INVESTMENT ANALYSIS

&
PORTFOLIO MANAGEMENT

Lecture # 34
Dr.Shahid A. Zia 1
 Investment Decisions
• Underlying investment decisions: the tradeoff
between expected return and risk
– Expected return is not usually the same as
realized return
• Risk:
• The risk/return tradeoff could easily be called the
iron stomach test.
• The possibility that the realized return will be
different than the expected return.
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 The Investment Decision Process
• Two-step process:
– Security analysis and valuation.
• Necessary to understand security
characteristics.
– Portfolio management:
• Selected securities viewed as a single unit.

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The Investment Decision Process
• How efficient are financial markets in
processing new information?
• How and when should it be revised?
• How should portfolio performance be
measured?

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 Basic Strategies
– The basic decision involved in fixed-income
management is the decision to be active or
passive.
– An active strategy has as its goal to secure
superior returns from the fixed-income
portfolio.
– Superior returns can be earned if the investor
can predict interest rate movements that are
not currently incorporated into price or if the
investor can identify bonds that are mis-
priced for other factors.
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 Basic Strategies
– For example, finding a bond that has a credit
risk premium that is too large for its credit risk.
Passive management involves controlling risk
and balancing risk and return.

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 Fixed Income
Passive Management
• Bond-Index Funds
• Immunization of interest rate risk.
– Net worth immunization:
Duration of assets = Duration of liabilities
– Target date immunization:
Holding Period matches Duration.
• Cash flow matching and dedication.

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 Contingent Immunization
• Combination of active and passive management.
• Strategy involves active management with a
floor rate of return.
• As long as the rate earned exceeds the floor, the
portfolio is actively managed.
• Once the floor rate or trigger rate is reached, the
portfolio is immunized.

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 Factors Affecting the Process
• Uncertainty in ex post returns dominates
decision process.
– Future unknown and must be estimated.
• Foreign financial assets: opportunity to enhance
return or reduce risk.
• Quick adjustments are needed to a changing
environment.
• The Internet and the investment opportunities.
• Institutional investors are important.

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 Portfolio theory: Investment
Decisions
• Involve uncertainty
• Focus on expected returns
– Estimates of future returns needed to
consider and manage risk.
• Goal is to reduce risk without affecting returns.
– Accomplished by building a portfolio.
– Diversification is key.

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 Dealing With Uncertainty
• Risk that an expected return will not be realized.
• Investors must think about return distributions,
not just a single return.
– Can be discrete or continuous.
• Probabilities weight outcomes.
– Should be assigned to each possible outcome
to create a distribution.

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 Calculating Expected Return
• Expected value:
– The single most likely outcome from a
particular probability distribution.
– The weighted average of all possible return
outcomes.
– Referred to as an ex ante or expected return.

m
E(R )   R ipri
i1

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 Calculating Risk
• Variance and standard deviation used to
quantify and measure risk.
– Measures the spread in the probability
distribution.
– Variance of returns: σ² = (Ri - E(R))²pri
– Standard deviation of returns:
σ =(σ²)1/2

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 Portfolio Expected Return
• Weighted average of the individual security
expected returns.
– Each portfolio asset has a weight, w, which
represents the percent of the total portfolio
value.

n
E(R p )   w iE(R i )
i 1

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 Portfolio Risk
• Portfolio risk not simply the sum of individual
security risks.
• Emphasis on the risk of the entire portfolio and
not on risk of individual securities in the portfolio.
• Individual stocks are risky only if they add risk to
the total portfolio.

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 Portfolio Risk
• Measured by the variance or standard deviation
of the portfolio’s return.
– Portfolio risk is not a weighted average of the
risk of the individual securities in the portfolio.

n
   wi
2
p i
2

i 1

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 Risk Reduction in Portfolios
• Assume all risk sources for a portfolio of
securities are independent.
• The larger the number of securities the smaller
the exposure to any particular risk.
– “Insurance principle”
• Only issue is how many securities to hold.

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 Risk Reduction in Portfolios
• Random diversification:
– Diversifying without looking at relevant
investment characteristics.
– Marginal risk reduction gets smaller and
smaller as more securities are added.
• A large number of securities is not required for
significant risk reduction.
• International diversification benefits.

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 Portfolio Risk and Diversification

p %
35 Portfolio risk

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Market Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio
 Markowitz Diversification
• Non-random diversification:
– Active measurement and management of
portfolio risk.
– Investigate relationships between portfolio
securities before making a decision to invest.
– Takes advantage of expected return and risk
for individual securities and how security
returns move together.

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 Measuring Portfolio Risk

• Needed to calculate risk of a portfolio:

– Weighted individual security risks.
• Calculated by a weighted variance using
the proportion of funds in each security.
• For security i: (wi × i)2
– Weighted co-movements between returns.
• Return co-variances are weighted using the
proportion of funds in each security.
• For securities i, j: 2wiwj × ij
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 Correlation Coefficient
• Statistical measure of association.
 mn = correlation coefficient between securities
m and n
 mn = +1.0 = perfect positive correlation
 mn = -1.0 = perfect negative (inverse)
correlation
 mn = 0.0 = zero correlation

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 Correlation Coefficient
• When does diversification pay?
– With perfectly positive correlated securities?
• Risk is a weighted average, therefore there
is no risk reduction.
– With zero correlation correlation securities?
– With perfectly negative correlated securities?

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 Covariance
• Absolute measure of association:
– Not limited to values between -1 and +1
– Sign interpreted the same as correlation.
– Correlation coefficient and covariance are
related by the following equations:

m
 AB   [R A ,i  E(R A )][R B,i  E(R B )]pri
i 1

 AB   AB  A  B
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 Calculating Portfolio Risk
• Encompasses three factors:
– Variance (risk) of each security.
– Covariance between each pair of securities.
– Portfolio weights for each security.
• Goal: select weights to determine the minimum
variance combination for a given level of
expected return.

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 Calculating Portfolio Risk
• Generalizations:
– The smaller the positive correlation between
securities, the better.
– Covariance calculations grow quickly.
• n(n-1) for n securities
– As the number of securities increases:
• The importance of covariance relationships
increases.
• The importance of each individual
security’s risk decreases. 26
Simplifying Markowitz Calculations
• Markowitz full-covariance model:
– Requires a covariance between the returns of
all securities in order to calculate portfolio
variance.
– n(n-1)/2 set of co-variances for n securities.
• Markowitz suggests using an index to which all
securities are related to simplify.

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 An Efficient Portfolio
• Smallest portfolio risk for a given level of
expected return.
• Largest expected return for a given level of
portfolio risk.
• From the set of all possible portfolios:
– Only locate and analyze the subset known as
the efficient set.
• Lowest risk for given level of return.

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 An Efficient Portfolio
• All other portfolios in attainable set are
dominated by efficient set.
• Global minimum variance portfolio.
– Smallest risk of the efficient set of portfolios.
• Efficient set:
– Part of the efficient frontier with greater risk
than the global minimum variance portfolio.

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