SECURITY ANALYSIS AND PORTFOLIO

MANAGEMENT
UNIT -V
Meaning of Portfolio Management
The art of selecting the right investment
policy for the individuals in terms of minimum
risk and maximum return is called as portfolio
management
Phases of Portfolio Management

Security Analysis

Portfolio Construction

Portfolio Selection

Portfolio Revision

Portfolio Evaluation
1.Security Analysis
 1.Fundamental Analysis
 2.Technical Analysis
2.Portfolio Construction/Analysis
 Investor attempt to spread a risk not putting all the
Eggs into one basket
3.Portfolio Selection
 Portfolio analysis provides the input the next phase in
portfolio management which is portfolio selection
4.Portfolio Revision
 To monitor the portfolio, it leads to purchase of some
new securities and sale of some of the existing
securities from the portfolio
5.Portfolio Evaluation
 Portfolio evaluation is the process which is concerned
with assessing the performance of the portfolio over a
selected period of time in terms of return and risk
1.PORTFOLIO ANALYSIS/CONSTRUCTION
 To obtain Optimum return with minimum risk
Portfolio Theory
 Portfolio theory deals with the selection of optimal
portfolio by rational risk averse investors
 It determines the combination of risk and return that
the investor to achieve the highest return for a given
level of risk
Portfolio Risk and Return
 Portfolio returns are the weighted returns of all
securities constituting the portfolio
 The portfolio risk considers the standard deviation
together with covariance between securities
 Portfolio Expected Return and Risk

Expected Return Risk

Expected Portfolio Risk of the Portfolio Correlation

returns on Weights Securities weights coefficients
Portfolio
Expected Return on Portfolio
Rp=WARA + WBRB +……..WnRn

Were
R = Expected Rate of Return in a Portfolio
p
th
Wi = Proportion of total investment invested in i asset
th
Ri = Expected Rate of return as i Security
n= Number of securities in a given portfolio
Portfolio Risk
Measurement
 Correlation plays a main role to estimate of portfolio risk
 Correlation is basically a relationship measure between
two variables X and Y, it gives the degree of relationship as
a coefficient called ‘Correlation Coefficient’
 Correlation Coefficient is denoted by small ‘r’ whose value
ranges from +1.0(Positive) to -1.0(Negative)
 Correlation is calculated as ratio between Covariance (Cov)
and Variance (σ)of individual variables
Cov (x,y)
R= ----------
σx σy
2.PORTFOLIO SELECTION
 Portfolio analysis provides the input for the next phase
in portfolio management is called Portfolio Selection
Approaches in Portfolio Selection
1. Traditional Approach
2. Modern Approach
1. Traditional Approach
 It is a comprehensive financial plan for the individual.
It takes into account the individual needs such as
housing, life insurance and pension plan. It is basically
deals with 2 major decisions
1. Determining the objectives of the portfolio
2. Selection of securities to be included in the portfolio
Steps in Traditional Approach
Analysis of Constraints

Determination of Objectives

Selection of Portfolio

Bond & Common Stock

Assessment of Risk and Return

Diversification
1. Analysis of Constraints
i)Income Needs
 The income needs depend on the need for income
(Living Expenses)
ii)Liquidity
 Liquidity need of the investment is highly
individualistic of the investor (Money Market Funds,
Shares)
iii)Safety of Principal
 The investors is the safety of the principal value at the
time of liquidation (Bonds and Debentures)
iv)Time Horizon
 Time Horizon is the investment planning period of the
individuals
v)Tax Consideration
 Investors in the income tax paying group consider
the tax concessions they could get from their
investments
vi)Temperament
 Risk Taking (High Risk and Low Risk)
2. Determination of Objectives
The Common Objectives
i) Current Income
ii) Growth in Income
iii)Capital Appreciation
iv) Preservation of Capital
3. Selection of Portfolio
i) Objectives and Asset Mix
 60% of the investment is made on debts and 40% on equities
ii) Growth of Income and Asset Mix
 Here the investor requires a certain % of the growth in the income
received from his investment
iii) Capital Appreciation and Asset Mix
 That means the value of the original investment over the year (Real
Estate)
iv) Safety of Principal and Asset Mix
 All investor have this objective in their mind .no one like to lose his
money invested in different asset
4. Assessment of Risk and Return
 The risks are namely interest rate risk, Purchasing power risk,
financial risk and market risk
5. Diversification
 Once the asset mix is determined and the risk and return are
analyzed, the final step is the diversification
2. Modern Approach
It is represent Markowitz approach
Factors influencing Portfolio Selection
1.Security
 Maintenance of the capital value of the investment
2.Return
 Money put into investment is expected to earn a
satisfactory rate of return
3.Growth Prospects
 The returns from investments should not only be
satisfactory but also over time grow to keep the investors
happy
4.Liquidity
 This refers to the convertibility of investments back into
cash at short notice
5.Risk
 Risk can be reduced by diversification
Portfolio Models
1. Markowitz Model
2. Sharpe single index model
3. Capital Asset Pricing Model (CAPM)
1. Markowitz Model
 Markowitz portfolio selection method identifies an investor’s
unique risk – return preferences
Assumptions of Markowitz Model
1.Investors consider each investment alternative as being represented
by a probability distribution of expected returns over some holding
period
2.Individual estimate risk on the basis of the variability of expected
returns
3.Investors base decisions solely on expected return and variance or
returns only
7.For a given risk level, investors prefer high returns to lower returns

Risk Adjusted Return (Utility) =Expected return – Risk Penalty

Risk Penalty = Risk squared / Risk tolerance
2.Sharp Single Index Model
Assumptions of Single Index Model
1)Security returns are liner in a common index
2)The parameters of the index model α and β
are computed through a linear regression
procedure such that the risk premium is
purely a function of the index , not security
specific risk
3)The index represents the only source of
covariance between asset returns
Calculation of Return under Single Index Model
R=α + β Rm + e
Where
R=Return on security
Rm=Return on a market index
α=constant term
β= market beta or market sensitivity of a given stock
e= unsystematic risk
Systematic risk = β2 * Variance of market index
Unsystematic risk = Total variance – Systematic risk
Total risk = Systematic risk + Unsystematic risk
Uses of Single Index Model
1)To reduce the number of inputs and computations required
for portfolio analysis
2)To build and apply equilibrium models such as the Capital
Asset Pricing Model
3)Capital Asset Pricing Model(CAPM)
Assumption of CAPM
1)Investors objective is to maximize the Utility of terminal
wealth
2)Investors have Homogeneous Expectations of Risk and
Return
3)Investor Make Choices on the Basis of Risk and Return
4)Investors have Identical Time Horizons
5)Information is Freely and Simultaneously available to
Investors
6)There is a Risk Free Asset and Investors can Borrow and
Lend Unlimited Amount at the Risk Free Return
7)There are No Taxes, Transaction Costs and Restrictions on
Short Rate or Other Market Imperfections
8)Total assets Quality is Fixed and all Assets are Marketable
and Divisible
Key Facts/Term in CAPM
1)Risk-Free Return
2)Market Portfolio
3)Market Risk Premium
4)Beta
Calculation
Rj=α+βj*Rmt+e
Where
α=Intercept Term Alpha
βj = Regression Coefficient ,Beta
Rm=Return on Market Portfolio
e=Random Error Term
Cov(x,y)
Βj= -----------
σ2
Shortcomings of CAPM
1)The model assumes that asset returns are
normally distributed random variables
2)The model assumes that the variance of
returns is an adequate measurement of risk
3)The model does not appear to adequately
explain the variation in stock returns
4)The model assumes that all investors have
access to the same information
5)The model assumes that there are no taxes or
transaction cost
Capital Market Line(CML)
 CML tries to exhibit the linear relationship
between risk and return in case of portfolio
E(Rm) -Rf
E(Rp)=Rf + ------------- σp
σm
Where
E(Rp)=Expected Rate of Return on a Portfolios and its
total risk is measured by standard deviation σp
Rf = Risk Free Rate of Return
E(Rm) = Expected rate of return from the market
portfolio(M)
σm = S.D of Returns of Market Portfolio
Capital Market Line ( CML)
Security Market Line(SML)
SML provides an explanation on how
individual securities are priced based on the
size of ‘systematic risk’ that each security
possesses
E(Rj) = Rj + β(Rm-Rf)
where
E(Rj) = Expected return on security j
Rf = Risk-Free Return
β = Beta of Security j
Rm = Expected return on market portfolio
Security Market Line ( SML)
4.PORTFOLIO REVISION
 Portfolio revision involves changing the existing mix of
securities
 New securities may be added to the portfolio or some
of the existing securities may be removed from the
portfolio
 The objectives is same as objectives of portfolio
selection
 Ultimate aim of portfolio revision is maximizing of
returns and minimizing of risk
Needs of Revision
1)Availability of additional funds for investment
2)Change in risk tolerance
3)Change in the investment goals
4)Need to liquidate a part of the portfolio to provide
funds for some alternative use
Constraints in Portfolio Revision
1)Transaction Cost
2)Taxes
3)Statutory stipulations
4)Basic Difficulty
Portfolio Revision Strategy/Techniques
1)Active Revision Strategy
 Active revision strategy involves frequent and
sometimes substantial adjustments to the portfolio
 Active portfolio revision is essentially carrying out
portfolio analysis and selection all over again
2)Passive Revision Strategy
 It involves only minor and frequent adjustment to the
portfolio over time
 Using Formula Plans
Formula Plan
 The buying and/or selling of securities according to a
predetermined formula. It is helped to eliminate the
investor's emotions and instead follow a mechanical
set of rules
 Portfolio usually have a composition of ‘less risk ,less
return’ as well as ‘high risk , high return’ securities
Assumptions of Formula Plan
1)Certain % of investors fund is allocated to fixed income
securities and common stocks
2)Market higher –portfolio may decline, Market Low-
more aggressive on buying
3)Stocks are buy/sell whenever there is a significant
change in price-help of Sensex and Nifty moves
4)Strictly follow Formula plan
5)The investors should select good stocks and move
along with the market
Advantages
1)Basic rules and regulations for the purchase and
sale of securities
2)The rules and regulations are help to overcome
human emotion
3)Earn higher profits
4)Controls the buying and selling of securities
5)Useful to taking decision on the timing of
investments
Disadvantages
1)Does not help to selection of securities
2)Should not be applied long periods
3)Needs market forecasting
Types of Formula Plan
1)Rupee Cost Average Plans
2)Constant Value
3)Variable Ratio Plan
4)Dollar cost Average Plan
1) Rupee Cost Average Plans
 Here the investors are buyers in the market
 Fall in the price of the shares –Purchased
Large Quantity
 Share price keep rising –Purchase similar
quantity
Advantages of Cost Averaging plan
1)Reduce the average cost per share
2)Applicable to both falling and rising market
3)Takes away the pressure
Disadvantages
1)Extra transactions cost involved
2)Does not to indicate when to sell
3)There is not indication of the appropriate
interval between purchases
2) Constant Value Plan
The target value could be fixed initially by the
investor in a desirable proportion
The investor can specify either 5% or 10% or
20%
Advantages
1)Fixed return
Disadvantages
1)Fall market investor face risk(Loss)
3)Variable Ratio Plan
 The variable ratio plan gives more flexible to the
investor to revise the portfolio components
 When share price falls, the investor may shift a
major component of the conservative portfolio
to the aggressive component
Advantages
1)Automatically the investor correct his portfolio
position
Disadvantages
1)The plan does not help in the selection of scrip's
4)Dollar Cost Averaging Plan
The dollar cost averaging is really a technique
of building up a portfolio over a period of
time
It is utilize cyclic movement in share prices to
construct a portfolio at low cost
Invest such as 5000rs,10000rs….. To specified
shares at periodic intervals such as month ,
two months , quarter etc….
5.PORTFOLIO EVALUATION
 Portfolio evaluation refers to the evaluation performance
of the portfolio
 2 functions Performance Measurement –return earned on
a portfolio during the holding period
 Performance Evaluation- performance was superior or
inferior
Need of Portfolio Evaluation
1)Self Evaluation
 Individual investor Construct and manage their own
portfolio of securities
2)Evaluation of Portfolio Managers
 The Organization would like to evaluate the
performance of each portfolio (Managers Portfolio’s)
3)Evaluation of Mutual Funds
Evaluation Perspective
1)Transaction View
An Investor may attempt to evaluate every
transaction of purchase/sale of securities
2)Security View
Each security include in the portfolio has been
purchased at a particular price
3)Portfolio View
An investor evaluate the performance of
whole portfolio
Methods Of Portfolio Evaluation
1)Sharp’s Ratio/Measure
2)Treynor’s Ratio/Measure
3)Jensen Ratio/Measure
4)Modigliani & Modigliani Measure (M2Measure)
1)Sharp’s Ratio/Measure
It is called as the “Reward to Variability’
Rp-Rf
Sharpe’s ratio (SR) = ---------
σp
Where
Rp=Realized Return on a portfolio during a holding period
Rf=Risk Free Rate of Return
σp=S.D of the Portfolio
2)Treynor’s Ratio/Measure
It is called as ‘Reward to Volatility’ ratio
Rp-Rf
TR= --------
βp
Where
Rp=Realized Return on a Portfolio
Rf=Risk Free Rate of Return
βp=Portfolio
3)Jensen Ratio/Measure
 Jensen attempts to construct a measure of
absolute performance on a risk adjusted basis
Rjt-Rft=αj+βj(Rmt-Rft)
Where
Rjt=Average return on portfolio j for period t
Rft=Risk Free rate of interest for period t
αj=Intercept the measures the forecasting ability of
the portfolio managers
βj=Measure of systematic risk
Rmt=Average return of a Market portfolio for
period t
4)Modigliani & Modigliani Measure
(M2 Measure)
M2 provides a risk adjusted measure of
performance that has economically
meaningful interpretation
M2=rp –rm
Where
rp=return on adjusted portfolio
rm=return on the market portfolio
Application of Evaluation Techniques
1)Degree of Risk Assumed
2)Selection Of Individual Securities
3)Cyclical and Market Timing
4)Risk-Adjusted returns
Mutual Fund
 A mutual fund is a professionally managed form
of collective investments that group of money
from many investors and invests it in stocks ,
bonds , short-term money market instruments
Characteristics of Mutual Fund
 It is managed by a team of investment
professionals
 The ownership is in the hands of the investors
who have group in their funds
 The value of a share of the mutual fund know as
NAV
Structure of Mutual Fund
Types of Mutual Fund
1.Open ended schemes
 The open ended scheme offers its units on a
continuous basis
 Investors withdraw their money at any time
 There is no maturity period
 It is not listed in stock exchanges
2.Closed ended schemes
 It is having fixed maturity period
 Scheme is kept open for a limited period
 Once closed the units are listed on a stock exchange
“same features of closed and opened ended is known as
Interval Funds”
Other classifications
1.Growth scheme
 Amis to provide capital appreciation over
medium or long time
 Invest in equities
2.Income scheme
 Aims to provide regular return
 Invest in fixed income securities
3.Balanced scheme
 A combination of steady return as well as
reasonable growth
 Invest in equities and debt
4.Money market scheme
Invest in money market instruments like
treasury bills , commercial papers etc.
5.Tax saving scheme
It is offers tax rebates to investors
Pension scheme and equity linked scheme
6.Index scheme
Invest in equities of the index like nifty ,
sensex
 Advantages of Mutual Fund

Transparency Diversification
Research Professional
Management
Convenience Stability
Tax Benefits Flexibility
Affordability Liquidity
1.Transparency
It is transparently declare their portfolio every
month
2.Diversification
It is invest in a number of companies across
various industries and sectors
3.Research
It is required information and date required
for investments so equity teams available
4.Professional Management
Funds are professionally managed by an
portfolio managers
5.Convenience
It will reduce the paper work , save time etc
6.Stability
 Large amount invested , so losses of stock market will
reduced and continue to invest
7.Tax Benefits
 Rs,9000 allowed under section 80L of the income tax
act
8.Flexibility
 It allows various family schemes so the investor have
option to transferring their holdings from one to other
9.Affordability
 Compare to direct investment its having less expensive
10.Liquidity
 Easily encash their investment by selling their units
Disadvantages of Mutual Fund
1.Many of the investor not willing to invest
unless there is a promise of a minimum return
2.Some times portfolio mangers invest in
unlisted companies
3.Corporate having restriction to invest upto
60% only
4.Hold only minimum % of shares in a particular
industry
5.Banks and MFs do not have strong distribution
network they depend on the brokers
 Risk in Mutual Fund
Market Risk Credit Risk
Inflation Risk Interest rate Risk
Political Risk Liquidity Risk
1.Market Risk
Outside factors affecting market that time mid
size companies will affect ( SIP)
2.Credit Risk
Interest payments or repayment of principal
3.Inflation Risk
Inflation is the loss of Purchasing power
4.Interest Rate Risk
Changes in interest rates affect the prices of
bonds as well as equities
5.Political Risk
Changes in government policy and political
decision can change the investment
environment
6.Liquidity Risk
It will arises when it becomes difficult to sell
the securities