SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

Unit-1

Investment
An investment is an asset or item accrued with the goal of generating income or
recognition. In an economic outlook, an investment is the purchase of goods that are not
consumed today but are used in the future to generate wealth. In finance, an investment is
a financial asset bought with the idea that the asset will provide income further or will later
be sold at a higher cost price for a profit.

Investment is elucidated and defined as an addition to the stockpile of physical capital such

as:

 Machinery
 Buildings
 Roads etc.,
To invest is to allocate money in the expectation of some benefit in the future.
In finance, the benefit from an investment is called a return.
The return may consist of a gain (or loss) realised from the sale of property or an
investment, unrealised capital appreciation (or depreciation), or investment income such
as dividends, interest, rental income etc., or a combination of capital gain and income. The
return may also include currency gains or losses due to changes in the foreign
currency exchange rates.
 Concept of investment
1. The Importance of Time
The question of when to start investing for retirement seems easy, but few people
understand the importance of the answer. Exponential growth is the powerful investment
concept that makes time the most important factor in determining the value of your
portfolio.
2. Keeping Expenses Low
High expenses do tremendous damage to portfolio values. Choosing the best
investment vehicles is the first step in keeping expenses low. The mutual fund expense
ratio is notorious for sapping an investor’s returns.
3. Asset Allocation
Asset Allocation is what will determine the vast majority of your returns. It is the
most important decision you can make in investing. Studies have shown that the average
investor’s actual investment returns are considerably lower than market averages.
4. Proper Diversification
There are large benefits to diversification in small numbers. In other words, three
stocks is much better than two, and six stocks is much better than three.

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5. Don’t Follow the Crowd
In portfolio management, following the crowd can lead to poor investment returns.
John Templeton said “If you want to have better performance than the crowd, you must do
things differently from the crowd”.
6. Buy Businesses – Not Stocks
When you buy a stock you are purchasing a business. Just because it is a fractional
share doesn’t mean you shouldn’t treat it the same as if you were buying the entire
business.
7. Margin of Safety
In my book review of The Intelligent Investor, Revised Edition, Updated with New
Commentary by Jason Zweig (affiliate link) I noted that Benjamin Graham made the
investment concept of margin of safety the last chapter of the book because I believe he
thought it to be the most important for investment analysis.

 Investment Vs Speculation

BASIS FOR INVESTMENT SPECULATION

COMPARISON
Meaning The Purchase Of An Asset With Speculation is an act of
The Hope Of Getting Returns Is conducting a risky financial
Called Investment. transaction in the hope of
sustainable profit.
Risk Low High
Consistency Constant Inconstant
Capital gains Long term Short term
Returns Higher Lower
Time period Long Short
Decision Fundamental Technical
Funds Own funds Own & borrowed funds
Motive Safety and security Profit motive

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  Investment Process

Investment Policy

Investment Planing
And Analysis

Valuation Of
Securities

Portfolio
Construction

Evalution Of
Portfolio

1. Investment Policy:
The first stage determines and involves personal financial affairs and objectives
before making investments. It may also be called preparation of the investment policy stage.

The investor has to see that he should be able to create an emergency fund, an
element of liquidity and quick convertibility of securities into cash.

2. Investment Analysis:
When an individual has arranged a logical order of the types of investments that he
requires on his portfolio, the next step is to analyse the securities available for investment.

3. Valuation of Securities:
The third step is perhaps the most important consideration of the valuation of
investments. Investment value, in general, is taken to be the present worth to the owners of
future benefits from investments.

4. Portfolio Construction:
Under features of an investment programme, portfolio construction requires
knowledge of the different aspects of securities.

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  Sources of investment information

Security Analysis requires as a first step the sources of information, on the basis of which
analysis is made. The Securities market is a perfect auction market where demand/supply
pressures determine the price.

1. World Affairs:

International factors, which influence domestic income, output and employment and for
investment in the domestic market by F.F.I.s, O.C.B.s, etc. Also foreign political affairs, wars,
and the state of foreign markets affect our markets.

2.  Domestic Economic and Political Factors:

Gross domestic products, agricultural output, monsoon, money supply, inflation, Govt.
policies, taxation, etc., affect our markets.

3. Industry Information:
Market demand, installed capacity, competing units, capacity utilisation, market share of
the major units, market leaders, prospects of the industry, international demand for
exports, inputs and capital goods abroad, import competing products, labour problems and
Govt.

4. Company Information:
Corporate data, annual reports, Stock Exchange publications, Dept. of company affairs and
their circulars, press releases on corporate affairs by Govt., industry chambers or
associations of industries etc. are also relevant for security price analysis.

5.  Security Market Information:

The Credit rating of companies, data on market trends, security market analysis and market
reports, equity research reports, trade and settlement data, listing of companies and
delisting, record dates and book closures etc., BETA factors, etc. are the needed information
for investment management.

6. Security Price Quotations:

Price indices, price and volume data, breadth, daily volatility, range and rate of changes of
these variables are also needed for technical analysis.

7. Data on Related Markets:

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Such as Govt., securities, money market, foreign market etc. are useful for deciding on
alternative avenues of investment.

8. Data on Mutual Funds:

Their schemes and their performance, N A V and repurchase prices etc. are needed as they
are also investment avenues.

9. Data on Primary Markets/New Issues, etc.

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 Unit-2
RISK
Risk is the potential for uncontrolled loss of something of value. Values (such
as physical health, social status, emotional well-being, or financial wealth) can be gained or
lost when taking risk resulting from a given action or inaction, foreseen or unforeseen
(planned or not planned).

Risk can also be defined as the intentional interaction with uncertainty.[1] Uncertainty

is a potential, unpredictable, and uncontrollable outcome; risk is an aspect of action taken in
spite of uncertainty.

RETURN
A return, also known as a financial return, in its simplest terms, is the money made
or lost on an investment over some period of time.

A return can be expressed nominally as the change in dollar value of an investment

over time. A return can also be expressed as a percentage derived from the ratio of profit to
investment. Returns can also be presented as net results (after fees, taxes, and inflation) or
gross returns that do not account for anything but the price change.

CAUSES OF RISK:

1. Wrong method of investment

2. Wrong time of investment
3. Wrong quality of investment
4. Interest rate risk
5. Maturity period or length of investment
6. Terms of lending
7. National and international factors
8. Natural calamities

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SYSTEMATIC RISK

Systematic risk is due to the influence of external factor on an organisation. Such

factors an organisation point of view. It a macro nature as it affects a large no of
organisation operating under a similar stream or same domain. It cannot be planned by the
organisation.

The types of systematic risk are depicted and listed below:

1. Interest rate risk

2. Market risk and
3. Purchasing power risk or inflation risk

Now let discuss each risk classified under the group.

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INTEREST RATE RISK:

Interest rate risk arises due to variability in the interest rates from time to
time. It particularly affects debt securities as they carry the fixed rate of interest. The types
of interest rate risk are depicted listed below:

1. Price risk and

2. Reinvestment rate risk

The meaning of price and reinvestment rate risk is as follows:

1. Price risk arises due to the possibility that the price of the shares commodity,
investment, etc., may decline or fall in the future.
2. Reinvestment rate risk from factor that the interest or dividend earned from an
investment can’t be invested with the same rate of return as it was acquiring earlier.

MARKET RISK:

Market risk is associated with consistent fluctuations seen in the trading price of any
particular shares or securities. That is it arises due to rise or fall in the trading price of listed
shares or securities in the stock market. The types of market risk are depicted and listed
below.

1. Absolute risk is without any content.

2. Relative risk is the assessment or evaluation of risk at different levels of business
functions.
3. Directional risks are those risks where the losses arise from an exposure to the
particular assets of a market.
4. Non-directional risk arises where the method of trading is not consulting followed by
the trader.
5. Basis risk due to the possibility of loss arising from imperfectly matched risks.
6. Volatility risk is of a change in the price of securities as a result of changes in the
volatility of a risk factor.

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PURCHASING POWER OR INFLATIONARY RISK:

Purchasing power risk is also known as inflation risk. It so, since it emanates from the
fact that it affects a purchasing power adversely. It is not desirable to invest in securities
during an inflation period.

The types of power or inflationary risk are depicted and listed below.

1. Demand inflation risk and

2. Cost inflation risk

The meaning of demand and cost inflation risks as follows.

Demand inflation risk arises due to increase in price, which result from an exceed of
demand over supply. It occurs when supply. It occurs when supply fails to cope with the
demand and hence cannot expand anymore. In other words, demand inflation occurs when
production factors are under maximum utilization.

Cost inflation risks due to increase in the price of goods and services. It is actually
caused by higher production cost. A high cost of production inflates the final price of
finished goods consumed by people.

UNSYSTEMATIC RISKS:

Unsystematic risks are due to the influence or internal factors prevailing within
organisation. Such factors are normally controllable from an organisations point of view.

It is a macro in nature as it effects only a particular organisation. It can be planned so

that necessary actions can be taken by the organisations to mitigate the risk. The types of
unsystematic risk are depicted and listed below.

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 1. Business or liquidity risk.
2. Financial or credit risk and
3. Operational risk

Now let’s discuss each risk classified under this group.

BUSINESS OR LIQUIDITY RISK

Business risk is also known as liquidity risk. It is so, since it emanates from the sale
and purchase of securities attends by business cycles, technologies changed etc..,

The types of business or liquidity risk are depicted and listed below.

1. Asset liquidity risk and

2. Funding liquidity risk

The meaning of asset and funding liquidity risk as follows:

Asset liquidity risk is due to losses arising from an inability to sell or pledge assets at
or near their carrying value when needed.

Funding liquidity risk exists for not having an access to the sufficient funds to make a
payment on time.

FINANCIAL OR CREDIT RISK

Financial risk is also known as credit risk. It arises due to change in the capital structure of
the organisation. The capital structure mainly comprises of three ways by which funds are
sourced for the projects. These are as follows

 Owned funds for e.g. share capital

 Borrowed capital e.g. loan funds
 Retained earnings for e.g. reserve and surplus

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 Exchange rate risk is also called as exposure rate risk. It is a form of financial risk that
arises from a potential change seen in the exchange rate of one countrys currency in
relation to another country currency and viceversa.

Recovery rate risk is an often neglected aspect of a credit risk analysis. The recovery
rate is normally needed to be evaluated.

Sovereign risk is associated with the govt. Here, a govt is unable to meet its loan
obligations, reneging on loan it guaranteed etc..,

Settlement risk exists when counter party does not deliver a security or its value in
cash as per the agreement of trade or business.

OPERATIONAL RISK

Operational risks are the business process risks failing due to human errors. Thus risk
will change from industry to industry. It occurs due to breakdown in the internal
procedures, people, policies and systems.

1. Model risk
2. People risk
3. Legal risk
4. Political risk

The meaning of types of operational risks is as follows

1. Model risk is involved in using various models to value financial sectors. It is due to
probability of loss resulting from the weaknesses in the financial model used in
assessing and managing a risk.
2. People risk arises when people do not follow the organisations proceeds practices
and/or rules. That is they deviate from their expected behaviour
3. Legal risks arise when parties are not lawfully competent to enter an agreement
among them. This relates to the regulatory risk, where a transaction could conflict
with a govt policy or particular legislation might be amended in the future with
respective effect.
4. Political risk occurs due to changes in govt policies. Such changes may have an
unfavourable impact on an investor. It is especially relevant in the third- world
countries.

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TOOLS FOR MEASURING RISK

1. Standard deviation:

It is a measure of the value of the variables around its mean or its mean or it is the square root
of the sum of the squared deviation from the mean divided by the number of observances. The
athematic mean of the return may be same for two companies but the return may vary widely.

Standard deviation as a measure of risk. The standard deviation is often used by investors to
measure the risk of a stock or stock portfolio. The basic idea is that the standard deviation is a
measure of volatility. The more a stock’s returns vary from the stock average return, the more
volatile the stock.

 Standard deviation is a tool for assessing risk associated with a particular investment.
 Standard deviation measures the dispersion or variability around a mean/excepted value.

Formula: √∑ x 2∗P ( X )−¿ ¿ ¿ 2

2. Alpha
Alpha measures risk relative to the market or a selected benchmark index. For example,
if the S&P 500 has been deemed the benchmark for a particular fund, the activity of the fund
would be compared to that experienced by the selected index. If the fund outperforms the
benchmark, it is said to have a positive alpha. If the fund falls below the performance of the
benchmark, it is considered to have a negative alpha.

3. Beta
Beta measures the volatility or systemic risk of a fund in comparison to the market or the
selected benchmark index. A beta of one indicates the fund is expected to move in
conjunction with the benchmark. Betas below one are considered less volatile than the
benchmark, while those over one are considered more volatile than the benchmark.

4. R-Squared
R-Squared measures the percentage of an investment's movement attributable to
movements in its benchmark index. An R-squared value represents the correlation between the
examined investment and its associated benchmark. For example, an R-squared value of 95
would be considered to have a high correlation, while an R-squared value of 50 may be
considered low.

5. Sharpe Ratio
The Sharpe ratio measures performance as adjusted by the associated risks. This is done by
removing the rate of return on a risk-free investment, such as a U.S. Treasury Bond, from the
experienced rate of return.

This is then divided by the associated investment’s standard deviation and serves as an indicator
of whether an investment's return is due to wise investing or due to the assumption of excess risk.

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 Unit-4
TECHNICAL ANALYSIS:

In finance, technical analysis is a security analysis discipline for forecasting the

direction of prices through the study of past market data, primarily price and volume.

Technical analysis is the study of financial market action. The technician looks at price
changes that occur on a day-to-day or week-to-week basis or over any other constant time period
displayed in graphic form, called charts. Hence the name chart analysis.

Technical analysis is a means of examining and predicting price movements in the financial
markets, by using historical price charts and market statistics. It is based on the idea that if a trader
can identify previous market patterns, they can form a fairly accurate prediction of future price
trajectories.

Technical analysis can be used on any security with historical trading data. This
includes Forex, stocks, futures and commodities, fixed-income securities, etc. In this part of the
tutorial, well emphasize analysing Forex in our examples, but keep in mind that these concepts can
be applied to any type of instrument. In fact, technical analysis is more frequently associated with
commodities and Forex.

CONCEPTS OR TOOLS OF TECHNICAL ANALYSIS

AVERAGE TRUE RANGE

Average true range (ATR) is a technical analysis volatility indicator originally developed by J.
Welles Wilder, Jr. for commodities. The indicator does not provide an indication of price trend,
simply the degree of price volatility. The average true range is an N-day exponential moving average
of the true range values. Wilder recommended a 14-period smoothing.

BREAKOUT
A breakout is when prices pass through and stay through an area of support or resistance.
On the technical analysis chart a break out occurs when price of a stock or commodity exits an area
pattern with an increase volumes.

CHART PATTERN
A chart pattern or price pattern is a pattern within a chart when prices are graphed. In stock
and commodity markets trading, chart pattern studies play a large role during technical analysis.
When data is plotted there is usually a pattern which naturally occurs and repeats over a period.
Chart patterns are used as either reversal or continuation signals.

CYCLES
Stock market cycles are the long-term price patterns of the stock market. Time targets for
potential change in price action (price only moves up, down, or sideways)

DEAD CAT
In finance, a dead cat bounce is a small, brief recovery in the price of a declining stock.
Derived from the idea that “even a dead cat will bounce if it falls from a great height”, the phrase,

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which originated on Wall Street, is also popularly applied to any case where a subject experiences a
brief resurgence during or following a severe decline.

ELLIOTT WAVE PRINCIPLE

The Elliott wave principle is a form of technical analysis that some traders use to analyse
financial market cycles and forecast market trends by identifying extremes in investor psychology,
highs and lows in prices, and other collective factors. Ralph Nelson Elliott (1871–1948), a
professional accountant proposed that market prices unfold in specific patterns, which practitioners
today call Elliott waves, or simply waves.

FIBONACCI RATIOS
Fibonacci retracement is a method of technical analysis for determining support and
resistance levels. They are named after their use of the Fibonacci sequence. Fibonacci retracement is
based on the idea that markets will retrace a predictable portion of a move, after which they will
continue to move in the original direction.

MOMENTUM
Momentum and rate of change (ROC) are simple technical analysis indicators showing the
difference between today’s closing price and the close N days ago. Momentum is the absolute
difference in stock, commodity.

POINT AND FIGURE ANALYSIS

Point and figure (P&F) is a charting technique used in technical analysis. Point and figure
charting is unique in that it does not plot price against time as all other techniques do. Instead it
plots price against changes in direction by plotting a column of Us as the price rises and a column of
so as the price falls.

SUPPORT AND RESISTANCE
A support level is level where the price tends to find support as it is going down. This means
the price is more likely to “bounce” off this level rather than break through it. However, once the
price has passed this level, by an amount exceeding some noise, it is likely to continue dropping until
it finds another support level.

TRENDING
A market trend is a tendency of financial markets to move in a particular direction over time.
These trends are classified as secular for long time frames, primary for medium time frames, and
secondary for short time frames. Traders identify market trends using technical analysis, a
framework which characterizes market trends as predictable price tendencies within the market
when price reaches support and resistance levels, varying over time.

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FUNDAMENTAL ANALYSIS vs TECHNICAL ANALYSIS

The following are some of the differences between fundamental and technical analysis

DIFFERENCE FUNDAMNETAL TECHNICAL ANALYSIS

ANALYSIS
Purpose It seeks to forecast stock prices It mainly focuses on internal
on the basis of economic, market data.
industry and company
statistics.
Long-term & Short-term Price Long-term investors buy a high The technical analysis
Movement dividend paying stock and hold determines the short-term
it for many years through price movements of the
market fluctuations. securities.
Value of Share The fundamental analyst The technician believes that
estimates the intrinsic value of there is no real value to any
shares and purchases them stock. According to him, stock
when their market price is less prices depend on demand and
than the intrinsic value. supply forces which in turn are
governed by rational and
irrational factors.
Finding the trend In fundamental analysis, there Technicians believe that past
is no scope for finding out the trend will be repeated again
past trend of share and also the and the current movements
fluctuations in the price trend. can be used for studying the
future trend.
Assumptions There are no assumptions in Technical analysis works on the
fundamental analysis. basis of various assumptions
which have been outlined
earlier.
Decision Making The fundamental analysis It listen to what the market has
carefully studies the financial to say. So, the view of the
statements, demand forecasts, market is the most important
quality of management, factor in determining stock
earnings and growth. Then they prices.
judge the prices of securities.
Thus, the fundamental analysts
are making decisions based on
their own (subjective) opinions.
Usefulness It helps identify undervalued or It is useful in timing a buy or
overvalued shares sell order.

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EFFICIENT MARKET THEORY
The efficient market hypothesis is a central idea of a modern finance that has profound
implications. An understanding of the efficient market hypothesis will help to ask the right questions
and save from a lot of confusion that dominates popular thinking in finance. An efficient market is
one in which the market price of a security is an unbiased estimate of its intrinsic value. Note that
market efficiency does not imply that the market price equals intrinsic value at every point in time.

A corollary is that investors will also be less likely to discover great bargains and thereby
earn extraordinary high rates of return. The requirements for a securities market to be efficient
market are

(1) Prices must be efficient so that new inventions and better products will cause a firm s securities
prices to rise and motivate investors to supply capital to the firm (i.e., buy its stock);

2) Information must be discussed freely and quickly across the nations so all investors can react to
new information;

(3) Transactions costs such as sales commissions on securities are ignored;

(4) Taxes are assumed to have no noticeable effect on investment policy;

(5) Every investor is allowed to borrow or lend at the same rate; and, finally,

(6) Investors must be rational and able to recognize efficient assets and that they will want to invest
money where it is needed most (i.e., in the assets with relatively high returns).

Forms of Efficient Market Hypothesis

Eugene Fama suggested that it is useful to distinguish three levels of market efficiency. They are

1) Weak-form efficiency - Prices reflect all information found in the record of past and volumes
2) Semi-strong form efficiency - Prices reflect not only all information found in the record of
past prices and volumes but also all other publicly available information
3) Strong form efficiency - Prices reflect all available information, public as well as private.

Weak form of EMH

The week form of market holds that present stock market prices reflect all known
information with respect to past stock prices, trends, and volumes. This form of theory is just the
opposite of the technical analysis because according to it, the sequence of prices occurring
historically does not have any value for predicting the future stocks prices. The technical analysts
rely completely on charts and past behaviour of prices of stocks.

Three types of tests have been commonly employed to empirically verify the weak-form
efficient market hypothesis: (a) serial correlation tests; (b) runs tests; and (c) filter rules tests.

Semi-Strong Form of EMH

The semi strong form of the efficient market hypothesis centers on how rapidly and
efficiently market prices adjust to new publicly available information. In this state, the market
reflects even those forms of information which may be concerning the announcement of a firm s
most recent earnings forecast and adjustments which will have taken place in the prices of security.

The investor in the semi-strong form of the market will find it impossible to earn a return on
the portfolio which is based on the publicly available information in excess of the return which may

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be said to be commensurate with the portfolio risk. Many empirical studies have been made on the
semi-strong form of the efficient market hypothesis to study the reaction of security prices to
various types of information around the announcement time of the information.

Two studies commonly employed to test semi-strong form efficient market are event study
and portfolio study.

Strong-Form of EMH
The strong-form efficient market hypothesis holds that all available information, public or
private, is reflected in the stock prices. The strong form is concerned with whether or not certain
individuals or groups of individuals possess inside information which can be used to make above
average profits.

If the strong form of the efficient capital market hypothesis holds, then and day is as good as
any other day to buy any stock. This the most extreme form of the efficient market hypothesis. Most
of the research work has indicated that the efficient market hypothesis in the strongest form does
not hold good.

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 Unit- 5
PORTFOLIO MANAGEMENT
‘Portfolio management is art of selecting the right investment policy for the individuals in
terms of minimum risk and maximum return’. It refers to managing an individual’s investment in
the form of bonds, shares, cash, mutual funds etc. so that he earns the maximum profits within the
stipulated time frame.

In plain terms, it is managing money of an individual under expert guidance of portfolio

managers.

ELEMENTS OF PORTFOLIO MANAGEMENT

We find that most successful approaches include these four elements: effective
diversification, active management of asset allocation, cost efficiency and tax efficiency.

1. Effective diversification—beyond asset allocation

Traditional views of diversification tend to focus on asset classes (e.g., equity, fixed income).
Although holding various asset classes can help steer you towards diversification, they don't go far
enough to provide meaningful diversification benefits. Creating effective diversification requires
consideration of an asset's underlying source of risk.

2. Active management—tactical asset allocation strategy

Research shows that markets are relatively efficient—most information is already priced into
the stock. This makes it difficult to predict the markets or individual stocks in the short term.
However, Nobel Prize-winning research indicates that markets are actually somewhat predictable
over three to five year periods.

Another way to think about this is that markets that look expensive today will tend to
perform worse than markets that appear cheap today and vice versa. By monitoring global markets,
investors may be able to avoid economic bubbles and take advantage of potential growth
opportunities.

3. Cost efficiency
Whether you're managing your own investments or working with an advisor, paying fees is a
fact of life. So, if you're going to pay fees, make sure you're getting good value. There are several
types of fees to consider including advisory and custodian fees, investment expense ratios and
transaction costs—all together you could be paying almost 3% in fees annually. If you are, that's too
much.

4. Tax efficiency
The real measure of success for an investment strategy is how much of your money you
actually get to keep. That’s where incorporating tax efficiencies into the investment philosophy
come in. Research has shown that comprehensive tax planning can save investors 75 basis points
annually. It might not sound like much, but it’s a big deal.

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PORTFOLIO MODELS

Portfolio management refers to the art of managing various financial products and assets to
help an individual earn maximum revenues with minimum risks involved in the long run. Portfolio
management helps an individual to decide where and how to invest his hard earned money for
guaranteed returns in the future.

MARKOWITZ MODEL
In finance, the Markowitz model - put forward by Harry Markowitz in 1952 - is a portfolio
optimization model; it assists in the selection of the most efficient portfolio by analysing various
possible portfolios of the given securities. Here, by choosing securities that do not 'move' exactly
together, the HM model shows investors how to reduce their risk. The HM model is also
called mean-variance model due to the fact that it is based on expected returns (mean) and
the standard deviation (variance) of the various portfolios. It is foundational to Modern portfolio
theory.

Determining the efficient set

A portfolio that gives maximum return for a given risk, or minimum risk for given return is an
efficient portfolio. Thus, portfolios are selected as follows:
(a) From the portfolios that have the same return, the investor will prefer the portfolio with lower
risk, and 
(b) From the portfolios that have the same risk level, an investor will prefer the portfolio with higher
rate of return.

As the investor is rational, they would like to have higher return. And as they are risk averse,
they want to have lower risk. In Figure 1, the shaded area PVWP includes all the possible securities
an investor can invest in. The efficient portfolios are the ones that lie on the boundary of PQVW. For
example, at risk level x2, there are three portfolios S, T, U. But portfolio S is called the efficient
portfolio as it has the highest return, y 2, compared to T and U. All the portfolios that lie on the
boundary of PQVW are efficient portfolios for a given risk level.

The boundary PQVW is called the Efficient Frontier. All portfolios that lie below the Efficient
Frontier are not good enough because the return would be lower for the given risk. Portfolios that lie
to the right of the Efficient Frontier would not be good enough, as there is higher risk for a given rate
of return. All portfolios lying on the boundary of PQVW are called Efficient Portfolios. The Efficient
Frontier is the same for all investors, as all investors want maximum return with the lowest possible
risk and they are risk averse.

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Choosing the best portfolio
For selection of the optimal portfolio or the best portfolio, the risk-return preferences are
analysed. An investor who is highly risk averse will hold a portfolio on the lower left hand of the
frontier, and an investor who isn’t too risk averse will choose a portfolio on the upper portion of the
frontier.

Figure 2 shows the risk-return indifference curve for the investors. Indifference curves C 1,

C2 and C3 are shown. Each of the different points on a particular indifference curve shows a different
combination of risk and return, which provide the same satisfaction to the investors. Each curve to
the left represents higher utility or satisfaction. The goal of the investor would be to maximize their
satisfaction by moving to a curve that is higher. An investor might have satisfaction represented by
C2, but if their satisfaction/utility increases, the investor then moves to curve C 3 Thus, at any point of
time, an investor will be indifferent between combinations S 1 and S2, or S5 and S6.

The investor's optimal portfolio is found at the point of tangency of the efficient frontier
with the indifference curve. This point marks the highest level of satisfaction the investor can obtain.
This is shown in Figure 3. R is the point where the efficient frontier is tangent to indifference curve
C3, and is also an efficient portfolio. With this portfolio, the investor will get highest satisfaction as
well as best risk-return combination (a portfolio that provides the highest possible return for a given
amount of risk). Any other portfolio, say X, isn't the optimal portfolio even though it lies on the same
indifference curve as it is outside the feasible portfolio available in the market. Portfolio Y is also not
optimal as it does not lie on the best feasible indifference curve, even though it is a feasible market
portfolio. Another investor having other sets of indifference curves might have some different
portfolio as their best/optimal portfolio.

All portfolios so far have been evaluated in terms of risky securities only, and it is possible to
include risk-free securities in a portfolio as well. A portfolio with risk-free securities will enable an
investor to achieve a higher level of satisfaction. This has been explained in Figure 4.

SHIRIN MAHAJAN 20
 R1 is the risk-free return, or the return from government securities, as those securities are
considered to have no risk for modelling purposes. R 1PX is drawn so that it is tangent to the efficient
frontier. Any point on the line R1PX shows a combination of different proportions of risk-free
securities and efficient portfolios. The satisfaction an investor obtains from portfolios on the line
R1PX is more than the satisfaction obtained from the portfolio P. All portfolio combinations to the
left of P show combinations of risky and risk-free assets, and all those to the right of P represent
purchases of risky assets made with funds borrowed at the risk-free rate.
In the case that an investor has invested all their funds, additional funds can be borrowed at
risk-free rate and a portfolio combination that lies on R 1PX can be obtained. R 1PX is known as
the Capital Market Line (CML). This line represents the risk-return trade off in the capital market.
The CML is an upward sloping line, which means that the investor will take higher risk if the return of
the portfolio is also higher. The portfolio P is the most efficient portfolio, as it lies on both the CML
and Efficient Frontier, and every investor would prefer to attain this portfolio, P. The P portfolio is
known as the Market Portfolio and is also the most diversified portfolio. It consists of all shares and
other securities in the capital market.
In the market for portfolios that consists of risky and risk-free securities, the CML represents
the equilibrium condition. The Capital Market Line says that the return from a portfolio is the risk-
free rate plus risk premium. Risk premium is the product of the market price of risk and the quantity
of risk, and the risk is the standard deviation of the portfolio.
The CML equation is: RP = IRF + (RM – IRF)σP/σM
Where,
RP = expected return of portfolio
RM = return on the market portfolio
IRF = risk-free rate of interest
σM = standard deviation of the market portfolio
σP = standard deviation of portfolio
(RM – IRF)/σM is the slope of CML. (RM – IRF) is a measure of the risk premium, or the reward for
holding risky portfolio instead of risk-free portfolio. σ M is the risk of the market portfolio. Therefore,
the slope measures the reward per unit of market risk.

The characteristic features of CML are:

1. At the tangent point, i.e. Portfolio P, is the optimum combination of risky investments and
the market portfolio.
2. Only efficient portfolios that consist of risk free investments and the market portfolio P lie on the CML.
3. CML is always upward sloping as the price of risk has to be positive. A rational investor will not invest unless
they know they will be compensated for that risk.

SHIRIN MAHAJAN 21
 Figure 5 shows that an investor will choose a portfolio on the efficient frontier, in the
absence of risk-free investments. But when risk-free investments are introduced, the investor can
choose the portfolio on the CML (which represents the combination of risky and risk-free
investments). This can be done with borrowing or lending at the risk-free rate of interest (I RF) and the
purchase of efficient portfolio P. The portfolio an investor will choose depends on their preference of
risk. The portion from IRF to P, is investment in risk-free assets and is called Lending Portfolio. In this
portion, the investor will lend a portion at risk-free rate. The portion beyond P is called Borrowing
Portfolio, where the investor borrows some funds at risk-free rate to buy more of portfolio P.

LIMITATIONS OF MARKOWITZ MODEL

1. Large number of input data required for calculations : An investor must obtain
estimates of return and variance of returns for all securities as also covariance of returns for
each pair of securities included in the portfolio. If there are N securities in the portfolio, he
would need N return estimates, N variance estimates and N (N-1) / 2 covariance estimates,
resulting in a total of 2N + [N (N-1) / 2] estimates.
2. Complexity of computations required: The computations required are numerous and
complex in nature. With a given set of securities infinite number of portfolios can be
constructed. The expected returns and variances of returns for each possible portfolio have
to be computed. The identification of efficient portfolios requires the use of quadratic
programming which is a complex procedure

SINGLE-INDEX MODEL
The single-index model (SIM) is a simple asset pricing model to measure both the risk and
the return of a stock. The model has been developed by William Sharpe in 1963 and is commonly
used in the finance industry. Mathematically the SIM is expressed as

The basic notion underlying the single index model is that all stocks are affected by
movements in the stock market. Casual observation of share prices reveals that when the market
moves up, prices of most shares tend to increase. When the market goes down, the prices of most
shares tend to decline. This suggests that one reason why security returns might be correlated and
there is co-movement between securities, is because of a common response to market changes. This
co movement of stocks with a market index may be studied with the help of a simple linear
regression analysis, taking the returns on an individual security as the dependent variable (Ri) and
the returns on the market index (Rm) as the independent variable.

The return of an individual security is assumed to depend on the return on the market index.
The return of an individual security may be expressed as:

where:
rit is return to stock i in period t

SHIRIN MAHAJAN 22
 rf is the risk free rate (i.e. the interest rate on treasury bills)
rmt is the return to the market portfolio in period t
αi is the stock's alpha, or abnormal return
βi is the stock's beta, or responsiveness to the market return

Note that   is called the excess return on the stock,   the excess return on the
market
 are the residual (random) returns, which are assumed independent normally distribute with

mean zero and standard deviation 

These equations show that the stock return is influenced by the market (beta), has a firm specific
expected value (alpha) and firm-specific unexpected component (residual). Each stock's
performance is in relation to the performance of a market index (such as the All Ordinaries). Security
analysts often use the SIM for such functions as computing stock betas, evaluating stock selection
skills, and conducting event studies.

CAPITAL ASSET PRICING METHOD

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
the expected return and risk of investing in a security. It shows that the expected return on a
security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security. Below is an illustration of the CAPM concept.

CAPM Formula and Calculation

CAPM is calculated according to the following formula:

Ra = Rrf + [Ba X (Rm- Rrf)]

Where,

Ra = Expected return on a security

Rrf = Risk-free rate

SHIRIN MAHAJAN 23
Ba = Beta of the security
Rm = Expected return of the market

Note: “Risk Premium” = (Rm – Rrf)

The CAPM formula is used for calculating the expected returns of an asset.  It is based on the idea of
systematic risk (otherwise known as non-diversifiable risk) that investors need to be compensated
for in the form of a risk premium. A risk premium is a rate of return greater than the risk-free rate.
When investing, investors desire a higher risk premium when taking on more risky investments.

CAPM FORMULA

EXCEPTED RETURN = RISK- FREE RATE + (BETA X MARKET RISK PREMIUM)

Expected Return 

The “Ra” notation above represents the expected return of a capital asset over time, given
all of the other variables in the equation.  “Expected return” is a long-term assumption about how an
investment will play out over its entire life.

Risk-Free Rate 

The “Rrf” notation is for the risk-free rate, which is typically equal to the yield on a 10-year
US government bond.  The risk-free rate should correspond to the country where the investment is
being made, and the maturity of the bond should match the time horizon of the investment.
Professional convention, however, is to typically use the 10-year rate no matter what, because it’s
the most heavily quoted and most liquid bond.

Beta 

The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk (volatility of
returns) reflected by measuring the fluctuation of its price changes relative to the overall market. In
other words, it is the stock’s sensitivity to market risk. For instance, if a company’s beta is equal to
1.5 the security has 150% of the volatility of the market average. However, if the beta is equal to 1,
the expected return on a security is equal to the average market return.  A beta of -1 means security
has a perfect negative correlation with the market.

Market Risk Premium

From the above components of CAPM, we can simplify the formula to reduce “expected
return of the market minus the risk-free rate” to be simply the “market risk premium”.  The market
risk premium represents the additional return over and above the risk-free rate, which is required to
compensate investors for investing in a riskier asset class. Put another way, the more volatile a
market or an asset class is, the higher the market risk premium will be.

SHIRIN MAHAJAN 24
THE EFFICIENT FRONTIER APPROACH

Efficient Frontier Analysis traces its origins to Nobel Prize winner Harry Markowitz and his
work related to modern portfolio theory. According to this theory and common investment sense,
there is a trade-off between portfolio risk and portfolio return: the more risk an investor is willing to
accept, the higher the expected return of the investment. This is not only true in portfolios made up
of securities and financial assets, but also in project portfolios.

Therefore, for a given amount of risk, there is an “optimal” portfolio of projects that
produces the highest possible return. If we were able to plot on a graph all possible portfolios, we
would get something that looks like the graph in figure 1.

The best possible project portfolios for a given amount of risk (i.e. variability of returns, capital
investment cost, etc.) lie on the Efficient Frontier curve. These are also called the “optimal” project
portfolios.

Efficient Frontier Analysis helps portfolio managers and executives to understand the trade-
offs between portfolio value and cost. It also shows how companies manage its scarce resources, by
understanding the effect of scarcity on potential returns.

Of course, this analysis is not possible unless the organization possesses the means to find
the Efficient Frontier – a method for finding optimal project portfolios. Software products such as
Opt Folio® are especially designed to do this.

PORTFOLIO PERFORMANCE EVALUATION

The portfolio performance evaluation involves the determination of how a managed

portfolio has performed relative to some comparison benchmark. Performance evaluation methods
generally fall into two categories, namely conventional and risk adjusted methods. The most widely
used conventional methods include benchmark comparison and style comparison.

The risk-adjusted methods adjust returns in order to take account of differences in risk levels
between the managed portfolio and the benchmark portfolio. The major methods are the Sharpe
ratio, Treynor ratio, Jensen’s alpha, Modigliani and Modigliani, and Treynor Squared. The
riskadjusted methods are preferred to the conventional methods.

SHIRIN MAHAJAN 25
RISK-ADJUSTED METHODS

The risk-adjusted methods make adjustments to returns in order to take account of the
differences in risk levels between the managed portfolio and the benchmark portfolio. While there
are many such methods, the most notables are the Sharpe ratio (S), Treynor ratio (T), Jensen’s alpha
(a), Modigliani and Modigliani (M2), and Treynor Squared (T2). These measures, along with their
applications, are discussed below.

1. SHARPE RATIO

The Sharpe ratio (Sharpe, 1966) computes the risk premium of the investment portfolio per
unit of total risk of the portfolio. The risk premium, also known as excess return, is the return of the
portfolio less the risk-free rate of interest as measured by the yield of a Treasury security.

The total risk is the standard deviation of returns of the portfolio. The numerator captures
the reward for investing in a risky portfolio of assets in excess of the risk-free rate of interest while
the denominator is the variability of returns of the portfolio. In this sense, the Sharpe measure is
also called the ‘‘rewardto-variability’’ ratio. Equation (34.1) gives the Sharpe ratio.

The Sharpe ratio for an investment portfolio can be compared with the same for a
benchmark portfolio such as the overall market portfolio. Suppose that a managed portfolio earned
a return of 618 ENCYCLOPEDIA OF FINANCE 20 percent over a certain time period with a standard
deviation of 32 percent. Also assume that during the same period the Treasury bill rate was 4
percent, and the overall stock market earned a return of 13 percent with a standard deviation of 20
percent. The managed portfolio’s risk premium is (20 percent 4 percent) ¼ 16 percent, while its
Sharpe ratio, S, is equal to 16 percent=32 percent ¼ 0.50. The market portfolio’s excess return is (13
percent 4 percent) ¼ 9 percent, while its S equals 9 percent=20 percent ¼ 0.45. Accordingly, for each
unit of standard deviation, the managed portfolio earned a risk premium of 0.50 percent, which is
greater than that of the market portfolio of 0.45 percent, suggesting that the managed portfolio
outperformed the market after adjusting for total risk.

2. JENSEN’S ALPHA

Jensen’s alpha (Jensen, 1968) is based on the Capital Asset Pricing Model (CAPM) of Sharpe
(1964), Lintner (1965), and Mossin (1966). The alpha represents the amount by which the average
return of the portfolio deviates from the expected return given by the CAPM. The CAPM specifies
the expected return in terms of the risk-free rate, systematic risk, and the market risk premium. The
alpha can be greater than, less than, or equal to zero. An alpha greater than zero suggests that the
portfolio earned a rate of return in excess of the expected return of the portfolio. Jensen’s alpha is
given by.

SHIRIN MAHAJAN 26
 Using the same set of numbers from the previous example, the alpha of the managed portfolio
and the market portfolio can be computed as follows. The expected return of the managed portfolio
is 4 percent þ 1.5 (13 percent 4 percent) ¼ 17.5 percent. Therefore, the alpha of the managed
portfolio is equal to the actual return less the expected return, which is 20 percent 17.5 percent ¼
2.5 percent. Since we are measuring the expected return as a function of the beta and the market
risk premium, the alpha for the market is always zero.

Thus, the managed portfolio has earned a 2.5 percent return above that must be earned given
its market risk. In short, the portfolio has a positive alpha, suggesting superior performance. When
the portfolio is well diversified all three methods – Sharpe, Treynor, and Jensen – will give the same
ranking of performance. In the example, the managed portfolio outperformed the market on the
basis of all three ratios. When the portfolio is not well diversified or when it represents the total
wealth of the investor, the appropriate measure of risk is the standard deviation of returns of the
portfolio, and hence the Sharpe ratio is the most suitable. When the portfolio is well diversified,
however, a part of the total risk has been diversified away and the systematic risk is the most
appropriate risk metric.

Both Treynor ratio and Jensen’s alpha can be used to assess the performance of well-diversified
portfolios of securities. These two ratios are also appropriate when the portfolio represents a sub-
portfolio or only a part of the client’s portfolio. Chen and Lee (1981, 1986) examined the statistical
distribution of Sharpe, Treynor, and Jensen measures and show that the empirical relationship
between these measures and their risk proxies is dependent on the sample size, the investment
horizon and market conditions. Cumby and Glen (1990), Grinblatt and Titman (1994), Kallaberg et al.
(2000), and Sharpe (1998) have provided evidence of the application of performance evaluation
techniques.

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