Modern Portfolio Management
Modern Portfolio Management
Modern Portfolio Management
ARUN G DSOUZA
JKSHIM NITTE
Investment Portfolio
• A portfolio investment is ownership of a stock, bond, or other
financial asset with the expectation that it will earn a return or grow
in value over time, or both. It entails passive or hands-off ownership
of assets as opposed to direct investment, which would involve an
active management role.
• Portfolio investment may be divided into two main categories:
• Strategic investment involves buying financial assets for their long-
term growth potential or their income yield, or both, with the
intention of holding onto those assets for a long time.
• The tactical approach requires active buying and selling activity in
hopes of achieving short-term gains.
Portfolio Construction
• The composition of investments in a portfolio depends on a number of factors.
The most important are the investor’s tolerance for risk and investment horizon.
• Is the investor a young professional with children, a mature person looking
forward to retirement, or a retiree looking for a reliable income supplement?
• Those with a greater risk tolerance may favor investments in growth stocks, real
estate, international securities, and options, while more conservative investors
may opt for government bonds and blue-chip stocks.
• On a larger scale, mutual funds and institutional investors are in the business of
making portfolio investments. For the largest institutional investors such as
pension funds and sovereign funds, this may include infrastructure assets like
bridges and toll roads.
• Portfolio investments by institutional investors generally are held for the long
term and are relatively conservative. Pension funds and college endowment
funds are not invested in speculative stocks.
Portfolio Construction Process
Traditional Approach of Portfolio Management
• It basically deals with two major decisions viz., determining the objectives of the
portfolio and selection of securities.
• The need of a rational investor is concerned all about income generation and capital
appreciation.
• The traditional approach describes the appropriate level of which is to be selected to
meet the investors’ needs.
• The traditional approach is carried out in the following steps:
a) Analysis of constraints
e) Diversification
Example
• Mr. A is assertive investors whose annual saving is Rs.2,00,000. He wants to invest his saving in different financial
instruments, his main investment motive is regular income i.e. dividend as well as capital appreciation in the
medium to long term. Mr. A set some objectives before the investment these are capital appreciation in the
medium term, earning dividend i.e. regular income. He also set the objective of safety at a given level of risk,
liquidity of the investors is one of the another objective of Mr. A because many investors fail to take into account
or understand the liquidity factor and as a result, their financial plans fail
Mr. A invests his saving in such a way that all objectives he set should be fulfilled. His portfolio consists of equity
shares, short term money market instruments, bonds, foreign investment, and property. He invests 50% of his
saving in equity shares i.e. 1,00,000 of his total saving. 30% investment in the money market this is commercial
paper, certificate of deposit, etc. 30% of his saving in bonds, 30% in foreign capital, and 10% in property
consisting gold.
He invests half of his saving in equity because its return is not constant it gives higher return as well as also the
risk of getting loss of money generally equity shares gives higher rate of return as compared to fixed interest-
bearing securities. The money market and bonds give him a fixed rate of return that helps him to maintain
liquidity. Foreign investment helps in tax incentives but it is also carries high risk and property helps in capital
appreciation because its price goes higher with time.
If Mr. A faces any loss from equity then fixed interest bearing securities and property helps him recover those
losses and if equity gives a higher rate of return then Mr. A gets a good amount of return. And also equity and
property helped him in getting capital appreciation.
• Mr. A should never be static and sit cool after investing. He should consider shares of different companies
belonging to a different sectors. Similarly, the same diversification applies to all categories of investment. If his
present portfolio does not seem to combat his set objective, diversification is the only answer to meet his dream.
Modern Portfolio Approach
Introduction
• Finance in its present form dates only from 1950s
• In the last seven decades there has been many revolutionary ideas
being generated in this area
• Most of it coming from USA (most from Jewish scholars)
• The first in the series of modern portfolio theory (MPT) was the
problem of ‘Portfolio Selection’ by Harry Markowitz in 1952 published
by JoF
• This articles gave the origin to risk return
Markowitz Portfolio Theory
• In the early 1960s, the investment community talked about risk, but there was
no specific measure for the term
• To build a portfolio model, however, investors had to quantify their risk variable.
• The basic portfolio model was developed by Harry Markowitz (1952, 1959), who
derived the expected rate of return for a portfolio of assets and an expected risk
measure.
• Markowitz showed that the variance of the rate of return was a meaningful
measure of portfolio risk under a reasonable set of assumptions.
• More important, he derived the formula for computing the variance of a
portfolio.
• This portfolio variance formula not only indicated the importance of diversifying
investments to reduce the total risk of a portfolio but also showed how to
effectively diversify.
MPT Assumptions
• The Markowitz model is based on several assumptions regarding investor behaviour:
• Investors consider each investment alternative as being represented by a
probability distribution of expected returns over some holding period.
• Investors estimate the risk of the portfolio on the basis of the variability of
expected returns.
• Investors base decisions solely on expected return and risk, so their utility curves
are a function of expected return and the expected variance (or standard
deviation) of returns only.
• For a given risk level, investors prefer higher returns to lower returns. Similarly, for
a given level of expected return, investors prefer less risk to more risk.
• Under these assumptions, a single asset or portfolio of assets is considered to be
efficient if no other asset or portfolio of assets offers higher expected return with
the same (or lower) risk or lower risk with the same (or higher) expected return.
Such a portfolio is called OPTIMAL PORTFOLIO
Feasible set of portfolio
• Portfolio means combination of securities.
• With a limited no. of securities, an investor can create a very large no.
of portfolios by combining these securities in different proportions.
• These constitute feasible set/opportunity set in which investor can
invest.
Efficient Portfolio
• Each portfolio has its own expected return and risk
• So the investor is not interested in every portfolio but interested in only
efficient portfolio.
• A portfolio is efficient if and only if, there is no other alternative with
• Same expected return E(R) and lower risk- σp
• Same risk ( σp) but higher expected return E(R)
• Higher return and lower risk (σp)
• Other portfolio are called inefficient portfolios in which the investor is
not interested
Example
• Let us assume you want to invest ₹100,000. You have two stocks A
and B. You can buy each stock individually or 50% in each stock. The
forecasted returns are given in the table:
State of the Probability Return on Stock A Return on Stock B Portfolio Return
Economy
1 0.20 15% -5% 5
3 0.20 5% 25% 15
4 0.20 35% 5% 20
35%
30%
25%
20%
15%
10%
5%
0%
1 2 3 4 5
-5%
-10%
• N Security Case:
Illustrations
• A portfolio consists of two securities A and B in the proportion of 0.5 and 0.5.
The SD (A) is 10 and SD (B) is 16. The correlation is 0.5 what is the Portfolio SD?
• A portfolio consists of two securities A and B and Mr. JOHN is invested 2 lacs in
A and 3 lacs in B. The SD (A) is 18 and SD (B) is 12. The correlation is 0.75 what
is the Portfolio SD?
• A portfolio consists of 3 securities A, B and C. The proportion is 1/3. The SD (A)
is 12 SD (B) is 19 and SD (C) is 22. The correlation between A and B is 0.6, B&C
is 0.5 and A&C is 0.8. What is the portfolio SD?
• A portfolio consists of 3 securities A, B and C. The proportion is 0.5, 0.3 and
0.2. The SD (A) is 15 SD (B) is 09 and SD (C) is 12. The correlation between A
and B is 0.5, B&C is 0.8 and A&C is 0.2. What is the portfolio SD?
Efficient Frontier
• Suppose an investor is evaluating two securities, A and B:
A B
Expected Return 12% 20%
SD 20% 40%
Correlation 0.20