Session 20

PORTFOLIO MANAGEMENT
FRAMEWORK
The Grand Design
 OUTLINE
• Phases of Portfolio Management
• Specification of Investment Objectives and Constraints
• Choice of Asset Mix
• Formulation of Portfolio Strategy
• Selection of Securities
• Portfolio Execution
• Portfolio Revision
• Portfolio Evaluation
PHASES OF PORTFOLIO MANAGEMENT
SPECIFICATION OF INVESTMENT
OBJECTIVES AND CONSTRAINTS

CHOICE OF ASSET MIX

FORMULATION OF PORTFOLIO
STRATEGY

SELECTION OF SECURITIES

PORTFOLIO EXECUTION

PORTFOLIO REVISION

PORTFOLIO EVALUAYION
 SPECIFICATION OF INVESTMENT
OBJECTIVES

• The commonly stated investment goals are : income,

growth, and stability

• Since income and growth represent two ways by which

return is generated and stability implies containment of
risk, investment objectives may be expressed more
succinctly in terms of return and risk.
 A RISK TOLERANCE QUESTIONNAIRE
To assess your risk tolerance, seven questions are given below. Each question
is followed by three possible answers. Circle the letter that corresponds to
your answer.
1. Just six weeks after you invested in a stock, its price declines by 20
percent. If the fundamentals of the stock have not changed, what would
you do?
a. Sell
b. Do nothing
c. Buy more
2. Consider the previous question another way. Your stock dropped 20
percent, but it is part of a portfolio designed to meet investment goals with
three different time horizons.
(i) What would you do if your goal were five years away?
a. Sell
b. Do nothing
c. Buy more
(ii) What would you do if the goal were 15 years away?
a. Sell
b. Do nothing
c. Buy more
(iii) What would you do if the goal were 30 years away?
a. Sell
b. Do nothing
c. Buy more
3. You have bought a stock as part of your retirement portfolio. It price rises
by 25 percent after one month. If the fundamentals of the stock have not
changed, what would you do?
a. Sell
b. Do nothing
c. Buy more
4. You are investing for retirement which is 15 years away. What would you
do?
a. Invest in money market mutual fund or a guaranteed investment
contract
 b. Invest in a balanced mutual fund that has a stock : bond mix of
50 : 50
c. Invest in an aggressive growth mutual fund
5. As a prize winner, you have been given some choice. Which one would you
choose?
a. Rs 50,000 in cash
b. A 50 percent chance to get Rs 125,000
c. A 20 percent chance to get Rs 375,000
6. A good investment opportunity has come your way. To participate in it
you have to borrow money. Would you take a loan?
a. No
b. Perhaps
c. Yes
7. Your company, which is planning to go public after three years, is offering
stock to its employees. Until it goes public, you can’t sell your shares. Your
investment, however, has the potential of multiplying 10 times when the
company goes public. How much money would you invest?
 a. Nothing
b. Three months’ salary
c. Six months’ salary
Your risk tolerance score is:
Number of (a) answers x 1
+ Number of (b) answers x 2
+ Number of (c) answers x 3
If your score is … You may be a …
9–14 points Conservative investor
15–21 points Moderate investor
22–27 points Aggressive investor
Adapted from a risk tolerance questionnaire developed by Dow Jones &
Company Inc.
 CONSTRAINTS

• LIQUIDITY

• TAXES

• TIME HORIZON

• UNIQUE PREFERENCES & CIRCUMSTANCES

 SELECTION OF ASSET MIX

• Should the long-term stock-bond mix be 50 : 50 or

75 : 25 or 25 : 75 or any other ?

• Referred to as the strategic asset-mix decision (or policy

asset-mix decision), this is by far the most important
decision by the investor. Empirical studies have shown
that nearly 90 percent of the variance of the portfolio
return is explained by its asset mix.
 SELECTION OF ASSET MIX

CONVENTIONAL WISDOM
1. GREATER RISK TOLERANCE STOCKS
2. LONGER INVESTMENT HORIZON STOCKS

RISK-RETURN RELATIONSHIP FOR VARIOUS TYPES

OF BONDS AND STOCKS
SPECULATIVE
RETURN SHARES
BLUE CHIP
SHARES
NCDs OF PRIVATE
PUBLIC SECTOR
SECTOR
BONDS GROWTH
SHARES
DEFENSIVE
SHARES

BANK INCOME/GROWTH
ORIENTED UNITS
DEPOSITS

RISK
 RANGE OF RETURN ON COMMON STOCKS
60%

50%

40%

30%

20%

10%

0%

-10%

-20%

-30%

1-year 5-year 10-year 15-year 20-year 25-year

periods periods periods periods periods periods

High +52.6% +23.9% +19.3% +16.4% +13.4% +10.3%

Average +13.0% +10.4% + 9.5% + 9.3% + 9.4% + 9.4%
Low -26.5% - 2.4% + 1.2% + 4.3% + 6.5% + 8.4%

Source : Vanguard Group

 ENDURING RELATION

J.H.LORIE : “THE MOST ENDURING RELATION IN

ALL FINANCE PERHAPS IS THE RELATIONSHIP
BETWEEN RETURNS ON EQUITIES (OR STOCKS)
AND RETURNS ON BONDS. IN ALL PERIODS OF
AMERICAN HISTORY, BRITISH HISTORY, AND
GERMAN HISTORY, EQUITIES (STOCKS) HAVE
PROVIDED HIGHER RETURNS THAN BONDS” A
SIMILAR OBSERV’N CAN BE MADE WHEN WE
LOOK AT THE RETURNS ON STOCKS AND BONDS
IN INDIA FOR THE LAST TWO DECADES
 APPROPRIATE PERCENTAGE
ALLOCATION

RISK TOLERANCE
TIME HORIZON
LOW MODERATE HIGH

SHORT 0 25 50
MEDIUM 25 50 75
LONG 50 75 100
 FALLACY OF TIME DIVERSIFICATION
EVEN THOUGH . . UNCERTAINTY ABOUT THE AVERAGE
RATE OF RETURN DIMINISHES OVER A LONG PERIOD OF
TIME, IT COMPOUNDS OVER A LONGER TIME PERIOD
EXPECTED RETURN STANDARD DEVIATION
1 YR 15% 30%
5 YRS 15% 30% / 5 = 13.42%
A DISAPPOINTMENT OF ONE STANDARD DEVIATION WILL
AFFECT THE TERMINAL WEALTH BY A FACTOR OF (1
- 0.1342)5 = 0.487
THIS CERTAINLY … LARGER . . IMPACT … 30%
BODIE : “ WHILE THE CONFIDENCE BAND AROUND THE
EXPECTED RATE OF RETURN NARROWS WITH
INVESTMENT LIFE, THE DOLLAR CONFIDENCE BAND
WIDENS”
 RESURRECTION OF TIME DIVERSIFICATION

1. THERE IS SOME EVIDENCE THAT STOCK RETURNS

ARE NOT SERIALLY INDEPENDENT BUT TEND TO
MEAN - REVERT OVER LONG INTERVALS .. THE
DISPERSION OF TERMINAL WEALTH INCREASES -
AT A SLOWER RATE THAN WHAT IS IMPLIED BY
SERIALLY INDEPENDENT RETURNS

2. YOU MAY BE MORE INCLINED TO ACCEPT MORE

RISK OVER A LONGER HORIZON AS YOU HAVE
GREATER SCOPE TO ADJUST YOUR CONSUMPTION
AND WORK HABITS
 PORTFOLIO STRATEGY

• ACTIVE
• PASSIVE

HIGHLY ACTIVE HIGHLY PASSIVE

MARKET TIMING | …………………………………………… |

SECTOR ROTATION | …………………………………………… |

SECURITY SELECTION | …………………………………………… |

USE OF A SPECIALISED | …………………………………………… |

CONCEPT
 MARKET TIMING

• REVIEW . . MARKET FLUCT’NS . . TEMPTED . . PLAY . .

GAME
• A CAREFUL STUDY . . MARKET TIMING … SUGGESTS
… CORRECTLY FORECAST … 75% … BREAK-EVEN
• FISHER BLACK SAYS :
“THE MARKET DOES JUST AS WELL, ON AVERAGE,
WHEN THE INVESTOR IS OUT OF THE MARKET AS IT
DOES WHEN HE IS IN. SO HE LOSES MONEY,
RELATIVE TO A SIMPLE BUY-AND-HOLD STRATEGY,
BY BEING OUT OF THE MARKET PART OF THE TIME”
 USE OF A SPECIALISED CONCEPT

CHARLES .D. ELLIS … A POSSIBLE WAY TO ENHANCE

RETURNS
• GROWTH STOCKS
• NEGLECTED OR ‘OUT OF FAVOUR’ STOCKS
• ASSET-RICH STOCKS
• TECHNOLOGY STOCKS
• CYCLICAL STOCKS

PROS CONS
FOCUS OBSOLETE
MASTERY INERTIA
 PASSIVE STRATEGY

ACTIVE STRATEGY … PREMISE . . INEFFICIENCIES …

EXPLOITED

PASSIVE STRATEGY … TENET MARKET . .

EFFICIENT . . AVAILABLE INFOR’N

1. CREATE A WELL-DIVERSIFIED PORTFOLIO AT A

PRE-DETERMINED LEVEL OF RISK

2. HOLD THE PORTFOLIO RELATIVELY UNCHANGED

OVER TIME, UNLESS IT BECOMES INADEQUATELY
DIVERSIFIED OR INCONSISTENT WITH THE
INVESTOR’S RISK-RETURN PREFERENCES
 PORTFOLIO STRATEGY MIX

ABILITY TO SELECT ABILITY TO FORECAST OVERALL MARKET

UNDERVALUED GOOD BAD
SECURITIES
1. CONCENTRATE 1. CONCENTRATE
GOOD 2. SHIFT BETA 2. KEEP BETA STABLE

1. DIVERSIFY 1. DIVERSIFY
BAD 2. SHIFT BETA 2. KEEP BETA STABLE
 SELECTION OF SECURITIES

SELECTION OF BONDS
• YTM
• DEFAULT RISK
• TAX SHIELD
• LIQUIDITY
• DURATION

SELECTION OF STOCKS
• TECHNICAL ANALYSIS
• FUNDAMENTAL ANALYSIS
• RANDOM ANALYSIS
 MARKET EFFICIENCY AND
SECURITY SELECTION

LEVEL OF APPROACH TECHNICAL FUNDAMENTAL RANDOM

EFFICIENCY ANALYSIS ANALYSIS SELECTION

INEFFICIENCY BEST POOR POOR

WEAK-FORM POOR BEST POOR

EFFICIENCY

SEMI-STRONG-FORM
EFFICIENCY POOR GOOD FAIR

STRONG-FORM
EFFICIENCY POOR FAIR BEST
 PORTFOLIO EXECUTION
TRADING GAME

BUSINESS TRANSACTION SECURITY TRANSACTION

• MOTIVE AND IDENTITY OF • MOTIVE AND IDENTITY

THE COUNTERPARTY OF THE COUNTERPARTY

KNOWN NOT KNOWN

• CONSTRUCTIVE MOTIVES • ZERO SUM GAME
+ SUM GAME

MOTIVES FOR TRADE

• COGNITIVE
• EMOTIONAL
 TRADING MOTIVATIONS, TIME HORIZONS,
AND TIME VS PRICE PREFERENCES

TRANSACTOR MOTIVATION TIME TIME VS PRICE

HORIZON PREFERENCE

VBT DISCREPANCY WEEKS TO PRICE

BETWEEN VALUE MONTHS
AND PRICE

IBT NEW INFORMATION HOURS TO TIME

DAYS

LBT RELEASE OR ABSORB HOURS TO TIME

CASH DAYS

PIBT APPARENTLY NEW HOURS TO TIME

INFORMATION DAYS

DEALER ACCOMODATION MINUTES TO INDIFFERENT

HOURS
 PORTFOLIO REVISION

• NEED

• PORTFOLIO REBALANCING
• BUY AND HOLD POLICY
• CONSTANT MIX POLICY
• PORFOLIO INSRANCE POLICY

• PORTFOLIO UPGRADING
 PERFORMANCE EVALUATION RATE OF RETURN
1. ARITHMETIC MEAN 2. IRR 3. GEOMETRIC MEAN
RATE OF RETURN DATA
Year Market value of Dividend and Rate of return
the portfolio interest income
(Rs) (Rs)
0 100,000

1 105,000 10,000 10,000 + (105,000 – 100,000)

= 15%
100,000
2 95,000 10,000 10,000 + (95,000 – 105,000)
= 0.0%
105,000
3 120,000 10,000 10,000 + (120,000 – 95,000)
= 36.8%
95,000
4 140,000 12,000 12,000 + (140,000 – 120,000)
= 26.7%
120,000
5 150,000 12,000 12,000 + (130,000 – 140,000)
= 15.7%
140,000
A.M : (15.0 + 0.0 + 36.8 + 26.7 + 15.7) / 5 = 18.8%
10,000 10,000 10,000 12,000 12,000 + 150,000
IRR :100000 = + + + +
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5
r ≃ 17.65%
GM : [ (1.15) (1.00) (1.368) (1.267) (1.157)] 1/5 - 1 ≃ 18.2%
 IRR
PERIOD
1 2 3 4
RATE OF RETURN EARNED 10% 30% 20% -
PORTFOLIO A
1. BEGINNING VALUE BEFORE
INFLOW OR OUTFLOW 10,000 11,000 14,300 17,160
2. INFLOW (OUTFLOW) - - - (17,160)
3. AMOUNT INVESTED 10,000 11,000 14,300 -
4. ENDING VALUE 11,000 14,300 17,160
-PORTFOLIO B
1. BEGINNING VALUE BEFORE
INFLOW OR OUTFLOW 10,000 11,000 3,900 4,680
2. INFLOW (OUTFLOW) - (8,000) - (4,680)
3. AMOUNT INVESTED 10,000 3,000 3,900 -
4. ENDING VALUE 11,000 3,900 4,680 -
17,160
A : 10,000 = r = 19.72%
(1+r)3

8,000 0 4680
B : 10,000 = + + r = 15.27%
(1+r) (1+r)2 (1+r)3
IRR REFLECTS INVESTMENT PERFORMANCE AS WELL AS THE EFFECT OF CONTRIBUTIONS AND
WITHDRAWALS .. TOTAL EXPERIENCE OF A FUND (a) INVESTMENET PERFORMANCE & (b) CASH
FLOWS.
G.M : [(1.10) (1.30) (1.20)] 1/3 - 1 = 0.1972 OR 19.72%
 RISK

• Mean Absolute Deviation

 d n

• Standard Deviation

• Beta
 PERFORMANCE MEASURE

Rp - Rf
TREYNOR MEASURE :
p

Rp - Rf
SHARPE MEASURE :
p

JENSEN MEASURE : Rp - [Rf + p (RM - Rf)]

ANNUAL RETURNS FOR THREE MUTUAL FUNDS
AND A MARKET INDEX

PERIOD FUND A FUND B FUND C RETURN ON RISK-FREE

MARKET RETURN

1 - 38.7 -16 -33 -26 7.9

2 39.6 39.4 30 36.9 5.8
3 11.1 34.3 18.2 23.6 5.0
4 12.7 -6.9 -7.3 -7.2 5.3
5 20.9 3.2 4.9 6.4 7.2
6 35.5 28.9 30.9 18.2 10
7 57.6 24.1 34.7 31.5 11.5
8 -7.8 0.0 6.0 -4.8 14.1
9 22.8 23.4 33.0 20.4 10.7

Mean: Rp 17.1 14.5 13.0 11 8.6

Standard
Deviation: σp 28.1 19.7 22.8 20.5 _
Beta: βp 1.20 0.92 1.04 1.00 _
 PERFORMANCE EVALUATION OF
THE THREE FUNDS
Rp - Rf
TREYNOR MEASURE :
p
17.1 - 8.6
FUND A : = 7.1
1.20
14.5 - 8.6
FUND B : = 4.9
0.92
13.0 - 8.6
FUND C : = 4.8
1.04
11.0 - 8.6
MARKET INDEX : = 2.4
1.0
 Rp - Rf
SHARPE MEASURE :
p
17.1 - 8.6
FUND A : = 0.302
28.1
14.5 - 8.6
FUND B : = 0.299
19.7
13.0 - 8.6
FUND C : = 0.193
22.8
11.0 - 8.6
MARKET INDEX : = 0.117
20.5
JENSEN MEASURE : Rp - [Rf + p (RM - Rf )]
FUND A : 17.1 - [8.6 + 1.20 (2.4)] = 5.62
FUND B : 14.5 - [8.6 + 0.92 (2.4)] = 3.69
FUND C : 13.0 - [8.6 + 1.04 (2.4)] = 1.90
MARKET INDEX : O (BY DEFINITION)
 PROBLEMS WITH
PERFORMANCE MEASUREMENT
• QUANTIFICATION .. FUNCTION ONLY PARTLY
AMENABLE
• SHORT-TERMISM
• CULT OF MARKET-TIMING
DIETZ & KIRSCHMAN: “FOR ACCURACY OF
COMPUTATIONS, PERFORMANCE SHOULD BE
COMPUTED AS OFTEN AS PRACTICED, BUT RESULTS
SHOULD NOT BE TAKEN AS SIFNIFICANT BY THE
INVESTOR OR THE INVESTMENT MANAGER UNTIL A
REASONABLE PERIOD OF TIME, SUCH AS A MARKET
CYCLE FOR EQUITIES OR AN INTEREST RATE CYCLE
FOR FIXED INCOME SECURITIES, HAS ELAPSED”
 SUMMING UP
• Portfolio management is a complex process or activity that may
be divided into seven broad phases.
• Investment objectives are expressed in terms of return and risk.
• The strategic asset-mix decision (or policy asset-mix decision) is
the most important decision made by the investor.
• Investors with greater tolerance for risk and longer investment
horizon should tilt the asset mix in favour of stocks
• The four principal vectors of an active portfolio strategy are :
market timing, sector rotation, security selection, and the use of
a specialised concept.
• A passive portfolio strategy calls for creating a well-diversified
portfolio at a pre-determined level of risk and holding it
relatively unchanged over time.
• The factors commonly considered in selecting bonds are : yield
to maturity, risk of default, tax shield, liquidity, and duration.
• Three broad approaches are employed for stock selection :
technical analysis, fundamental analysis, and random selection.
• Motives of trading are cognitive and emotional.
• Portfolio revision involves portfolio rebalancing and portfolio
upgrading
• The key dimensions of performance evaluation are rate of
return and risk.
• Treynor measure, Sharpe measure, and Jensen measure are
three popularly employed performance measures.