example we shall now calculate the portfolio standard deviation when correlation coefficient is +1.
Standard deviation of security A = 40% Standard deviation of security B = 25% Proportion of investment in A = 0.4 Proportion of investment in B = 0.6 Correlation coefficient = +1.0
Portfolio standard deviation maybe calculated as:
σp = (0.4) (40) + (0.6) (25) = 31
Thus it can be seen that the portfolio standard deviation will lie between the standard deviations of the two individual securities. It will vary between 40 and 25 as the proportion of investment in each security changes.
"Now suppose, if the proportion of investment in A and B are changed to 0.75 and 0.25 respectively; portfolio standard deviation of the portfolio will become:"
σp = (0.75) (40)+ (0.25) (25) = 36.25
"It is important to note that when the security returns are perfectly positively correlated, diversification provides only risk averaging and no risk reduction because the portfolio risk cannot be reduced below the individual security risk. Hence, reduction of risk is not achieved when the constituent securities' returns are perfectly positively correlated."
"4.4.3.2 Perfectly Negatively Correlated : When two securities' returns are perfectly negatively correlated, two returns always move in exactly opposite directions and correlation coefficient between them becomes -1. The variance of such negatively correlated portfolio may be calculated"
as:
2  x22  x22  2x x r   
p 1 1 2 2 1 2 12 1 2
"As r12 = -1, this may be rewritten as:"
σ2 = (x σ - x σ )2
p 1 1 2 2
Hence Standard Deviation will become
σp = x1σ1 - x2σ2
Taking the above example we shall now calculate the portfolio standard deviation when correlation
coefficient is -1.
σp = (0.4)(40) - (0.6)(25) =1
"Thus, from above it can be seen that the portfolio risk has become very low in comparison of risk of individual securities. By changing the weights it can even be reduced to zero. For example, if the proportion of investment in A and B are 0.3846 and 0.6154 respectively, portfolio standard deviation"
becomes:
= (0.3846)(40) - (0.6154)(25) = 0
"Although in above example the portfolio contains two risky assets, the portfolio has no risk at all. Thus, the portfolio may become entirely risk-free when security returns are perfectly negatively correlated. Therefore, diversification can substantially reduce or even eliminate risk when securities are perfectly negatively correlated, . However, in real life it is very rare to find securities that are perfectly negatively correlated."
"4.4.3.3 Returns are uncorrelated or independent : When the returns of two securities are entirely uncorrelated, the coefficient of correlation of these two securities would be zero and the formula for"
portfolio variance will be as follows:
2  x22  x22  2x x r  
p 1 1 2 2
"As r12 = 0, this may be rewritten as:"
1 2 12 1 2
σ2 = x2σ2 + x2σ2
Hence Standard Deviation will become
p 1 1 2 2
σp =
Taking the above example we shall now calculate the portfolio standard deviation when correlation
coefficient is 0.
σp =
σp =
σp = 21.93
"Thus, it can be observed that the portfolio standard deviation is less than the standard deviations of individual securities in the portfolio. Therefore, when security returns are uncorrelated, diversification can reduce risk ."
"We may now tabulate the portfolio standard deviations of our illustrative portfolio having two securities A and B, for different values of correlation coefficients between them. The proportion of investments in A and B are 0.4 and 0.6 respectively. The individual standard deviations of A and B"
are 40 and 25 respectively.
Portfolio Standard Deviations
Correlation coefficient Portfolio Standard Deviation
1.00 31
0.60 27.73
0 21.93
-0.60 13.89
-1.00 1.00
"Summarily it can be concluded that diversification reduces risk in all cases except when the security returns are perfectly positively correlated. With the decline of correlation coefficient from +1 to -1, the portfolio standard deviation also declines. But the risk reduction is greater when the security
returns are negatively correlated."
4.4.4 Portfolio with more than two securities
"So far we have considered a portfolio with only two securities. The benefits from diversification increase as more and more securities with less than perfectly positively correlated returns are included in the portfolio. As the number of securities added to a portfolio increases, the standard deviation of the portfolio becomes smaller and smaller. Hence, an investor can make the portfolio risk arbitrarily small by including a large number of securities with negative or zero correlation in the portfolio."
"But, in reality, securities rarely show negative or even zero correlation. Typically, securities show some positive correlation, that is above zero but less than the perfectly positive value (+1). As a result, diversification (that is, adding securities to a portfolio) results in some reduction in total portfolio risk but not in complete elimination of risk. Moreover, the effects of diversification are exhausted fairly rapidly. That is, most of the reduction in portfolio standard deviation occurs by the time the portfolio size increases to 25 or 30 securities. Adding securities beyond this size brings"
about only marginal reduction in portfolio standard deviation.
"Adding securities to a portfolio reduces risk because securities are not perfectly positively correlated. But the effects of diversification are exhausted rapidly because the securities are still positively correlated to each other though not perfectly correlated. Had they been negatively correlated, the portfolio risk would have continued to decline as portfolio size increased. Thus, in practice, the benefits of diversification are limited."
4.4.5 Calculation of Return and Risk of Portfolio with more than two securities
"The expected return of a portfolio is the weighted average of the returns of individual securities in the portfolio, the weights being the proportion of investment in each security. The formula for calculation of expected portfolio return is the same for a portfolio with two securities and for portfolios"
with more than two securities. The formula is:
Where
rp
= Expected return of portfolio.
n
rp = ∑
i=1
xi ri
xi = Proportion of funds invested in each security.
ri = Expected return of each security.
n = Number of securities in the portfolio.
Let us consider a portfolio with four securities having the following characteristics:
Security Returns (per cent) Proportion of investment
P 11 0.3
Q 16 0.2
R 22 0.1
S 20 0.4
The expected return of this portfolio may be calculated using the formula:
rp = (0.3)(11) + (0.2)(16) + (0.1)(22) + (0.4)(20) = 16.7 per cent
The portfolio variance and standard deviation depend on the proportion of investment in each security as also the variance and covariance of each security included in the portfolio.
Let us take the following example to understand how we can compute the risk of multiple asset portfolio.
Security xi σi Correlation Coefficient
X 0.25 16 X and Y = 0.7
Y 0.35 7 X and Z = 0.3
Z 0.40 9 Y and Z = 0.4
"It may be noted that correlation coefficient between X and X, Y and Y, Z and Z is 1."
A convenient way to obtain the result is to set up the data required for calculation in the form of a variance-covariance matrix.
"As per data given in the example, the first cell in the first row of the matrix represents X and X the second cell in the first row represents securities X and Y, and so on. The variance or covariance in each cell has to be multiplied by the weights of the respective securities represented by that cell. These weights are available in the matrix at the left side of the row and the top of the column containing the cell."
This process may be started from the first cell in the first row and continued for all the cells till the last cell of the last row is reached as shown below:
Weights 0.25 0.35 0.40
X Y Z
"0.25
0.35
0.40" "X
Y Z" "1 x 16 x 16
0.7 x 7 x 16
0.3 x 9 x 16" "0.7 x 16 x 7 1 x 7 x 7
0.4 x 9 x 7" "0.3 x 16 x 9
0.4 x 7 x 9 1 x 9 x 9"
"Once the variance-covariance matrix is set up, the computation of portfolio variance is a comparatively simple operation. Each cell in the matrix represents a pair of two securities."
"When all these products are summed up, the resulting figure is the portfolio variance. The square root of this figure gives the portfolio standard deviation."
Thus the variance of the portfolio given in the example above can now be calculated.
σp2 = (0.25 x 0.25 x 1 x 16 x 16) + (0.25 x 0.35 x 0.7 x 16 x 7) + (0.25 x 0.40 x 0.3 x 16 x 9) +
(0.35 x 0.25 x 0.7 x 7 x 16) + (0.35 x 0.35 x 1 x 7 x 7) + (0.35 x 0.40 x 0.4 x7 x 9) + (0.40 x
0.25 x 0.3 x 9 x 16) + (0.40 x 0.35 x 0.4 x 9 x 7) + (0.40 x 0.40 x 1 x 9 x 9)
= 16 + 6.86 + 4.32 + 6.86 + 6.0025 + 3.528 + 4.32 + 3.528 + 12.96 = 64.3785
The portfolio standard deviation is:
σp= =8.0236
"Hence, the formula for computing Portfolio Variance may also be stated as follows:"
n n
2  x x r  
p
i1
2 n
i
j1
Or
n
j i j i j
p = ∑∑
xix jσi j
where
σp2 = Portfolio variance.
i=1
j=1
xi = Proportion of funds invested in security i (the first of a pair of securities).
xj = Proportion of funds invested in security j (the second of a pair of securities).
σi = Standard Deviation of security i
σj = Standard Deviation of security j
rij = The co-efficient of correlation between the pair of securities i and j
σij = The covariance between the pair of securities i and j n = Total number of securities in the portfolio.
"Thus from above discussion it can be said that a portfolio is a combination of assets. From a given set of 'n' securities, any number of portfolios can be created. These portfolios may comprise of two securities, three securities, all the way up to 'n' securities. A portfolio may contain the same securities as another portfolio but with different weights. A new portfolios can be created either by changing"
the securities in the portfolio or by changing the proportion of investment in the existing securities.
Thus summarily it can be concluded that each portfolio is characterized by its expected return and risk. Determination of expected return and risk (variance or standard deviation) of each portfolio that can be used to create a set of selected securities which is the first step in portfolio management and called portfolio analysis.

"Unlike the CAPM, the Optimal Portfolio as per Markowitz Theory is investor specific. The portfolio selection problem can be divided into two stages:"
(1) finding the mean-variance efficient portfolios and
(2) selecting one such portfolio.
"Investors do not like risk and the greater the riskiness of returns on an investment, the greater will be the returns expected by investors. There is a trade-off between risk and return which must be reflected in the required rates of return on investment opportunities. The standard deviation (or variance) of return measures the total risk of an investment. It is not necessary for an investor to accept the total risk of an individual security. Investors can diversify to reduce risk. As number of holdings approach larger, a good deal of total risk is removed by diversification."
5.1 Assumptions of the Model
"It is a common phenomenon that the diversification of investments in the portfolio leads to reduction in variance of the return, even for the same level of expected return. This model has taken into account risks associated with investments - using variance or standard deviation of the return. This model is based on the following assumptions. :"
(i) The return on an investment adequately summarises the outcome of the investment.
(ii) The investors can visualise a probability distribution of rates of return.
(iii) The investors' risk estimates are proportional to the variance of return they perceive for a security or portfolio.
(iv) Investors base their investment decisions on two criteria i.e. expected return and variance of return.
"(v) Investors are assumed to be rational in so far as they would prefer greater returns to lesser ones given equal or smaller risk and are risk averse. Risk aversion in this context means merely that, as between two investments with equal expected returns, the investment with the smaller risk would be preferred."
(vi) Though 'Expected Return' could be a suitable measure of monetary inflows like NPV but yield in different scenarios is the most commonly used measure of return. The standard deviation of return is referred to as deviation of yields from its expected value or return.
5.2 Efficient Frontier
"Markowitz has formalised the risk return relationship and developed the concept of efficient frontier using the Mean-Variance Dominance Principle. For selection of a portfolio, comparison between"
"combinations of portfolios is essential. As a rule, a portfolio is dominating another portfolio in terms of mean and variance if there is another portfolio with:"
(a) A lower expected value of return and same or higher standard deviation (risk).
(b) The same or higher standard deviation (risk) but a lower expected return.
Markowitz has defined the diversification as the process of combining assets that are less than perfectly positively correlated in order to reduce portfolio risk without sacrificing any portfolio returns. If an investors' portfolio is not efficient he may:
(i) Increase the expected value of return without increasing the risk.
"(ii) Decrease the risk without decreasing the expected value of return, or"
(iii) Obtain some combination of increase of expected return and decrease risk. This is possible by switching to a portfolio on the efficient frontier.
Fig. 1: Markowitz Efficient Frontier
"If all the investments are plotted on the risk-return space, individual securities would be dominated by portfolios, and the efficient frontier would be containing all Efficient Portfolios (An Efficient Portfolio has the highest return among all portfolios with identical risk and the lowest risk among all portfolios with identical return). Fig - 1 depicts the boundary of possible investments in securities, A, B, C, D, E and F; and B, C, D, are lying on the efficient frontier."
"The best combination of expected value of return and risk (standard deviation) depends upon the investors' utility function. The individual investor will want to hold that portfolio of securities which places him on the highest indifference curve, choosing from the set of available portfolios. The dark line at the top of the set is the line of efficient combinations, or the efficient frontier. The optimal portfolio for an investor lies at the point where the indifference curve for the concerned investor touches the"
efficient frontier. This point reflects the risk level acceptable to the investor in order to achieve a desired
return and provide maximum return for the bearable level of risk. The concept of efficient frontier and
the location of the optimal portfolio are explained with help of Fig-2.
Fig. 2 : Optimal Investment under Markowitz Model
"In Fig-2 A, B, C, D, E and F define the boundary of all possible investments out of which investments in B, C and D are the efficient portfolios lying on the efficient frontier. The attractiveness of the investment proposals lying on the efficient frontier depends on the investors' attitude to risk. At point B, the level of risk and return is at optimum level. The returns are highest at point D, but"
simultaneously it carries higher risk than any other investment.
Fig.3 : Selection of Portfolios
"The shaded area in Fig-3 represents all attainable or feasible portfolios, that is all the combinations of risk and expected return which may be achieved with the available securities. The efficient frontier contains all possible efficient portfolios and any point on the frontier dominates any point to the right of it or below it."
Consider the portfolios represented by points B and E. B and E promise the same expected return
"E (R1) but the risk associated with B is  (R1) whereas the associated with E is  (R2). Investors, therefore, prefer portfolios on the efficient frontier rather than interior portfolios given the assumption"
"of risk aversion; obviously, point A on the frontier represents the portfolio with the least possible risk, whilst D represents the portfolio with the highest possible rate of return with highest risk."
The investor has to select a portfolio from the set of efficient portfolios lying on the efficient frontier.
"This will depend upon his risk-return preference. As different investors have different preferences, the optimal portfolio of securities will vary from one investor to another."

The above figure 2 portrays the relationship between risk and return for efficient portfolio graphically. Point B represents the market portfolio and if a line tangent to this point is drawn and extended upto y-axis the point at which it will touch will be the riskless rate of interest. This is shown in Fig 4. Fig.4 : Selection of Portfolios "Preferred investment strategies plot along line RfBZ, representing alternative combinations of risk and return obtainable by combining the market portfolio with borrowing or lending. This is known as the Capital Market Line (CML). Portfolio lying on line from Rf to B shall be lending portfolio as it will involve some investment in risk-free securities and some investment in market portfolio. Portfolios lying from B to Z will be borrowing portfolio as it will be an investment in market portfolio by borrowing the same amount." The slope of the capital market line can be regarded as the reward per unit of risk borne and it is computed as follows: Slope = RM - Rf M Where RM = Market Return Rf= Risk Free Rate of Return σM = Standard Deviation of Market From the Capital Market Line the expected return of a portfolio can be found as follows: E(R) = Rf + RM - Rf ×σ M Where σP = Standard Deviation of Portfolio

"This model assumes that co-movement between stocks is due to change or movement in the market index. Casual observation of the stock prices over a period of time reveals that most of the stock prices move with the market index. When the Sensex increases, stock prices also tend to increase and vice-versa. This indicates that some underlying factors affect the market index as well as the stock prices. Stock prices are related to the market index and this relationship could be used to estimate the return on stock. Towards this purpose, the following equation can be used:" Ri i i Rm  i "Where," Ri = expected return on security i i = intercept of the straight line or alpha co-efficient i = slope of straight line or beta co-efficient Rm = the rate of return on market index i = error term or return expected on account of unsystematic risk "According to the equation, the return of a stock can be divided into two components, the return due to the market and the return independent of the market. βi indicates the sensitiveness of the stock return to the changes in the market return. For example, βi of 1.5 means that the stock return is expected to increase by 1.5% when the market index return increases by 1% and vice-versa. Likewise, βi of 0.5 expresses that the individual stock return would change by 0.5 per cent when there is a change of 1 per cent in the market return. βi of 1 indicates that the market return and the security return are moving in tandem. The estimates of βi and αi are obtained from regression" analysis. "The single index model is based on the assumption that stocks vary together because of the common movement in the stock market and there are no effects beyond the market (i.e. any fundamental factor effects) that accounts for the stocks co-movement. The expected return, standard deviation and co- variance of the single index model represent the joint movement of securities. The mean return is:" Ri i i Rm i The variance of security's return: 2 2 i 2 m 2i The covariance of returns between securities i and j is: 2 ij i j m "The variance of the security has two components namely, systematic risk or market risk and unsystematic risk or unique risk. The variance explained by the index is referred to as systematic risk. The unexplained variance is called Residual Variance or Unsystematic Risk." The systematic risk can be calculated by using following formula: Systematic risk  2 i × variance of market index = 2i 2m Unsystematic risk = Total variance - Systematic risk. 2 2 i = i - Systematic risk. "Thus, the total risk = Systematic risk + Unsystematic risk."  2 2  2 . i m i "From this, the portfolio variance can be derived"  N 2   N    2   X    2   X 2 2   "Where," p   i1 i i  m     i i   i 1    p 2 = variance of portfolio  m2 = expected variance of index i2 = variation in security's return not related to the market index xi = the portion of stock i in the portfolio. βi = Beta of stock i in the portfolio Likewise expected return on the portfolio also can be estimated. For each security αi and βi should be estimated. RP  xi (i i Rm ) i1 βi = Value of the beta for security i xi = Proportion of the investment on security i αi = Value of alpha for security i N = The number of securities in the portfolio Portfolio return is the weighted average of the estimated return for each security in the portfolio. The weights are the respective stocks' proportions in the portfolio. A portfolio's alpha value is the weighted average of the alpha values for its component securities using the proportion of the investment in a security as weight. P xii i1 α P = Value of the alpha for the portfolio "Similarly, a portfolio's beta value is the weighted average of the beta values of its component stocks using relative share of them in the portfolio as weights." N P = ∑ xii i=1 "Where," βP = Value of the beta for the portfolio. Illustration 1 The following details are given for X and Y companies' stocks and the Bombay Sensex for a period of one year. Calculate the systematic and unsystematic risk for the companies' stocks. If equal amount of money is allocated for the stocks what would be the portfolio risk? X Stock Y Stock Sensex Average return 0.15 0.25 0.06 Variance of return 6.30 5.86 2.25 β 0.71 0.685 Correlation Co-efficient 0.424 Co-efficient of determination (r2) 0.18 Solution "The co-efficient of determination (r2) i.e. square of Coefficient of Correlation gives the percentage of the variation in the security's return that is explained by the variation of the market index return. In the X company stock return, 18 per cent of variation is explained by the variation of the index and 82 per cent is not explained by the index." "According to Sharpe, the variance explained by the index is the systematic risk. The unexplained variance or the residual variance is the unsystematic risk." Company X: Systematic risk = 2 × Variance of market index = (0.71)2 × 2.25 = 1.134 Unsystematic risk(2 ) = Total variance of security return - Systematic Risk = 6.30 - 1.134 = 5.166 or = Variance of Security Return (1-r2) = 6.30 X (1-0.18) = 6.3 X 0.82 = 5.166 Total risk = 2 x 2  2 Company Y: = Systematic Risk + Unsystematic Risk = 1.134 + 5.166 = 6.30 Systematic risk = 2 x 2 = (0.685)2 x 2.25 = 1.056 Unsystematic risk = Total variance of the security return - systematic risk. = 5.86-1.056 = 4.804 Portfolio Risk  2   N X    2    N X 2  2   p   i1 i i  m     i  i1 i     = [(0.5 x 0.71 + 0.5 x 0.685)2 2.25] + [(0.5)2(5.166)+(0.5)2(4.804)] = [(0.355 + 0.3425)2 2.25] + [(1.292 + 1.201)] = 1.0946 + 2.493 = 3.5876

"The CAPM distinguishes between risk of holding a single asset and holding a portfolio of assets. There is a trade-off between risk and return. Modern portfolio theory concentrates on risk and stresses on risk management rather than on return management. Risk may be security risk involving danger of loss of return from an investment in a single financial or capital asset. Security risk differs from portfolio risk, which is the probability of loss from investment in a portfolio of assets. Portfolio risk is comprised of unsystematic risk and systematic risk. Unsystematic risks can be averted through diversification and is related to random variables. Systematic risk is market related component of portfolio risk. It is commonly measured by regression coefficient Beta or the Beta coefficient. Low Beta reflects low risk and high Beta reflects high risk."
"As the unsystematic risk can be diversified by building a portfolio, the relevant risk for determining the prices of securities is the non-diversifiable component of the total risk. As mentioned earlier, it can be measured by using Beta (β) a statistical parameter which measures the market sensitivity of returns. The beta for the market is equal to 1.0. Beta explains the systematic relationship between the return on a security and the return on the market by using a simple linear regression equation. The return on a security is taken as a dependent variable and the return on market is taken as independent variable then Rj = Rf + β (Rm - Rf). The beta parameter (β) in this William Sharpe model represents the slope of the above regression relationship and measures the sensitivity or responsiveness of the security returns to the general market returns. The portfolio beta is merely the weighted average of the betas of individual securities included in the portfolio."
Portfolio Beta (βP) =  Proportion of Security × Beta for Security.
CAPM provides a conceptual framework for evaluating any investment decision where capital is committed with a goal of producing future returns. CAPM is based on certain assumptions to provide conceptual framework for evaluating risk and return. Some of the important assumptions are discussed below:
"(i) Efficient market: It is the first assumption of CAPM. Efficient market refers to the existence of competitive market where financial securities and capital assets are bought and sold with full information of risk and return available to all participants. In an efficient market, the price of individual assets will reflect a real or intrinsic value of a share as the market prices will adjust quickly to any new situation, John J. Hampton has remarked in "Financial decision making" that although efficient capital market is not much relevant to capital budgeting decisions, but CAPM would be useful to evaluate capital budgeting proposal because the company can compare risk and return to be obtained by investment in machinery with risk and return from investment in securities."
"(ii) Rational investment goals: Investors desire higher return for any acceptable level of risk or the lowest risk for any desired level of return. Such a rational choice is made on logical and consistent ranking of proposals in order of preference for higher good to lower good and this is the scale of the marginal efficiency of capital. Beside, transactive preferences and certainty equivalents are other parameters of rational choice."
(iii) Risk aversion in efficient market is adhered to although at times risk seeking behaviour is adopted for gains.
(iv) CAPM assumes that all assets are divisible and liquid assets.
(v) Investors are able to borrow freely at a risk less rate of interest i.e. borrowings can fetch equal return by investing in safe Government securities.
"(vi) Securities can be exchanged without payment of brokerage, commissions or taxes and without any transaction cost."
(vii) Securities or capital assets face no bankruptcy or insolvency.
(viii) CAPM assumes that the Capital Market is in equilibrium.
Based on above assumptions the CAPM is developed with the main goal to formulate the return required by investors from a single investment or a portfolio of assets. The required rate of return is defined as the minimum expected return needed so that investors will purchase and hold an asset.
"Risk and return relationship in this model stipulates higher return for higher level of risk and vice versa. However, there may be exception to this general rule where markets are not efficient."
Three aspects are worth consideration:
(a) Stock market is not concerned with diversifiable risk
(b) It is not concerned with an investor having a diversified portfolio
(c) Compensation paid is restricted to non-diversifiable risk.
"Thus, an investor has to look into the non-diversifiable portion of risk on one side and returns on the other side. To establish a link between the two, the required return one expects to get for a given level of risk has been mandated by the Capital Asset Pricing Model."
"If the risk free investment Rf is 5%, an investor can earn this return of 5% by investing in risk free investment. Again if the stock market earns a rate of return Rm which is 15% then an investor investing in stocks constituting the stock market index will earn also 15%. Thus, the excess return earned over and above the risk free return is called the market risk premium (Rm - Rf) i.e. (15% - 5%) = 10% which is the reward for undertaking risk. So, if an investment is as risky as the stock market, the risk premium to be earned is 10%."
"If an investment is 30% riskier than the stock market, it would carry risk premium i.e. 30% more than the risk premium of the stock market i.e. 10% + 30% of 10% = 10% + 3% = 13%. β identifies how much more risky is an investment with reference to the stock market. Hence the risk premium that a stock should earn is β times the risk premium from the market [β × (Rm - Rf)]. The total return from an investment is the risk free rate of return plus the risk premium. So the required return from a stock would be Rj = Rf + [β × (Rm - Rf)]. In the above example 5% + 1.3 × (15% - 5%) = 18%"
The risk premium on a stock varies in direct proportion to its Beta. If the market risk premium is 6% and β of a stock is 1.2 then the risk premium for that stock shall be 7.2% (6% × 1.2)
Illustration 3
"The risk premium for the market is 10%. Assuming Beta values of Security K are 0, 0.25, 0.42, 1.00 and 1.67. Compute the risk premium on Security K."
Solution
Market Risk Premium is 10%
 Value of K Risk Premium of K
0.00 0%
0.25 2.50%
0.42 4.20%
1.00 10.00%
1.67 16.70%
Illustration 6
The following information is available with respect of Jaykay Ltd.
Year Jay Kay Limited Market Return on Govt. Bonds
"Average Share Price
(₹)" "DPS
(₹)" Average Index Dividend Yield (%)
2002 242 20 1812 4 6
2003 279 25 1950 5 5
2004 305 30 2258 6 4
2005 322 35 2220 7 5
Compute Beta Value of the company as at the end of 2005. What is your observation?
Solution
(1) Computation of Beta Value
Calculation of Returns
Returns  D1 (P1 P0 ) × 100
P0
Year Returns
2002 - 2003 "25 + 279 - 242
×100 = 25.62%
242"
2003 - 2004 "30 + 305 - 279
×100 = 20.07%
279"
2004 - 2005 "35 + 322 - 305
×100 = 17.05%
305"
Calculation of Returns from market Index
Year % of Index Appreciation Dividend Total
Yield % Return %
"2002  2003 1950  1812 × 100 = 7.62% 5% 12.62%
1812"
2003  2004 2258  1950 × 100 = 15.79% 6% 21.79%
2004  2005 2220  2258 × 100 = ()1.68% 7% 5.32%
"2258
Computation of Beta"
1950
Year X Y XY Y2
2002-2003 25.62 12.62 323.32 159.26
2003-2004 20.07 21.79 437.33 474.80
2004-2005 17.05 5.32 90.71 28.30
62.74 39.73 851.36 662.36
"X  62.74  20.91, Y  39.73  13.24"
3 3
   XY  n X Y
 Y2  n(Y)2
 851.36 - 3(20.91)(13.24)
662.36 - 3(13.24)2
 851.36 - 830.55  20.81  0.15
662.36 - 525.89 136.47
"(2) Observation: Based on the beta value of the company and the analysis of returns, it can be concluded that changes in the return on share of Jaykay Ltd. are less affected by changes in market returns."
8.2 Under Valued and Over Valued Stocks
"The CAPM model can be practically used to buy, sell or hold stocks. CAPM provides the required rate of return on a stock after considering the risk involved in an investment. Based on current market price or any other judgmental factors (benchmark) one can identify as to what would be the expected return over a period of time. By comparing the required return as per CAPM with the expected return"
the following investment decisions are available:
(a) When required return as per CAPM < Actual Return - Buy: This is due to the stock being undervalued i.e. the stock gives more return than what it should give.
(b) When required return as per CAPM > Actual Return - Sell: This is due to the stock being overvalued i.e. the stock gives less return than what it should give.
(c) When required return as per CAPM = Actual Return - Hold: This is due to the stock being correctly valued i.e. the stock gives same return than what it should give.
"From another angle, if the current market price is considered as a basis of CAPM then:"
"(i) Actual Market Price < Market Price using CAPM, stock is undervalued"
"(ii) Actual market Price > Market Price using CAPM, stock is overvalued"
"(iii) Actual market Price = Market Price using CAPM, stock is correctly valued."
Illustration 8
The expected returns and Beta of three stocks are given below
Stock A B C
Expected Return (%) 18 11 15
Beta Factor 1.7 0.6 1.2
If the risk free rate is 9% and the expected rate of return on the market portfolio is 14% which of the
"above stocks are over, under or correctly valued in the market? What shall be the strategy?"
Solution
Required Rate of Return is given by
Rj = Rf +  (Rm-Rf)
"For Stock A, Rj = 9 + 1.7 (14 - 9) = 17.50%"
"Stock B, Rj = 9 + 0.6 (14-9) = 12.00%"
"Stock C, Rj = 9 + 1.2 (14-9) = 15.00%"
Required Return % Expected Return % Valuation Decision
17.50% 18.00% Under Valued Buy
12.00% 11.00% Over Valued Sell
15.00% 15.00% Correctly Valued Hold
8.3 Advantages and Limitations of CAPM
The advantages of CAPM can be listed as:
"(i) Risk Adjusted Return: It provides a reasonable basis for estimating the required return on an investment which has risk inbuilt into it. Hence, it can also be used as Risk Adjusted Discount Rate in Capital Budgeting."
(ii) No Dividend Company: It is useful in computing the cost of equity of a company which does not declare dividend.
"There are certain limitations of CAPM as well, which are discussed as follows:"
(a) Reliability of Beta: Statistically reliable Beta might not exist for shares of many firms. It may not be possible to determine the cost of equity of all firms using CAPM. All shortcomings that apply to Beta value applies to CAPM too.
"(b) Other Risks: By emphasising on systematic risk only, the unsystematic risk that are of importance too does not find place in a diversified portfolio."
(c) Information Available: It is extremely difficult to obtain important information on risk free interest rate and expected return on market portfolio because depending upon the situations there can be multiple risk free rates and market being volatile its return varies from time to
time.

"Arbitrage pricing theory (APT) is used as an alternative to Capital Assets Pricing Model (CAPM). While the CAPM formula helps to calculate the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macroeconomic factors."
"In a simplistic way, if a particular asset, say a stock, has its major influencers factors then the stocks' return would be calculated by using the Arbitrage Pricing Theory (APT) in the following manner:"
"(a) Calculate the risk premium for these risk factors (beta for the risk factor 1 - interest rate, and beta of the risk factor 2 - sector growth rate; etc. Conceptually risk premium is compensation over and above risk free rate of return that an investor expects/ requires for bearing that risk."
(b) Adding the risk free rate of return.
"Thus, the formula for APT is represented as - E (Ri) = Rf + λ1β1 + λ2β2 + λ3β3 λnβn"
"Where,"
Rf = Risk Free Rate
λn = nth factor price or risk premium
βn = Sensitivity of the Factor n
The above formula provides the expected return in efficient market when equilibrium is reached.

Following three ratios are used to evaluate the portfolio:
10.1 Sharpe Ratio
Sharpe Ratio measures the Risk Premium per unit of Total Risk for a security or a portfolio of securities. The formula is as follows:
Ri - Rf
S = 
"Where,"
i
Ri = Return on Security/Portfolio Rf = Risk Free Rate of Return
σi = Standard Deviation of Return of Security/Portfolio
S = Sharpe Ratio
Example
Let's assume that we look at a one year period of time where an index fund earned 11% Treasury bills earned 6%. The standard deviation of the index fund was 20%
Therefore S = (0.11 -0.06)/.20 = 25%
"The Sharpe ratio is an appropriate measure of performance for an overall portfolio particularly when it is compared to another portfolio, or another index such as the S&P 500, Small Cap index, etc."
"That said however, it is not often provided in most rating services."
Example
"Consider two Portfolios A and B. Let return of A be 30% and that of B be 25%. On the outset, it appears that A has performed better than B. Let us now incorporate the risk factor and find out the Sharpe ratios for the portfolios. Let risk of A and B be 11% and 5% respectively. This means that the standard deviation of returns - or the volatility of returns of A is much higher than that of B."
"If risk free rate is assumed to be 8%,"
Sharpe ratio for portfolio A = (30% - 8%)/11% = 2 and Sharpe ratio for portfolio B = (25% - 8%)/5% = 3.4
"Higher the Sharpe Ratio, better is the portfolio on a risk adjusted return metric. Hence, our primary judgment based solely on returns was erroneous. Portfolio B provides better risk adjusted returns than Portfolio A and hence is the preferred investment. Producing healthy returns with low volatility is generally preferred by most investors to high returns with high volatility. Sharpe ratio is a good"
tool to use to determine a portfolio that is suitable to such investors.
10.2 Treynor Ratio
This ratio is same as Sharpe ratio with only difference that it measures the Risk Premium per unit of Systematic Risk (β) for a security or a portfolio of securities. The formula is as follows:
"Where,"
Ri = Return on Security/Portfolio Rf = Risk Free Rate of Return
i = Beta of Security or Portfolio
T = Treynor Ratio
T = Ri
 Rf
βi
"Treynor ratio is based on the premise that unsystematic or specific risk can be diversified and hence, only incorporates the systematic risk (beta) to gauge the portfolio's performance. It measures the returns earned in excess of those that could have been earned on a riskless investment per unit of market risk assumed."
"In above example if beta of Portfolio A and B are 1.5 and 1.1 respectively, Treynor ratio for Portfolio A= (30%-8%)/1.5=14.67%"
Treynor ratio for Portfolio B= (25%-8%)/1.1= 15.45%
The results are in line with that of the Sharpe ratio results.
"Both Sharpe ratio and Treynor ratio measure risk adjusted returns. The difference lies in how risk is defined in either case. In Sharpe ratio, risk is determined as the degree of volatility in returns - the variability in month-on-month or period-on-period returns - which is expressed through the standard deviation of the stream of returns you are considering."
"In Treynor ratio, you look at the beta of the portfolio or security - the degree of ""momentum"" that has been built into the portfolio by the fund manager in order to derive his excess returns. High momentum - or high beta (where beta is > 1) implies that the portfolio will move faster (up as well as down) than the market."
"While Sharpe ratio measures total risk (as the degree of volatility in returns captures all elements of risk - systematic as well as unsystematic), the Treynor ratio captures only the systematic risk in its"
computation.
"When one has to evaluate the funds which are sector specific, Sharpe ratio would be more meaningful. This is due to the fact that unsystematic risk would be present in sector specific funds. Hence, a true measure of evaluation would be to judge the returns based on the total risk."
"On the contrary, if we consider diversified equity funds, the element of unsystematic risk would be very negligible as these funds are expected to be well diversified by virtue of their nature. Hence, Treynor ratio would be more apt here."
"It is widely found that both ratios usually give similar rankings. This is based on the fact that most of the portfolios are fully diversified. To summarize, we can say that when the fund is not fully diversified, Sharpe ratio would be a better measure of performance and when the portfolio is fully diversified, Treynor ratio would better justify the performance of a fund."
"Example: In 2019-20 where Fidelity Magellan had earned about 18%. Many bond funds had earned 13%. Which is better? In absolute numbers, 18% beats 13%. But if we then state that the bond funds had about half the market risk, now which is better? We don't even need to do the formula for that analysis. But that is missing in almost all reviews by all brokers. For clarification, we do not suggest they put all the money into either one- just that they need to be aware of the implications."
10.3 Jensen Alpha
"This is the difference between a portfolio's actual return and those that could have been made on a benchmark portfolio with the same risk- i.e. Beta. It measures the ability of active management to increase returns above those that are purely a reward for bearing market risk. However, caveat applies it will only produce meaningful results if it is used to compare two portfolios which have similar betas. The formula is given as follows:"
Alpha = Actual Return on portfolio - Expected Return on portfolio.
Assume Two Portfolios
A B Market Return
Return 12 14 12
Beta 0.7 1.2 1.0
Risk Free Rate = 9%
The return expected as per CAPM
"= Risk Free Return + Beta portfolio (Return of Market - Risk Free Return) Hence, the expected return of Portfolio A using CAPM"
= 0 .09 + 0.7 (0.12 - 0.09) = 0.09 + 0.021 = 0.111
Alpha = Return of Portfolio - Expected Return
= 0.12 - 0.111 = 0.009
"As long as "apples are compared to apples"- in other words a computer sector fund A to computer sector fund B - it is a viable number. But if taken out of context, it loses meaning. Alphas are found in many rating services but are not always developed the same way- so you can't compare an alpha from one service to another. However, we have usually found that their relative position in the particular rating service is to be viable. Short-term alphas are not valid. Minimum time frames are one year- three year is more preferable."
Alpha can also be used to assess the performance of a Portfolio or a Fund Manager. While a positive
"alpha indicates that the Fund Manager is doing well, a negative alpha indicates that Portfolio Manager is not doing well in comparison of market return."
11. SHARPE'S OPTIMAL PORTFOLIO
William Sharpe has developed a simplified variant of Markowitz model that reduces substantially its data and computational requirements.
"This model is based on desirability of an investor for excess return of risk free rate of return to beta. Accordingly, the ranking of securities shall be based on the Sharpe Ratio and unique cut off point C* discussed below."
The steps for finding out the stocks to be included in the optimal portfolio are given below:
(a) Find out the "excess return to beta" ratio for each stock under consideration i.e. Treynor's ratio.
(b) Rank them from the highest to the lowest.
(c) Proceed to calculate Ci for all the stocks according to the ranked order using the following formula:
2 N Ri - Rf  βi
σm 
σ
Ci =
i=1 ei
2 N β2
1 + σm
 i
"Where,"
i = 1σ2
2  variance of the market index
i = variance of a stock's movement that is not associated with the movement of market index i.e. stock's unsystematic risk.
"(d) Compute the cut-off point which the highest value of Ci and is taken as C*. The stock whose excess-return to risk ratio is above the cut-off ratio are selected and all whose ratios are below are rejected. The main reason for this selection is that since securities are ranked from highest excess return to Beta to lowest, and if particular security belongs to optional portfolio all higher ranked securities also belong to optimal portfolio."
"(e) Once we came to know which securities are to be included in the optimum portfolio, we shall calculate the percent to be invested in each security by using the following formula:"
Xo = Zi
where
i N
 Zi j=1
Z = Bi
 Ri - Ro
- C* 
i 2  B 
ei
The first portion determines the weight each stock and total comes to 1 to ensure that all funds are
invested and second portion determines the relative investment in each security.
12. FORMULATION OF PORTFOLIO STRATEGY
Two broad choices are required for the formulation of an appropriate Portfolio Strategy. They are Active Portfolio Strategy and Passive Portfolio Strategy.
12.1 Active Portfolio Strategy (APS)
"An APS is followed by most investment professionals and aggressive investors who strive to earn superior return after adjustment for risk. The vast majority of funds (or schemes) available in India follow an "active" investment approach, wherein fund managers of "active" funds spend a great deal of time on researching individual companies, gathering extensive data about financial performance, business strategies and management characteristics. In other words, "active" fund managers try to identify and invest in stocks of those companies that they think will produce better returns and beat"
the overall market (or Index).
There are four principles of an active strategy. These are:
"(a) Market Timing : This involves departing from the normal i.e. strategy for long run asset mix to reflect assessment of the prospect of various assets in the near future. Market timing is based on an explicit or implicit forecast of general market movement. A variety of tools are employed for market timing analysis namely business cycle analysis, moving average analysis, advance-decline analysis, Econometric models. The forecast for the general market movement derived with the help of one or more of these tools is tempted by the subjective judgment of the investors. In most cases investors may go largely by their market sense. Those who reveal the fluctuation in the market may be tempted to play the game of market timing but few will succeed in this game. Further an investment manager has to forecast the market correctly and 75% of the time he is only able to break even after taking into account the cost of errors and cost of transactions. According to Fisher Black, the market is just as well as on an average when the investor is out of the market as it does when he is in. So, he loses money relative to a single buy and sale strategy by being out of the market part of the time."
"(b) Sector Rotation: Sector or group rotation may apply to both stock and bond component of the portfolio. It is used more compulsorily with respect to strategy. The components of the portfolio are used when it involves shifting. The weighting for various industry sectors is based on their asset outlook. If one thinks that steel and pharmaceutical would do well as compared to other sectors in the forthcoming period he may overweigh the sector relative to their position in the market portfolio, with the result that his portfolio will be tilted more towards these sectors in comparison to the market portfolio."
"With respect to bond portfolio sector rotation it implies a shift in the composition of the bond portfolio in terms of quality as reflected in credit rating, coupon rate, term of maturity etc. If one anticipates a rise in the interest rate one may shift from long term bonds to medium and short term. A long term bond is more sensitive to interest rate variation compared to a short term bond."
(c) Security Selection: Security selection involves a search for under-priced security. If one has to resort to active stock selection he may employ fundamental / technical analysis to identify stocks which seems to promise superior return and concentrate the stock components of portfolio on them. Such stock will be over weighted relative to their position in the market portfolio. Like wise stock which are perceived to be unattractive will be under weighted relative to their position in the market portfolio.
As far as bonds are concerned security selection calls for choosing bonds which offer the highest yields to maturity and at a given level of risk.
"(d) Use of Specialised Investment Concept: To achieve superior return, one has to employ a specialised concept/philosophy particularly with respect to investment in stocks. The concept which have been exploited successfully are growth stock, neglected or out of favour stocks, asset stocks, technology stocks and cyclical stocks."
The advantage of cultivating a specialized investment concept is that it helps to:
(i) Focus one's effort on a certain kind of investment that reflects one's ability and talent.
(ii) Avoid the distraction of perusing other alternatives.
(iii) Master an approach or style through sustained practice and continual self criticism.
The greatest disadvantage of focusing exclusively on a specialized concept is that it may become obsolete. The changes in the market risk may cast a shadow over the validity of the basic premise underlying the investor philosophy.
12.2 Passive Portfolio Strategy
Active strategy was based on the premise that the capital market is characterized by efficiency which can be exploited by resorting to market timing or sector rotation or security selection or use of special concept or some combination of these basis.
"Passive strategy, on the other hand, rests on the tenet that the capital market is fairly efficient with respect to the available information. Hence they search for superior return. Basically, passive strategy involves adhering to two guidelines. They are:"
(a) Create a well-diversified portfolio at a predetermined level of risk.
(b) Continue to hold the portfolio relatively unchanged over a period unless it becomes inadequately diversified or inconsistent with the investor risk return preference.
"A fund which is passively managed is called index funds. An Index fund is a mutual fund scheme that invests in the securities of the target Index in the same proportion or weightage. Though it is designed to provide returns that closely track the benchmark Index, an Index Fund carries all the risks normally associated with the type of asset the fund holds. So, when the overall stock market rises/falls, you can expect the price of shares in the index fund to rise/fall, too. In short, an index fund does not mitigate market risks. Indexing merely ensures that your returns will not stray far from the returns on the Index that the fund mimics. In other words, an index fund is a fund whose daily returns are the same as the daily returns obtained from an index. Thus, it is passively managed in the sense that an index fund manager invests in a portfolio which is exactly the same as the portfolio"
"which makes up an index. For instance, the NSE-50 index (Nifty) is a market index which is made"
"up of 50 companies. A Nifty index fund has all its money invested in the Nifty fifty companies, held in the same weights of the companies which are held in the index."
12.3 Selection of Securities
There are certain criteria which must be kept in mind while selecting securities. The selection criteria for both bonds and equity shares are given as following:
12.3.1 Selection of Bonds
Bonds are fixed income avenues. The following factors have to be evaluated in selecting fixed income avenues:
"(a) Yield to maturity: The yield to maturity for a fixed income avenues represent the rate of return earned by the investor, if he invests in the fixed income avenues and holds it till its maturity."
"(b) Risk of Default: To assess such risk on a bond, one has to look at the credit rating of the bond. If no credit rating is available relevant financial ratios of the firm have to be examined such as debt equity, interest coverage, earning power etc and the general prospect of the industry to which the firm belongs have to be assessed."
"(c) Tax Shield: In the past, several fixed income avenues offers tax shields but at present only a few of them do so."
(d) Liquidity: If the fixed income avenues can be converted wholly or substantially into cash at a fairly short notice it possesses a liquidity of a high order.
12.3.2 Selection of Stock (Equity Share)
"Three approaches are applied for selection of equity shares- Technical analysis, Fundamental analysis and Random selection analysis."
(a) Technical analysis looks at price behaviours and volume data to determine whether the share price will move up or down or remain trend less.
"(b) Fundamental analysis focuses on fundamental factors like earning level, growth prospects and risk exposure to establish intrinsic value of a share. The recommendation to buy hold or sell is based on comparison of intrinsic value and prevailing market price."
(c) Random selection analysis is based on the premise that the market is efficient and security is properly priced.
Levels of Market Efficiency and Approach to Security Selection
"Approach
Levels of Efficiency" Technical Analysis Fundaments Analysis Random Selection
1) Inefficiency Best Poor Poor
2) Weak form efficiency Poor Best Poor
3) Semi-strong efficiency Poor Good Fair
4) Strong Form efficiency Poor Fair Best
13. PORTFOLIO REVISION AND REBALANCING
"It means the value of portfolio as well as its composition. The relative proportion of bond and stocks may change as stock and bonds fluctuate in response to such changes. Portfolio rebalancing is necessary. There are three policies of portfolio rebalancing- Buy and hold policy, Constant mix policy, and Constant Proportion Portfolio Insurance (CPPI) policy. These policies have different pay off under varying market conditions. Under all these policies portfolio consists of investment in stock and bonds."
(a) Buy and Hold Policy: Sometime this policy is also called 'do nothing policy' as under this strategy no balancing is required and therefore investor maintain an exposure to stocks and therefore linearly related to the value of stock in general.
"Under this strategy investors set a limit (floor) below which he does not wish the value of portfolio should go. Therefore, he invests an amount equal to floor value in non-fluctuating assets (Bonds). Since the value of portfolio is linearly related to value of stocks the pay-off diagram is a straight line. This can be better understood with the help of an example. Suppose a portfolio consisting of Debt/ Bonds for ₹ 50,000 and ₹ 50,000 in equity shares currently priced at ₹ 100 per share. If price of the share moves from ₹ 100 to ₹ 200 the value of portfolio shall become ₹ 1,50,000. The pay-off diagram is shown in figure below i.e. a straight line:"
This policy is suitable for the investor whose risk tolerance is positively related to portfolio and stock market return but drops to zero of below floor value.
"Concluding, it can be said that following are main features of this policy:"
(a) The value of portfolio is positively related and linearly dependent on the value of the stock.
(b) The value of portfolio cannot fall below the floor value i.e. investment in Bonds.
(c) This policy performs better if initial percentage is higher in stock and stock outperform the bond. Reverse will happen if stock under perform in comparison of bond or their prices goes down.
"(b) Constant Mix Policy: Contrary to above policy this policy is a 'Do Something Policy'. Under this policy investor maintains an exposure to stock at a constant percentage of total portfolio. This strategy involves periodic rebalancing to required (desired) proportion by purchasing and selling stocks as and when their prices goes down and up respectively. In other words this plan specifies that value of aggressive portfolio to the value of conservative portfolio will be held constant at a pre- determined ratio. However, it is important to this action is taken only there is change in the prices of share at a predetermined percentage."
For example if an investor decided his portfolio shall consist of 60% in equity shares and balance 40% in bonds on upward or downward of 10% in share prices he will strike a balance.
"In such situation if the price of share goes down by 10% or more, he will sell the bonds and invest money in equities so that the proportion among the portfolio i.e. 60:40 remains the same. According if the prices of share goes up by 10% or more he will sell equity shares and shall in bonds so that the ratio remains the same i.e. 60:40. This strategy is suitable for the investor whose tolerance varies proportionally with the level of wealth and such investor holds equity at all levels."
The pay-off diagram of this policy shall be as follows:
"Accordingly, it gives a concave pay off, tends to do well in flat but fluctuating market."
Continuing above example let us how investor shall rebalance his portfolio (50 : 50) under different scenarios as follows:
(a) If price decreases
Share Price Value of Shares Value of Bonds Total Stock to Bond Switching Bond to Stock Switching
100 Starting Level "50,000" "50,000" "1,00,000" - -
80 Before Rebalancing "40,000" "50,000" "90,000" - -
After Rebalancing "45,000" "45,000" "90,000" - "5,000"
60 Before Rebalancing "33,750" "45,000" "78,750" - -
After Rebalancing "39,360" "39,390" "78,750" - "5,610"
(b) If price increases
Share Price "Value
of Shares" "Value
of Bonds" Total "Stock to
Bond Switching" Bond to Stock Switching
100 Starting Level "50,000" "50,000" "1,00,000" - -
150 Before Rebalancing "75,000" "50,000" "1,25,000" - -
After Rebalancing "62,400" "62,600" "1,25,000" "12,600" -
200 Before Rebalancing "83,200" "62,600" "1,45,800" - -
After Rebalancing "72,800" "73,000" "1,45,800" "10,400" -
"(c) Constant Proportion Insurance Policy : Under this strategy investor sets a limit below which he does not wish his asset to fall called 'Floor Value', which is invested in some non-fluctuating assets such as Treasury Bills, Bonds etc. The value of portfolio under this strategy shall not fall below this specified floor under normal market conditions. This strategy performs well especially in bull market as the value of shares purchased as cushion increases. In contrast in bearish market losses are avoided by sale of shares. It should however be noted that this strategy performs very poorly in the market hurt by sharp reversals. The following equation is used to determine equity allocation:"
Target Investment in Shares = Multiplier (Portfolio Value - Floor Value)
Multiplier is a fixed constant whose value shall be more than 1.
"The pay-off under this strategy can be understood better with the help of an example. Suppose wealth of Mr. A is ₹ 10,00,000, a floor value of ₹ 7,50,000 and a multiplier of 2. Since the initial cushion (difference between Portfolio Value and Floor) is ₹ 2,50,000, the initial investment in the share shall be ₹ 5,00,000 (double of the initial cushion). Accordingly, initial portfolio mix shall consist of ₹ 5,00,000 in shares and balance ₹ 5,00,000 in Bonds."
"Situation 1: Suppose stock market rises from 100 to 150. The value of shares of Mr. A's holding shall rise from ₹ 5,00,000 to ₹ 7,50,000 and value of portfolio shall jump to ₹ 12,50,000 and value of cushion to ₹ 7,50,000. Since the CPPI Policy requires the component of shares should go up to"
"₹ 10,00,000. This will necessitate the selling of bonds amounting ₹ 2,50,000 and re-investing proceeds in shares."
"Situation 2: If stock market falls from 100 to 80, the value of shares of portfolio falls from ₹ 5,00,000 to ₹ 4,00,000 resulting in reduction of value of portfolio to ₹ 9,00,000 and cushion to ₹ 1,50,000. Since as per CPPI the share component should be ₹ 3,00,000 (₹ 1,50,000 x 2), hence shares of ₹ 1,00,000 should be sold and invest in Bonds."
Thus from above it is clear that as per CPPI sell the shares as their prices fall and buy them as their prices rise. This policy is contrary to the Constant Mix Policy and hence pay-off of CPPI shall be convex as shown below:
(d) Comparative Evaluation
Basis Buy & Hold Policy Constant Mix Policy Constant Proportion Portfolio Insurance
Pay-off Line Straight Concave Convex
Protection in Down/Up Markets Definitely poor in Down market "Not much in Down market but relatively poor in
Up market" Good in Down market and performs well in Up market
Performance in flat market "Performs between
Constant and CPPI" Tend to do well in flat market. Performs poorly.
14. ASSET ALLOCATION STRATEGIES
"Many portfolios containing equities also contain other asset categories, so the management factors are not limited to equities. There are four asset allocation strategies:"
"(a) Integrated Asset Allocation: Under this strategy, capital market conditions and investor objectives and constraints are examined and the allocation that best serves the investor's needs while incorporating the capital market forecast is determined."
"(b) Strategic Asset Allocation: Under this strategy, optimal portfolio mixes based on returns, risk and co-variances is generated using historical information and adjusted periodically to restore target allocation within the context of the investor's objectives and constraints."
"(c) Tactical Asset Allocation: Under this strategy, investor's risk tolerance is assumed constant and the asset allocation is changed based on expectations about capital market conditions."
"(d) Insured Asset Allocation: Under this strategy, risk exposure for changing portfolio values (wealth) is adjusted; more value means more ability to take risk."
15. FIXED INCOME PORTFOLIO
"Fixed Income Portfolio is same as equity portfolio with difference that it consist of fixed income securities such as bonds, debentures, money market instruments etc. Since, it mainly consists of bonds, it is also called Bond Portfolio."
15.1 Fixed Income Portfolio Process
"Just like other portfolios, following five steps are involved in fixed income portfolio."
1. Setting up objective
2. Drafting guideline for investment policy
3. Selection of Portfolio Strategy - Active and Passive
4. Selection of securities and other assets
5. Evaluation of performance with benchmark
15.2 Calculation of Return on Fixed Income Portfolio
First and foremost step in evaluation of performance of a portfolio is calculation of return. Although there can be many types of measuring returns as per requirements but some of the commonly used measures are :
(i) Arithmetic Average Rate of Return
(ii) Time Weighted Rate of Return
(iii) Rupee Weighted Rate of Return
(iv) Annualized Return
15.3 Fixed Income Portfolio Management Strategies
There are two strategies
(i) Passive Strategy
(ii) Active Strategy
15.3.1 Passive Strategy
As mentioned earlier Passive Strategy is based on the premise that securities are fairly priced commensurate with the level of risk. Though investor does not try to outperform the market but it does not imply they remain totally inactive. Common strategies applied by passive investors of fixed income portfolios are as follows:
(i) Buy and Hold Strategy: This technique is do nothing technique and investor continues with initial selection and do not attempt to churn bond portfolio to increase return or reduce the level of risk.
"However, sometime to control the interest rate risk, the investor may set the duration of fixed income portfolio equal to benchmarked index."
(ii) Indexation Strategy: This strategy involves replication of a predetermined benchmark well known bond index as closely as possible.
(iii) Immunization: This strategy cannot exactly be termed as purely passive strategy but a hybrid strategy. This strategy is more popular among pension funds. Since pension funds promised to pay fixed amount to retiring people in the form of annuities any inverse movement in interest may threaten fund's ability to meet their liability timely. By building an immunized portfolio the interest
rate risk can be avoided.
(iv) Matching Cash Flows: Another stable approach to immunize the portfolio is Cash Flow Matching. This approach involves buying of Zero Coupon Bonds to meet the promised payment out of the proceeds realized.
15.3.2 Active Strategy
As mentioned earlier Active Strategy is usually adopted to outperform the market. Following are some of active strategies:
"(1) Forecasting Returns and Interest Rates: This strategy involves the estimation of return on basis of change in interest rates. Since interest rate and bond values are inversely related if portfolio manager is expecting a fall in interest rate of bonds he/she should buy with longer maturity period. On the contrary, if he/she expected a fall in interest then he/she should sell bonds with longer period."
Based on short term yield movement following three strategies can be adopted:
"(a) Bullet Strategy: This strategy involves concentration of investment in one particular bond. This type of strategy is suitable for meeting the fund after a point of time such as meeting education expenses of children etc. For example, if 100% of fund meant for investing in bonds is invested in 5-years Bond."
"(b) Barbell Strategy: As the name suggests this strategy involves investing equal amount in short term and long term bonds. For example, half of fund meant for investment in bonds is invested in 1-year Bond and balance half in 10-year Bonds."
(c) Ladder Strategy: This strategy involves investment of equal amount in bonds with different maturity periods. For example if 20% of fund meant for investment in bonds is invested in Bonds of periods ranging from 1 year to 5 years.
"Further estimation of interest ratio is a daunting task, and quite difficult to ascertain. There are several models available to forecast the expected interest rates which are based on:"
(i) Inflation
(ii) Past Trends
(iii) Multi Factor Analysis
"It should be noted that these models can be used as estimates only, as it is difficult to calculate the accurate changes."
There is one another technique of estimating expected change in interest rate called 'Horizon Analysis'. This technique requires that analyst should select a particular holding period and then
"predict yield curve at the end of that period as with a given period of maturity, a bond yield curve of a selected period can be estimated and its end price can also be calculated."
(2) Bond Swaps: This strategy involves regularly monitoring bond process to identify mispricing and try to exploit this situation. Some of the popular swap techniques are as follows:
"(a) Pure Yield Pickup Swap - This strategy involves switch from a lower yield bond to a higher yield bonds of almost identical quantity and maturity. This strategy is suitable for portfolio manager who is willing to assume interest rate risk as in switching from short term bond to long term bonds to earn higher rate of interest, he may suffer a capital loss."
"(b) Substitution Swap - This swapping involves swapping with similar type of bonds in terms of coupon rate, maturity period, credit rating, liquidity and call provision but with different prices. This type of differences exits due to temporary imbalance in the market. The risk a portfolio manager carries if some features of swapped bonds may not be truly identical to the swapped one."
(c) International Spread Swap - In this swap portfolio manager is of the belief that yield spreads between two sectors is temporarily out of line and he tries to take benefit of this mismatch. Since the spread depends on many factor and a portfolio manager can anticipate appropriate strategy and can profit from these expected differentials.
(d) Tax Swap - This is based on taking tax advantage by selling existing bond whose price decreased at capital loss and set it off against capital gain in other securities and buying another security which has features like that of disposed one.
(3) Interest Rate Swap: Interest Rate Swap is another technique that is used by Portfolio Manager. This technique has been discussed in details in the chapter on Interest Rate Risk Management.
16. ALTERNATIVE INVESTMENT AVENUES
"Plainly speaking, Alternative Investments (AIs) are Investments other than traditional investments (stock, bond and cash)."
Features of Alternative Investments
Though here may be many features of Alternative Investment but following are some common features.
(i) High Fees - Being a specific nature product the transaction fees are quite on higher side.
(ii) Limited Historical Rate - The data for historic return and risk is verity limited where data for equity market for more than 100 years in available.
(iii) Illiquidity - The liquidity of Alternative Investment is not good as next buyer may not be easily available due to limited market.
(iv) Less Transparency - The level of transparency is not adequate due to limited public information available.
(v) Extensive Research Required - Due to limited availability of market information extensive analysis is required by the Portfolio Managers.
(vi) Leveraged Buying - Generally investment in alternative investments is highly leveraged. Over the time various types of AIs have been evolved but some of the important AIs are as follows:
1. Real Estates
2. Gold
3. Private Equity
4. REITs
5. Hedge Funds
6. Exchange Traded Funds
7. Mutual Funds
8. Commodities
9. Distressed Securities
"Since, some of the above terms have been covered under the respective chapter in this study, we shall cover other terms hereunder."
16.1 Real Estates
"As opposed to financial claims in the form of paper or a dematerialized mode, real estate is a tangible form of assets which can be seen or touched. Real Assets consists of land, buildings, offices, warehouses, shops etc."
Although real investment is like any other investment but it has some special features as every country has their own laws and paper works which makes investment in foreign properties less attractive.
"However, in recent time due to globalization investment in foreign real estate has been increased."
16.1.1 Valuation Approaches
Comparing to financial instrument the valuation of Real Estate is quite complex as number of transactions or dealings comparing to financial instruments are very small.
Following are some characteristics that make valuation of Real Estate quite complex:
(i) Inefficient market: Information may not be freely available as in case of financial securities.
(ii) Illiquidity: Real Estates are not as liquid as financial instruments.
(iii) Comparison: Real estates are only approximately comparable to other properties.
"(iv) High Transaction cost: In comparison to financial instruments, the transaction and management cost of Real Estate is quite high."
(v) No Organized market: There is no such organized exchange or market as for equity shares and bonds.
16.1.2 Valuation of Real Estates
"Generally, following four approaches are used in valuation of Real estates:"
(1) Sales Comparison Approach - It is like Price Earning Multiplier as in case of equity shares. Benchmark value of similar type of property can be used to value Real Estate.
(2) Income Approach - This approach is like value of Perpetual Debenture or Irredeemable Preference Shares. In this approach the perpetual cash flow of potential net income (after deducting expense) is discounted at market required rate of return.
"(3) Cost Approach - In this approach, the cost is estimated to replace the building in its present form plus estimated value of land. However, adjustment of other factors such as good location, neighbourhood is also made in it."
"(4) Discounted After Tax Cash Flow Approach - In comparison to NPV technique, PV of expected inflows at required rate of return is reduced by amount of investment."
16.2 Gold
"Being a real asset Gold is an attractive alternative form of investment by various categories of investors. Gold has been a very popular source of investment since a long time especially among Indians. The most common avenue of making investment in the gold has been buying the jewellery by most of the households. However, this form of investment in gold suffers from a serious limitation of making charges because jeweller charge them both at the time of selling and buying back."
Hence with the passage of time other forms have been evolved some of which are as follows:
"(a) Gold Bars: An alternative to investment in jewellery, investors can buy gold coins/ bar of different denominations. However, similar to jewellery this form of investment suffers from the limitation of cost of physical storage."
"(b) Sovereign Gold Bonds (SGBs): The SGB offers a superior alternative to holding gold in physical form. SGBs are government securities denominated in grams of gold. They are substitutes for holding physical gold. Investors have to pay the issue price in cash and the bonds will be redeemed in cash on maturity. The Bond is issued by Reserve Bank on behalf of Government of India. The quantity of gold for which the investor pays is protected, since he receives the ongoing market price at the time of redemption/ premature redemption. The risks and costs of storage are eliminated. Investors are assured of the market value of gold at the time of maturity and periodical interest. SGB is free from issues like making charges and purity in the case of gold in jewellery form. The bonds are held in the books of the RBI or in demat form eliminating risk of loss of scrip etc."
"(c) Gold Exchange Traded Funds (ETFs): Gold ETFs can be considered as an investment avenue which is a hybrid of flexibility of stock investment and the simplicity of gold investments. Like any other company stock, they can be bought and sold continuously at market prices on Stock Exchanges."
"Prices of Gold ETFs are based on gold prices and investment of fund amount is made in gold bullion. Further because of its direct gold pricing, there is a complete transparency on the holdings of an ETF. Compared to physical gold investments due to its unique structure and creation mechanism, the ETFs have much lower expenses."
"(d) E-gold: Started in 2010 in India, E-gold is offered by the National Spot Exchange Ltd (NSEL). It can be bought by setting up a trading account with an authorized participant with NSEL. Each unit of e-gold is equivalent to one gram of physical gold and is held in the Demat account (different from holding and transacting in equities). Like Gold ETFs, e-gold units are fully backed by an equivalent quantity of gold kept with the custodian and have less storage cost compared to physical gold. These units can be traded on the exchange."
16.3 Distressed securities
"It is purchasing the securities of companies that are in or near bankruptcy. Since these securities are available at very low price, the main purpose of buying such securities is to make efforts to revive the sick company. Further, these securities are suitable for those investors who cannot participate in the market and those who wants to avoid due diligence."
"Now, question arises how profit can be earned from distressed securities. It can be by taking Long Position in Debt and Short Position in Equity. Now let us see how investor can earn arbitrage profit."
"(i) In case company's condition improves because of priority, the investor will get his interest payment which shall be more than the dividend on his short position in equity shares."
(ii) If company's condition further deteriorates the value of both share and debenture goes down. He will make good profit from his short position.
"Risks Analysis of Investment in Distressed Securities : On the face, investment in distressed securities appears to be a good proposition but following types of risks are needed to be analyzed."
(i) Liquidity Risk - These securities may be saleable in the market.
(ii) Event Risk - Any event that particularly effect the company not economy as a whole
(iii) Market Risk - This is another type of risk though it is not important.
(iv) Human Risk - The judge's decision on the company in distress also play a big role.

Two broad choices are required for the formulation of an appropriate Portfolio Strategy. They are Active Portfolio Strategy and Passive Portfolio Strategy.
12.1 Active Portfolio Strategy (APS)
"An APS is followed by most investment professionals and aggressive investors who strive to earn superior return after adjustment for risk. The vast majority of funds (or schemes) available in India follow an "active" investment approach, wherein fund managers of "active" funds spend a great deal of time on researching individual companies, gathering extensive data about financial performance, business strategies and management characteristics. In other words, "active" fund managers try to identify and invest in stocks of those companies that they think will produce better returns and beat"
the overall market (or Index).
There are four principles of an active strategy. These are:
"(a) Market Timing : This involves departing from the normal i.e. strategy for long run asset mix to reflect assessment of the prospect of various assets in the near future. Market timing is based on an explicit or implicit forecast of general market movement. A variety of tools are employed for market timing analysis namely business cycle analysis, moving average analysis, advance-decline analysis, Econometric models. The forecast for the general market movement derived with the help of one or more of these tools is tempted by the subjective judgment of the investors. In most cases investors may go largely by their market sense. Those who reveal the fluctuation in the market may be tempted to play the game of market timing but few will succeed in this game. Further an investment manager has to forecast the market correctly and 75% of the time he is only able to break even after taking into account the cost of errors and cost of transactions. According to Fisher Black, the market is just as well as on an average when the investor is out of the market as it does when he is in. So, he loses money relative to a single buy and sale strategy by being out of the market part of the time."
"(b) Sector Rotation: Sector or group rotation may apply to both stock and bond component of the portfolio. It is used more compulsorily with respect to strategy. The components of the portfolio are used when it involves shifting. The weighting for various industry sectors is based on their asset outlook. If one thinks that steel and pharmaceutical would do well as compared to other sectors in the forthcoming period he may overweigh the sector relative to their position in the market portfolio, with the result that his portfolio will be tilted more towards these sectors in comparison to the market portfolio."
"With respect to bond portfolio sector rotation it implies a shift in the composition of the bond portfolio in terms of quality as reflected in credit rating, coupon rate, term of maturity etc. If one anticipates a rise in the interest rate one may shift from long term bonds to medium and short term. A long term bond is more sensitive to interest rate variation compared to a short term bond."
(c) Security Selection: Security selection involves a search for under-priced security. If one has to resort to active stock selection he may employ fundamental / technical analysis to identify stocks which seems to promise superior return and concentrate the stock components of portfolio on them. Such stock will be over weighted relative to their position in the market portfolio. Like wise stock which are perceived to be unattractive will be under weighted relative to their position in the market portfolio.
As far as bonds are concerned security selection calls for choosing bonds which offer the highest yields to maturity and at a given level of risk.
"(d) Use of Specialised Investment Concept: To achieve superior return, one has to employ a specialised concept/philosophy particularly with respect to investment in stocks. The concept which have been exploited successfully are growth stock, neglected or out of favour stocks, asset stocks, technology stocks and cyclical stocks."
The advantage of cultivating a specialized investment concept is that it helps to:
(i) Focus one's effort on a certain kind of investment that reflects one's ability and talent.
(ii) Avoid the distraction of perusing other alternatives.
(iii) Master an approach or style through sustained practice and continual self criticism.
The greatest disadvantage of focusing exclusively on a specialized concept is that it may become obsolete. The changes in the market risk may cast a shadow over the validity of the basic premise underlying the investor philosophy.
12.2 Passive Portfolio Strategy
Active strategy was based on the premise that the capital market is characterized by efficiency which can be exploited by resorting to market timing or sector rotation or security selection or use of special concept or some combination of these basis.
"Passive strategy, on the other hand, rests on the tenet that the capital market is fairly efficient with respect to the available information. Hence they search for superior return. Basically, passive strategy involves adhering to two guidelines. They are:"
(a) Create a well-diversified portfolio at a predetermined level of risk.
(b) Continue to hold the portfolio relatively unchanged over a period unless it becomes inadequately diversified or inconsistent with the investor risk return preference.
"A fund which is passively managed is called index funds. An Index fund is a mutual fund scheme that invests in the securities of the target Index in the same proportion or weightage. Though it is designed to provide returns that closely track the benchmark Index, an Index Fund carries all the risks normally associated with the type of asset the fund holds. So, when the overall stock market rises/falls, you can expect the price of shares in the index fund to rise/fall, too. In short, an index fund does not mitigate market risks. Indexing merely ensures that your returns will not stray far from the returns on the Index that the fund mimics. In other words, an index fund is a fund whose daily returns are the same as the daily returns obtained from an index. Thus, it is passively managed in the sense that an index fund manager invests in a portfolio which is exactly the same as the portfolio"
"which makes up an index. For instance, the NSE-50 index (Nifty) is a market index which is made"
"up of 50 companies. A Nifty index fund has all its money invested in the Nifty fifty companies, held in the same weights of the companies which are held in the index."
12.3 Selection of Securities
There are certain criteria which must be kept in mind while selecting securities. The selection criteria for both bonds and equity shares are given as following:
12.3.1 Selection of Bonds
Bonds are fixed income avenues. The following factors have to be evaluated in selecting fixed income avenues:
"(a) Yield to maturity: The yield to maturity for a fixed income avenues represent the rate of return earned by the investor, if he invests in the fixed income avenues and holds it till its maturity."
"(b) Risk of Default: To assess such risk on a bond, one has to look at the credit rating of the bond. If no credit rating is available relevant financial ratios of the firm have to be examined such as debt equity, interest coverage, earning power etc and the general prospect of the industry to which the firm belongs have to be assessed."
"(c) Tax Shield: In the past, several fixed income avenues offers tax shields but at present only a few of them do so."
(d) Liquidity: If the fixed income avenues can be converted wholly or substantially into cash at a fairly short notice it possesses a liquidity of a high order.
12.3.2 Selection of Stock (Equity Share)
"Three approaches are applied for selection of equity shares- Technical analysis, Fundamental analysis and Random selection analysis."
(a) Technical analysis looks at price behaviours and volume data to determine whether the share price will move up or down or remain trend less.
"(b) Fundamental analysis focuses on fundamental factors like earning level, growth prospects and risk exposure to establish intrinsic value of a share. The recommendation to buy hold or sell is based on comparison of intrinsic value and prevailing market price."
(c) Random selection analysis is based on the premise that the market is efficient and security is properly priced.
Levels of Market Efficiency and Approach to Security Selection
"Approach
Levels of Efficiency" Technical Analysis Fundaments Analysis Random Selection
1) Inefficiency Best Poor Poor
2) Weak form efficiency Poor Best Poor
3) Semi-strong efficiency Poor Good Fair
4) Strong Form efficiency Poor Fair Best

"It means the value of portfolio as well as its composition. The relative proportion of bond and stocks may change as stock and bonds fluctuate in response to such changes. Portfolio rebalancing is necessary. There are three policies of portfolio rebalancing- Buy and hold policy, Constant mix policy, and Constant Proportion Portfolio Insurance (CPPI) policy. These policies have different pay off under varying market conditions. Under all these policies portfolio consists of investment in stock and bonds."
(a) Buy and Hold Policy: Sometime this policy is also called 'do nothing policy' as under this strategy no balancing is required and therefore investor maintain an exposure to stocks and therefore linearly related to the value of stock in general.
"Under this strategy investors set a limit (floor) below which he does not wish the value of portfolio should go. Therefore, he invests an amount equal to floor value in non-fluctuating assets (Bonds). Since the value of portfolio is linearly related to value of stocks the pay-off diagram is a straight line. This can be better understood with the help of an example. Suppose a portfolio consisting of Debt/ Bonds for ₹ 50,000 and ₹ 50,000 in equity shares currently priced at ₹ 100 per share. If price of the share moves from ₹ 100 to ₹ 200 the value of portfolio shall become ₹ 1,50,000. The pay-off diagram is shown in figure below i.e. a straight line:"
This policy is suitable for the investor whose risk tolerance is positively related to portfolio and stock market return but drops to zero of below floor value.
"Concluding, it can be said that following are main features of this policy:"
(a) The value of portfolio is positively related and linearly dependent on the value of the stock.
(b) The value of portfolio cannot fall below the floor value i.e. investment in Bonds.
(c) This policy performs better if initial percentage is higher in stock and stock outperform the bond. Reverse will happen if stock under perform in comparison of bond or their prices goes down.
"(b) Constant Mix Policy: Contrary to above policy this policy is a 'Do Something Policy'. Under this policy investor maintains an exposure to stock at a constant percentage of total portfolio. This strategy involves periodic rebalancing to required (desired) proportion by purchasing and selling stocks as and when their prices goes down and up respectively. In other words this plan specifies that value of aggressive portfolio to the value of conservative portfolio will be held constant at a pre- determined ratio. However, it is important to this action is taken only there is change in the prices of share at a predetermined percentage."
For example if an investor decided his portfolio shall consist of 60% in equity shares and balance 40% in bonds on upward or downward of 10% in share prices he will strike a balance.
"In such situation if the price of share goes down by 10% or more, he will sell the bonds and invest money in equities so that the proportion among the portfolio i.e. 60:40 remains the same. According if the prices of share goes up by 10% or more he will sell equity shares and shall in bonds so that the ratio remains the same i.e. 60:40. This strategy is suitable for the investor whose tolerance varies proportionally with the level of wealth and such investor holds equity at all levels."
The pay-off diagram of this policy shall be as follows:
"Accordingly, it gives a concave pay off, tends to do well in flat but fluctuating market."
Continuing above example let us how investor shall rebalance his portfolio (50 : 50) under different scenarios as follows:
(a) If price decreases
Share Price Value of Shares Value of Bonds Total Stock to Bond Switching Bond to Stock Switching
100 Starting Level "50,000" "50,000" "1,00,000" - -
80 Before Rebalancing "40,000" "50,000" "90,000" - -
After Rebalancing "45,000" "45,000" "90,000" - "5,000"
60 Before Rebalancing "33,750" "45,000" "78,750" - -
After Rebalancing "39,360" "39,390" "78,750" - "5,610"
(b) If price increases
Share Price "Value
of Shares" "Value
of Bonds" Total "Stock to
Bond Switching" Bond to Stock Switching
100 Starting Level "50,000" "50,000" "1,00,000" - -
150 Before Rebalancing "75,000" "50,000" "1,25,000" - -
After Rebalancing "62,400" "62,600" "1,25,000" "12,600" -
200 Before Rebalancing "83,200" "62,600" "1,45,800" - -
After Rebalancing "72,800" "73,000" "1,45,800" "10,400" -
"(c) Constant Proportion Insurance Policy : Under this strategy investor sets a limit below which he does not wish his asset to fall called 'Floor Value', which is invested in some non-fluctuating assets such as Treasury Bills, Bonds etc. The value of portfolio under this strategy shall not fall below this specified floor under normal market conditions. This strategy performs well especially in bull market as the value of shares purchased as cushion increases. In contrast in bearish market losses are avoided by sale of shares. It should however be noted that this strategy performs very poorly in the market hurt by sharp reversals. The following equation is used to determine equity allocation:"
Target Investment in Shares = Multiplier (Portfolio Value - Floor Value)
Multiplier is a fixed constant whose value shall be more than 1.
"The pay-off under this strategy can be understood better with the help of an example. Suppose wealth of Mr. A is ₹ 10,00,000, a floor value of ₹ 7,50,000 and a multiplier of 2. Since the initial cushion (difference between Portfolio Value and Floor) is ₹ 2,50,000, the initial investment in the share shall be ₹ 5,00,000 (double of the initial cushion). Accordingly, initial portfolio mix shall consist of ₹ 5,00,000 in shares and balance ₹ 5,00,000 in Bonds."
"Situation 1: Suppose stock market rises from 100 to 150. The value of shares of Mr. A's holding shall rise from ₹ 5,00,000 to ₹ 7,50,000 and value of portfolio shall jump to ₹ 12,50,000 and value of cushion to ₹ 7,50,000. Since the CPPI Policy requires the component of shares should go up to"
"₹ 10,00,000. This will necessitate the selling of bonds amounting ₹ 2,50,000 and re-investing proceeds in shares."
"Situation 2: If stock market falls from 100 to 80, the value of shares of portfolio falls from ₹ 5,00,000 to ₹ 4,00,000 resulting in reduction of value of portfolio to ₹ 9,00,000 and cushion to ₹ 1,50,000. Since as per CPPI the share component should be ₹ 3,00,000 (₹ 1,50,000 x 2), hence shares of ₹ 1,00,000 should be sold and invest in Bonds."
Thus from above it is clear that as per CPPI sell the shares as their prices fall and buy them as their prices rise. This policy is contrary to the Constant Mix Policy and hence pay-off of CPPI shall be convex as shown below:
(d) Comparative Evaluation
Basis Buy & Hold Policy Constant Mix Policy Constant Proportion Portfolio Insurance
Pay-off Line Straight Concave Convex
Protection in Down/Up Markets Definitely poor in Down market "Not much in Down market but relatively poor in
Up market" Good in Down market and performs well in Up market
Performance in flat market "Performs between
Constant and CPPI" Tend to do well in flat market. Performs poorly.

"Many portfolios containing equities also contain other asset categories, so the management factors are not limited to equities. There are four asset allocation strategies:" "(a) Integrated Asset Allocation: Under this strategy, capital market conditions and investor objectives and constraints are examined and the allocation that best serves the investor's needs while incorporating the capital market forecast is determined." "(b) Strategic Asset Allocation: Under this strategy, optimal portfolio mixes based on returns, risk and co-variances is generated using historical information and adjusted periodically to restore target allocation within the context of the investor's objectives and constraints." "(c) Tactical Asset Allocation: Under this strategy, investor's risk tolerance is assumed constant and the asset allocation is changed based on expectations about capital market conditions." "(d) Insured Asset Allocation: Under this strategy, risk exposure for changing portfolio values (wealth) is adjusted; more value means more ability to take risk."

"Fixed Income Portfolio is same as equity portfolio with difference that it consist of fixed income securities such as bonds, debentures, money market instruments etc. Since, it mainly consists of bonds, it is also called Bond Portfolio."
15.1 Fixed Income Portfolio Process
"Just like other portfolios, following five steps are involved in fixed income portfolio."
1. Setting up objective
2. Drafting guideline for investment policy
3. Selection of Portfolio Strategy - Active and Passive
4. Selection of securities and other assets
5. Evaluation of performance with benchmark
15.2 Calculation of Return on Fixed Income Portfolio
First and foremost step in evaluation of performance of a portfolio is calculation of return. Although there can be many types of measuring returns as per requirements but some of the commonly used measures are :
(i) Arithmetic Average Rate of Return
(ii) Time Weighted Rate of Return
(iii) Rupee Weighted Rate of Return
(iv) Annualized Return
15.3 Fixed Income Portfolio Management Strategies
There are two strategies
(i) Passive Strategy
(ii) Active Strategy
15.3.1 Passive Strategy
As mentioned earlier Passive Strategy is based on the premise that securities are fairly priced commensurate with the level of risk. Though investor does not try to outperform the market but it does not imply they remain totally inactive. Common strategies applied by passive investors of fixed income portfolios are as follows:
(i) Buy and Hold Strategy: This technique is do nothing technique and investor continues with initial selection and do not attempt to churn bond portfolio to increase return or reduce the level of risk.
"However, sometime to control the interest rate risk, the investor may set the duration of fixed income portfolio equal to benchmarked index."
(ii) Indexation Strategy: This strategy involves replication of a predetermined benchmark well known bond index as closely as possible.
(iii) Immunization: This strategy cannot exactly be termed as purely passive strategy but a hybrid strategy. This strategy is more popular among pension funds. Since pension funds promised to pay fixed amount to retiring people in the form of annuities any inverse movement in interest may threaten fund's ability to meet their liability timely. By building an immunized portfolio the interest
rate risk can be avoided.
(iv) Matching Cash Flows: Another stable approach to immunize the portfolio is Cash Flow Matching. This approach involves buying of Zero Coupon Bonds to meet the promised payment out of the proceeds realized.
15.3.2 Active Strategy
As mentioned earlier Active Strategy is usually adopted to outperform the market. Following are some of active strategies:
"(1) Forecasting Returns and Interest Rates: This strategy involves the estimation of return on basis of change in interest rates. Since interest rate and bond values are inversely related if portfolio manager is expecting a fall in interest rate of bonds he/she should buy with longer maturity period. On the contrary, if he/she expected a fall in interest then he/she should sell bonds with longer period."
Based on short term yield movement following three strategies can be adopted:
"(a) Bullet Strategy: This strategy involves concentration of investment in one particular bond. This type of strategy is suitable for meeting the fund after a point of time such as meeting education expenses of children etc. For example, if 100% of fund meant for investing in bonds is invested in 5-years Bond."
"(b) Barbell Strategy: As the name suggests this strategy involves investing equal amount in short term and long term bonds. For example, half of fund meant for investment in bonds is invested in 1-year Bond and balance half in 10-year Bonds."
(c) Ladder Strategy: This strategy involves investment of equal amount in bonds with different maturity periods. For example if 20% of fund meant for investment in bonds is invested in Bonds of periods ranging from 1 year to 5 years.
"Further estimation of interest ratio is a daunting task, and quite difficult to ascertain. There are several models available to forecast the expected interest rates which are based on:"
(i) Inflation
(ii) Past Trends
(iii) Multi Factor Analysis
"It should be noted that these models can be used as estimates only, as it is difficult to calculate the accurate changes."
There is one another technique of estimating expected change in interest rate called 'Horizon Analysis'. This technique requires that analyst should select a particular holding period and then
"predict yield curve at the end of that period as with a given period of maturity, a bond yield curve of a selected period can be estimated and its end price can also be calculated."
(2) Bond Swaps: This strategy involves regularly monitoring bond process to identify mispricing and try to exploit this situation. Some of the popular swap techniques are as follows:
"(a) Pure Yield Pickup Swap - This strategy involves switch from a lower yield bond to a higher yield bonds of almost identical quantity and maturity. This strategy is suitable for portfolio manager who is willing to assume interest rate risk as in switching from short term bond to long term bonds to earn higher rate of interest, he may suffer a capital loss."
"(b) Substitution Swap - This swapping involves swapping with similar type of bonds in terms of coupon rate, maturity period, credit rating, liquidity and call provision but with different prices. This type of differences exits due to temporary imbalance in the market. The risk a portfolio manager carries if some features of swapped bonds may not be truly identical to the swapped one."
(c) International Spread Swap - In this swap portfolio manager is of the belief that yield spreads between two sectors is temporarily out of line and he tries to take benefit of this mismatch. Since the spread depends on many factor and a portfolio manager can anticipate appropriate strategy and can profit from these expected differentials.
(d) Tax Swap - This is based on taking tax advantage by selling existing bond whose price decreased at capital loss and set it off against capital gain in other securities and buying another security which has features like that of disposed one.
(3) Interest Rate Swap: Interest Rate Swap is another technique that is used by Portfolio Manager. This technique has been discussed in details in the chapter on Interest Rate Risk Management.

"Plainly speaking, Alternative Investments (AIs) are Investments other than traditional investments (stock, bond and cash)."
Features of Alternative Investments
Though here may be many features of Alternative Investment but following are some common features.
(i) High Fees - Being a specific nature product the transaction fees are quite on higher side.
(ii) Limited Historical Rate - The data for historic return and risk is verity limited where data for equity market for more than 100 years in available.
(iii) Illiquidity - The liquidity of Alternative Investment is not good as next buyer may not be easily available due to limited market.
(iv) Less Transparency - The level of transparency is not adequate due to limited public information available.
(v) Extensive Research Required - Due to limited availability of market information extensive analysis is required by the Portfolio Managers.
(vi) Leveraged Buying - Generally investment in alternative investments is highly leveraged. Over the time various types of AIs have been evolved but some of the important AIs are as follows:
1. Real Estates
2. Gold
3. Private Equity
4. REITs
5. Hedge Funds
6. Exchange Traded Funds
7. Mutual Funds
8. Commodities
9. Distressed Securities
"Since, some of the above terms have been covered under the respective chapter in this study, we shall cover other terms hereunder."
16.1 Real Estates
"As opposed to financial claims in the form of paper or a dematerialized mode, real estate is a tangible form of assets which can be seen or touched. Real Assets consists of land, buildings, offices, warehouses, shops etc."
Although real investment is like any other investment but it has some special features as every country has their own laws and paper works which makes investment in foreign properties less attractive.
"However, in recent time due to globalization investment in foreign real estate has been increased."
16.1.1 Valuation Approaches
Comparing to financial instrument the valuation of Real Estate is quite complex as number of transactions or dealings comparing to financial instruments are very small.
Following are some characteristics that make valuation of Real Estate quite complex:
(i) Inefficient market: Information may not be freely available as in case of financial securities.
(ii) Illiquidity: Real Estates are not as liquid as financial instruments.
(iii) Comparison: Real estates are only approximately comparable to other properties.
"(iv) High Transaction cost: In comparison to financial instruments, the transaction and management cost of Real Estate is quite high."
(v) No Organized market: There is no such organized exchange or market as for equity shares and bonds.
16.1.2 Valuation of Real Estates
"Generally, following four approaches are used in valuation of Real estates:"
(1) Sales Comparison Approach - It is like Price Earning Multiplier as in case of equity shares. Benchmark value of similar type of property can be used to value Real Estate.
(2) Income Approach - This approach is like value of Perpetual Debenture or Irredeemable Preference Shares. In this approach the perpetual cash flow of potential net income (after deducting expense) is discounted at market required rate of return.
"(3) Cost Approach - In this approach, the cost is estimated to replace the building in its present form plus estimated value of land. However, adjustment of other factors such as good location, neighbourhood is also made in it."
"(4) Discounted After Tax Cash Flow Approach - In comparison to NPV technique, PV of expected inflows at required rate of return is reduced by amount of investment."
16.2 Gold
"Being a real asset Gold is an attractive alternative form of investment by various categories of investors. Gold has been a very popular source of investment since a long time especially among Indians. The most common avenue of making investment in the gold has been buying the jewellery by most of the households. However, this form of investment in gold suffers from a serious limitation of making charges because jeweller charge them both at the time of selling and buying back."
Hence with the passage of time other forms have been evolved some of which are as follows:
"(a) Gold Bars: An alternative to investment in jewellery, investors can buy gold coins/ bar of different denominations. However, similar to jewellery this form of investment suffers from the limitation of cost of physical storage."
"(b) Sovereign Gold Bonds (SGBs): The SGB offers a superior alternative to holding gold in physical form. SGBs are government securities denominated in grams of gold. They are substitutes for holding physical gold. Investors have to pay the issue price in cash and the bonds will be redeemed in cash on maturity. The Bond is issued by Reserve Bank on behalf of Government of India. The quantity of gold for which the investor pays is protected, since he receives the ongoing market price at the time of redemption/ premature redemption. The risks and costs of storage are eliminated. Investors are assured of the market value of gold at the time of maturity and periodical interest. SGB is free from issues like making charges and purity in the case of gold in jewellery form. The bonds are held in the books of the RBI or in demat form eliminating risk of loss of scrip etc."
"(c) Gold Exchange Traded Funds (ETFs): Gold ETFs can be considered as an investment avenue which is a hybrid of flexibility of stock investment and the simplicity of gold investments. Like any other company stock, they can be bought and sold continuously at market prices on Stock Exchanges."
"Prices of Gold ETFs are based on gold prices and investment of fund amount is made in gold bullion. Further because of its direct gold pricing, there is a complete transparency on the holdings of an ETF. Compared to physical gold investments due to its unique structure and creation mechanism, the ETFs have much lower expenses."
"(d) E-gold: Started in 2010 in India, E-gold is offered by the National Spot Exchange Ltd (NSEL). It can be bought by setting up a trading account with an authorized participant with NSEL. Each unit of e-gold is equivalent to one gram of physical gold and is held in the Demat account (different from holding and transacting in equities). Like Gold ETFs, e-gold units are fully backed by an equivalent quantity of gold kept with the custodian and have less storage cost compared to physical gold. These units can be traded on the exchange."
16.3 Distressed securities
"It is purchasing the securities of companies that are in or near bankruptcy. Since these securities are available at very low price, the main purpose of buying such securities is to make efforts to revive the sick company. Further, these securities are suitable for those investors who cannot participate in the market and those who wants to avoid due diligence."
"Now, question arises how profit can be earned from distressed securities. It can be by taking Long Position in Debt and Short Position in Equity. Now let us see how investor can earn arbitrage profit."
"(i) In case company's condition improves because of priority, the investor will get his interest payment which shall be more than the dividend on his short position in equity shares."
(ii) If company's condition further deteriorates the value of both share and debenture goes down. He will make good profit from his short position.
"Risks Analysis of Investment in Distressed Securities : On the face, investment in distressed securities appears to be a good proposition but following types of risks are needed to be analyzed."
(i) Liquidity Risk - These securities may be saleable in the market.
(ii) Event Risk - Any event that particularly effect the company not economy as a whole
(iii) Market Risk - This is another type of risk though it is not important.
(iv) Human Risk - The judge's decision on the company in distress also play a big role.