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This is to certify that Report entitled Diversification application in portfolio management which is submitted by me in partial fulfillment of the requirement for the award of degree of Masters in Business Administration to G.G.S.I.P.U. University, Dwarka, Delhi, comprises only my original work and due acknowledgment has been made in the text to all other material used.

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ACKNOWLEDGEMENT Project work is never the accomplishment of one individual. Rather it is an amalgamation of the efforts, ideas and co operation of a number of individuals. It gives me immense pleasure to take this opportunity to thank all those who helped me in successfully completing the project.

I express my deep sense of gratitude to DR. AMIT GUPTA (ASSISTANT PROFESSOR), SCHOOL OF BUSINESS ADMINISTRATION in MBA department for her timely guidance, support, advice and co operation during the project. Her guidance is invaluable in this project; otherwise project would not have been according to the given format.

I would also like to take this opportunity to thank Mr. H.D. Sharma, Head of the department(HOD), Bhagwan Parshuram Institute Of Technology for giving me this opportunity to learn so much from him and this institute.

An investment is a sacrifice of current money or other resources for future benefits. Numerous avenues of investment are available today. The two key aspects of any investment are time and risk. Very broadly, the investment process consists of two tasks. The first task is security analysis which focuses on assessing the risk and return characteristics of the available investment alternatives. The second task is portfolio selection which involves choosing the best possible portfolio from the set of feasible portfolios. Construction of portfolio is only part of the battle. Once it is built, the portfolio needs to be maintained. The market values, needs of the beneficiary, and relative merits of the portfolio components can change over time. The portfolio manager must react to these changes. Portfolio management usually requires periodic revision of the portfolio in accordance with a predetermined strategy. Notwithstanding these concerns, investing can be fairly manageable, rewarding, and enjoyable experience, if we adhere to certain principles and guidelines. By this we can expect and hope to maximize our returns by diversifying our investments into suitable portfolios. For this, each and every investor has to be well educated about economy, investment options, market conditions and its consequences. The main objective is to select the suitable investment criteria like if we want better returns, or consider risk factors, or liquidity or safety of principal. By this we can set our portfolio objectives and construct our portfolio according to our needs and manage it with respect to the market conditions and the securities fairing in the market.



MEANING Combination of individual assets or securities is a portfolio. Portfolio includes investment in different types of marketable securities or investment papers like shares, debentures stock and bonds etc., from different companies or institution held by individuals firms or corporate units and portfolio management refers to managing securities. Portfolio management is a complex process and has the following seven broad phases.

1. Specification of investment objectives and constraints. 2. Choice of asset mix. 3. Formulation of portfolio strategy. 4. Selection of securities. 5. Portfolio execution. 6. Portfolio rebalancing. 7. Portfolio performance. A portfolio is a collection of investments held by an institution or a private individual. In building up an investment portfolio a financial institution will typically conduct its own investment analysis, whilst a private individual may make use of the services of a financial advisor or a financial institution which offers portfolio management services. Holding a portfolio is part of an investment and risk-limiting strategy called diversification. By owning several assets, certain types of risk (in particular specific risk) can be reduced.

PORTFOLIO DIVERSIFICATION: An important way to reduce the risk of investing is to diversify your investments. Diversification is akin to not putting all your eggs in one basket. For example, if your portfolio only consisted of stocks of technology companies. It would likely face a substantial loss in value if a major event adversely affected the technology industry. There are different ways to diversify a portfolio whose holding are concentrated in one industry. You might invest in the stocks of companies belonging to other industry groups. You might allocate to different categories of stocks, such as growth, value, or income stocks. You might include bonds and cash investments in your asset allocation decisions. Diversification requires you to invest in securities whose investment returns do not move together. In other words, their investment returns have a low correlation. The correlation coefficient is used to measure the degree that returns of two securities are related. For example, two stocks whose returns move in lockstep have a coefficient of +1.0. Two stocks whose returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversity, you should aim to find investments that have a low or negative correlation. As you increase the number of securities in your portfolio, you reach a point where youve likely diversified as much as reasonably possible. Financial planners vary in their views on how many securities you need to have a fully diversified portfolio. Some say it is 10 to 20 securities. Others say it is closer to 30 securities. Mutual funds offer diversification at a lower cost. You can buy no-load mutual funds from an online broker. Often, you can buy shares fund directly from the mutual fund, avoiding a commission altogether.


1. Return: Portfolio management is technique of investing in securities. The ultimate object of investment in the securities is return. Hence, the first objective of portfolio management is getting higher return. 2. Capital Growth: Some investors do not need regular returns. Their object of portfolio management is that not only their current wealth is invested in the securities; they also want a channel where their future incomes will also be invested. 3. Liquidity: Some investors prefer that the portfolio should be such that whenever they need their money, they may get the same. 4. Availability of Money at Pre-decided Time: Some persons invest their money to use it at pre-decided time, say education of children, etc. Their objective of portfolio planning would be that they get their money at that time. 5. Favourable Tax Treatment: Sometimes, some portfolio planning is done to obtain some tax savings. 6. Maintaining the Purchasing Power: Inflation eats the value of money, i.e., purchasing power. Hence, one object of the portfolio is that it must ensure maintaining the purchasing power of the investor intact besides providing the return.


In India, portfolio management is still in its infancy. Barring a few Indian banks, and foreign banks and UTI, no other agency had professional portfolio management until 1987. After the setting up of public sector mutual funds, since 1987, professional portfolio management, backed by competent research staff became the order of the day. After the success of mutual funds in portfolio management, a number of brokers and investment consultants, some of whom are also professionally qualified have become portfolio managers. They have managed the funds of clients on both discretionary and Nondiscretionary basis. It was found that many of them, Including mutual funds have guaranteed a minimum return or capital appreciation and adopted all kinds of incentives, which are now prohibited by SEBI. They resorted to speculative over trading and insider trading, discounts, etc., to achieve their targeted returns to the clients, which are also prohibited by SEBI. The recent CBI probe into the operations of many market dealers has revealed the unscrupulous practices by banks, dealers and brokers in their portfolio operations. The SEBI has imposed stricter rules, which included their registration, a code of conduct and minimum infrastructures, experience etc. it is no longer possible for unemployed youth, or retired person or self- styled consultant to engage in portfolio management without SEBIs license. The guidelines of SEBI are in the direction of making portfolio management a responsible professional service to be rendered by experts in the field.





1. To know the meaning of portfolio and objectives of constructing portfolio. 2. To explain different investment options to be included in options 3. To study different methods of portfolio. 4. To know how to construct optimum portfolio. 5. To study the different strategies of measuring the performance of portfolio. 6. To know about different revision plans.

Portfolio management is a continuous process. It is a dynamic activity. The following are the basic operations of a portfolio management. 1. Monitoring the performance of portfolio by incorporating the latest market conditions. 2. Identification of the investors objective, constraints and preferences. 3. Making an evaluation of portfolio income (comparison with targets and achievement). 4. Making revision in the portfolio. 5. Implementation of the strategies in tune with investment objectives.


My research is based on Descriptive, Qualitative and Quantitative research. 1. Descriptive Research:- Descriptive research includes surveys and fact finding enquires of different kinds. The major purpose of descriptive research is description of the state of affairs as it exists at present. Researcher has no control over the variables of this type of research. 2. Qualitative Research:- Qualitative research is especially important in the behavioural sciences where the aim is to discover the underline motives of human behaviour. Through such research we can analyses various factors which motivate to people to behave in a particular manner or which make people like or dislike a particular thing. 3.Quantitative research:- Quantitative research is based on the measurement of quantity or amount. It is applicable to phenomena that can be expressed in terms of quantity. So we can use it in our research for collection of all the numerical data.





1. Detailed study of the topic was not possible due to the limited size of the project. 2. There was a constraint with regard to time allocated for the research study. 3. The availability of information from secondary sources such as internet not ensures 100 percent accuracy of information.




An investor has wide range of investment avenues such as: 1. Non security form of investment In India, the household sectors investment in non security forms constitutes a major proportion of its total investment in financial assets. One of the basic channels of influence of financial development on growth is the saving rate. In recent years, a notable feature of the GDP growth has been a sharply rising trend in gross domestic investment and saving, with the former rising by 14.1 per cent of GDP and the latter by 12.4 per cent of GDP over five years. Recent reforms transformed the investment climate, improved business confidence and generated a wave of entrepreneurial optimism. They can be classified into various categories such as: Bank deposits, Post office deposits, Company deposits and Provident fund deposits. a. Indian banking sector: A growing economy needs investment to sustain its growth process. Such investments can be quickly and efficiently undertaken if investors have access to well developed financial system and markets. Historically, banks have played the role of intermediaries matching savers with investors. b. Indian insurance industry: The potential and performance of the insurance sector is universally assessed in the context of two parameters, viz., insurance penetration and insurance density. Insurance penetration is defined as the ratio of premium underwritten in a given year to the GDP. c. Pension sector: The pension sector essentially encompasses the organized sector. The majority of the countrys workforce in the

unorganized sector has no access to formal channels of old age income support. Only about 12 per cent of the working population in India is covered by some form of retirement benefit scheme. Besides the problem of limited coverage, the existing mandatory and voluntary pension system had been characterized by limitations like fragmented regulatory framework, lack of individual choice and portability, lack of uniform standards,. India need for comprehensive reforms in the pension system is thus self-evident. Post office small savings schemes are: post office saving account, post office recurring deposit, post office time deposit. d. Deposit with companies. These deposits are accepted by the companies under relevant Government regulations. But these regulations do not mean any great safety to the depositor. The interest rates are quite attractive but there is no tax exemption on interest earned. The interest income is subject to tax deduction at source, at the rates in force under section 194-a of the income tax act. e. Bullion: From times immemorial gold and silver have constituted important media for investment both from capital appreciation point of view and liquidity point of view. But it does not give any current return, in fact, there is a cost even if modest, in holding bullion, capital appreciation could also b e on some equity shares besides a current return.


2. Equity Shares
With a broadening of the corporate sector, volume of business on the exchanges in India is likely to increase. The greater interest shown in recent years by investors is partly reflected in the over-subscription of new issues. Equity shares represent ownership

capital. An equity shareholder has an ownership stake in the company i.e. he / she has a residual interest in income and wealth. Equity shares are classified into broad categories by stock market analysts such as: Blue chip Shares, Growth Shares, Income Shares, Cyclical Shares and Speculative Shares. Advantages of equity shares: Potential profit Limited liability Hedge against Inflation Free transferability Tax advantage 3. Bonds Bonds or Debentures represent long-term debt instruments. The issuer of a bond promises to pay a stipulated stream of cash flow. Bonds may be classified into the following categories such as: Government Securities, Savings Bonds, Government Agency Securities, PSU Bonds, Debentures of Private Sector Companies and Preference Shares. The investment media included, inter alia, bonds and debentures. This form of investment represents the most usual way of borrowing by a company., It is intended to suit investment needs of a risk avertor who is primarily interested in steady returns coupled with safety of the principal sum. It would be worthwhile to comprehend the salient features, kinds, risk-return relationship, etc, of debentures and bonds.

4. Money Market. Money market are markets for short term financial assets that are close substitutes for money usually with maturities of less than a year. The deregulation of money markets and their development are an essential component of financial sector reform. Well functioning money markets provide a relatively safe income-yielding outlet for the short-term investment of funds both for banks and firms and can also be an important source of short term funds to banks in need of quick liquidity. The effective use of open market operations greatly depends on an active secondary market for T-bills and the linkages between the T-bill market and other key money markets, in particular the Inter Bank call money market. Money market instrument classified as : a. commercial paper b. certificate of deposit c. commercial bills market d. Treasury bill 5. Mutual Fund Schemes Instead of directly buying equity shares and / or fixed income instruments we can participate in various schemes of mutual funds which, in turn, invest in equity shares and fixed income securities. There are three broad types of mutual fund schemes such as: Equity Schemes, Debt Schemes, Balanced Schemes.


6. Financial derivative A financial derivative is an instrument whose value is derived from the value of an underlying asset. The most important financial derivatives from the point of view of investors are: Options, Futures. 7. Government securities Fiscal policy encompasses the taxation, expenditure and debt management of the government. It is used to pursue national economic goals; full employment, price stability and economic growth. When government expenditure exceeds revenues, this deficit must be financed in order to do so, the government issuers a variety of securities. This variety helps the government to tap the different sources of funds that are available in debt market. Following a developmental model rather than a regulatory and supervisory model, the Reserve Bank of India took up the task of developing the government securities market, so as to facilitate overall improvement in the strength of financial and economic system of the country. 8. Real Estate For the bulk of the investors the most important asset in their portfolio is a residential house. In addition to a residential house, the more affluent investors are likely to be interested in the following types of real estate: Agricultural Land, Semi Urban Land, Commercial Property, A resort home. Modern investment decisions involve a lot more than traditional stocks and bond issues. A general lack of understanding of concepts like duration and or the utility of futures market products contributed to the demise of many savings and loans. Todays executives in any business must keep pace with

changes in the industry if they want to survive. There are two assets timberland and gold, which are nontraditional in the sense that most portfolio managers have limited understanding of them. Not every portfolio can, or should, invest in these. Before looking at specific information about these investment alternatives, it is useful to know the distinction between financial assets and real assets. Most portfolios are invested in financial assets. These are familiar securities such as shares of common stock, corporate bonds, and bank certificates of deposit. The key characteristic of a financial asset is that for each such asset, somewhere out there a corresponding liability exists. Financial assets are on two balance sheets: as an asset for someone and as a liability for someone else. Real assets, in contrast, do not have a corresponding liability, although one may be created to finance the purchase of the asset. Real estate purchases are normally leveraged. Real estate offers an attractive way to diversify an investment portfolio. In addition, it offers favorable risk-return tradeoffs due to the uniqueness of properties and the localized and relatively inefficient market in which they are traded. Real estate differs from security investments in two ways:

a. It involves ownership of a tangible asset. b. Managerial decisions about real estate greatly affect the buying right or selling right. Like other investment markets, the real estate market changes over time. It also differs from region to region.




Portfolio is combination of securities such as stocks, bonds and money market instruments. The process of blending together the broad assets classes so as to obtain optimum return with minimum risk is called portfolio construction. Minimization of risks: The company specific risks (unsystematic risks) can be reduced by diversifying into a few companies belonging to various industry groups, asset group or different types of instruments like equity shares, bonds, debentures etc. thus, asset classes are bank deposits, company deposits, gold, silver, land, real estate, equity shares etc. industry group like tea, sugar paper, cement, steel, electricity etc. Each of them has different risk return characteristics and investments are to be made, based on individuals risk preference. The second category of risk (systematic risk) is managed by the use of beta of different company shares. Approaches in portfolio construction: Commonly there are two approaches in the construction of the portfolio of securities viz., Traditional approach Markowitz efficient frontier approach. In the traditional approach, investors needs in terms of income and capital appreciation are evaluated and then appropriate securities are selected to, meet the needs of investors. The common practice in the traditional approach is to evaluate the entire financial plan of the individuals. In the modern approach, portfolios are constructed to maximize the expected return


for a given level of risk. It view portfolio construction in terms of the expected return and the risk associated with obtaining the expected return. Efficient portfolio: To construct an efficient portfolio, we have to conceptualize various combinations of investments in a basket and designate them as portfolio one to N. Then the expected returns from these portfolios are to be worked out and then portfolios are to be estimated by measuring the standard deviation of different portfolio returns. To reduce the risk, investors have to diversify into a number of securities whose risk return profiles vary. A single asset or a portfolio of assets is considered to be efficient if no other asset offers higher expected return with the same risk or lower risk with the same expected return. A portfolio is said to be efficient when it is expected to yield the highest returns for the level of risk accepted or, alternatively, the smallest portfolio risk or a specified level of expected return. Main features of efficient set of port folio: The investor determines a set of efficient portfolios from a universe of n securities and an efficient set of portfolio is the subset of n security universe. The investor selects the particular efficient that provides him with most suitable combination of risk and return.


Sharpe assumed that, for the sake of simplicity, the return on a security could be regarded as being linearly related to a single index like the market index. Theoretically, the market index should consist of all the securities trading on the market. However, a popular average can be treated as a surrogate for the market index. Acceptance of the ideas of a market index, Sharpe argued, would obviate the need for calculating thousands of covariance between individual securities, because any movements in securities could be attributed to movements in the single underlying factor being measured by the market index. The simplification of the Markowitz Model has come to be known as the Market Model or Single Index Model Optimal portfolios set up by using the single index model of sharpe. Share Model Equation was set as Rj= aj+Bj I +ej Rj = Expected return on security Aj = Intercept of a straight line or alpha coefficient Bj =beta coefficient is the slope of a straight line I =expected return on index of the market Ej =error term with a mean of zero and standard deviation which is constant. The return on the stock in relation to the return on the market Indeed, namely, Beta is a measure of the systematic risk of the market. The error term n the above equation explains the unsystematic risk. Beta is thus a measure of Systematic Risk of the market only and does not represent the unsystematic risk.



MARKOWITZ MODEL Harry Markowitz has credited and introduced the new concept of risk measurement and their application to the selection of portfolios. He started with the idea of investors and their desire to maximize expected return with the least risk. Markowitz model is a theoretical frame work for analysis of risk and return and their relationships. He used statistical analysis for the measurement of risk and mathematical programming for selection of assets in a portfolio in an efficient manner. His framework lead to the concept of efficient portfolios, which are expected to yield the highest return for, given a level of risk or lowest risk for a given level of return. Risk and return two aspects of investment considered by investors. The expected return may very depending on the assumptions. Risk index is measured by the variance or the distribution around the mean its range etc, and traditionally the choice of securities depends on lower variability where as Markowitz emphasizes on the need for maximization of returns through a combination of securities whose total variability is lower. The risk of each security is different from that of other and by proper combination of securities, called diversification, one can form a portfolio where in that of the other offsets the risk of one partly or fully. In other words, the variability of each security and covariance for

his or her returns reflected through their inter-relationship should be taken into account. Thus, expected returns and the covariance of the returns of the securities with in the portfolio are to be considered for the choice of a portfolio.

ASSUMPTIONS OF MARKOWITZ THEORY: The analytical frame work of Markowitz model is based on several assumptions regarding the behavior of investor: The investor invests his money for a particular length of time known as holding period. At the end of holding period, he will sell the investments. Then he spends the proceeds on either for consumption purpose or for reinvestment purpose or sum of both. The approach therefore holds good for a single period holding. The market efficient in the sense that, all investors are well informed of all the facts about the stock market. Since the portfolio is the collection of securities, a decision about an optimal portfolio is required to be made from a set of possible portfolio. The security returns over the forth coming period are unknown, the investor could therefore only estimate the Expected return(ER). All investors are risk averse. Investors study how the security returns are co-related to each other and combine the assets in an ideal way so that they give maximum returns with the lowest risk. He would choose the best one based on the relative magnitude of these two parameters. The investors base their decisions on the price-earning ratio. Standard deviation of the rate of return, which is been offered on the investment, is one of the important criteria considered by the investors for choosing different securities.

MARKOWITZ DIVERSIFICATION Markowitz postulated that diversification should not only aim at reducing the risk of a security by reducing its variability of standard deviation, but by reducing the co-variance or interactive risk of two or more securities in a portfolio. By combining the different securities it is theoretically possible to have a range of risk varying from zero to infinity. Markowitz theory of portfolio diversification attaches importance to standard deviation, to reduce it to zero, if possible, covariance to have as much as possible negative interactive effect among the securities with in the portfolio and coefficient of correlation to have -1 (negative) so that the over all risk of portfolio as whole is nil or negligible than the securities have to be combined in the manner that standard deviation is zero. EFFICIENT FRONTIER:

As for Markowitz model minimum variance portfolio is used for determination of proportion of investment in first security and second security. It means a portfolio consists of two securities only. When different portfolios and their expected return and standard deviation risk rates are given for determination of best portfolio, efficient frontier is used. Efficient frontier is graphical representation on the base of the optimum point this is to identify the portfolio which may give better returns at low risk. At that point the investor can choose portfolio. On the basis of these holding period of portfolio can be determined. On X axis risk rate of portfolio (s.d of p), and on y axis return on portfolios are to be shown. Calculate return on portfolio and standard deviation of portfolio for various combinations of weights of two securities. Various returns are shown in the graphical and identify the optimum point.

Calculation of expected rate of return (ERR): Calculate the proportion of each securitys proportion in the total investment. It gives the weight for each component of securities. Multiply the funds invested in the each component with the weights. It gives the initial wealth or initial market values. Equation: Rp = w1R1+w2R2+w3R3+..+wnRn Where Rp = Expected return on portfolio w1, w2, w3, w4 = proportional weight invested R1, R2, R3, R4 = expected returns on securities The rate of return on portfolio is always weighted average of the securities in the portfolio. ESTIMATION OF PORTFOLIO RISK: A useful measure of risk should take into account both the probability of various possible bad outcomes and their associated magnitudes. Instead of measuring the probability of a number of different possible outcomes and ideal measure of risk would estimate the extent to which the actual outcome is likely to diverge from the expected outcome. Two measures are used for this purpose: Average absolute deviation Standard deviation In order to estimate the total risk of a portfolio of assets, several estimations are needed: a) The predicted return on the portfolio is simply a weighted average of the predicted returns on the securities, using the proportionate values as weights.


b) The risk of the portfolio depends not only on the risk of its securities considered in isolation, but also on the extent to which they are affected similarly by underlying events c) The deviation of each securities return from its expected value is determined and the product of the two obtained. d) The variance in a weighted average of such products, using the probabilities of the events as weight. Effect of combining two securities: It is believed that spreading the portfolio in two securities is less risky than concentrating in only one security. If two stocks, which have negative correlation, were chosen on a portfolio risk could be completely reduced due to the gain in the whole offset the loss on the other. The effect of two securities, one more risky and other less risky, on one another can also be studied. Markowitz theory is also applicable in the case of multiple securities. CRITICISM ON MARKOWITZ THEORY: The Markowitz model is confronted with several criticisms on both theoretical and practical point of view. Very tedious I and in variably required a computer to effect numerous calculations. Another criticism related to this theory is rational investor can avert risk. Most of the works stimulated by Markowitz uses short term volatility to determine whether the expected rate of return from a security should be assigned high or a low expected variance, but if an investor has limited liquidity constraints, and is truly a long term holder, and then price volatility per share does not really pose a risk. Rather in this case, the question concern is one ultimate price realization and not interim volatility.


Another apparent hindrance is that practicing investment managers found it difficult to under stand the conceptual mathematics Involved in calculating the various measure of risk and return. There was a general criticism that an academic approach to portfolio management is essentially unsound. Security analysts are not comfortable in calculating covariance among securities while assessing the possible ranges of error in their expectations.

CAPITAL ASSETS PRICING MODEL (CAPM): Under CAPM model the changes in prices of capital assets in stock exchanges can be measured by using the relationship between security return and the market return. So it is an economic model describes how the securities are priced in the market place. By using CAPM model the return of security can be calculated by comparing return of security with market place. The difference of returns of security and market can be treated as highest return and the risk premium of the investor is identified. It is the difference between the return of security and risk free rate of return Risk premium = Return on security Risk free rate of return So the CAPM attempts to measure the risk of a security in the portfolio sense. Assumptions: The CAPM model depends on the following assumptions, which are to be considered while calculating rate of return. The investors are basically average risk assumers and diversification is needed to reduce the risk factor.


All investors want to maximize the return by assuming expected return of each security. All investors assume increase of net wealth of the security. All investors can borrow or lend an unlimited amount of fund at risk free rate of interest. There are no transaction costs and no taxes at the time of transfer of security. All investors have identical estimation of risk and return of all securities. All the securities are divisible and tradable in capital market. Systematic risk factor can be calculated and it is assumed perfectly by the investor. Capital market information must be available to all the investors.

LIMITATION OF CAPM: In practical purpose CAPM cant be applied due to the following limitations. The calculation of beta factor is not possible in certain situations due

to more assets are traded in the market. The assumption of unlimited borrowings at risk free rate is not certain.

For every individual investor borrowing facilities are restricted. The wealth of the shareholder or investor is assessed by using security

return. But it is not only the factor for calculation of wealth of the investor. For every transfer of security transition cost is required on every

return tax must be paid.


Beta: Beta described the relationship between the stock return and the market index returns. This can be positive and negative. It is the percentage change is the price of his stock regressed (or related) to the percentage changes in market index. if beta is 1, a one- percentage changes in market index will lead to one percentage change in price of the stock. If beta is 0, stock price is un related to the market index if the market goes up by a +1%, the stock price will fall by 1% beta measures the systematic market related risk , which cannot be eliminated by diversification. If the portfolio is efficient, Beta measures the systematic risk effectively.

Evaluation process: 1. Risk is the variance of expected return of portfolio. 2. two types of risk are assumed they are o systematic risk o unsystematic risk 3. Systematic risk is calculated by the investor by comparison of security return With market return. Co-variance of security and market = ________________________________ Variance of market Higher value of beta indicates higher systematic risk and vice versa. When number of securities is hold by an investor, composite beta or portfolio can be calculated by the use of weights of security and individual beta. 4. Risk free rate of return is identified on the basis of the market conditions.

The following two methods are used for calculation of return of security or portfolio. CAPITAL MARKET LINE: Under CAPM model Capital market line determined the relationship between risk and return of efficient portfolio. When the risk rates of market and portfolio risk are given, expected return on security or portfolio can be calculated by using the following formula. ERP = T + p (Rpm T) M ERP = Expected return of portfolio T = risk free rate of return p = portfolio of standard deviation Rpm = return of portfolio and market M = risk rate of the market. SECURITY MARKET LINE: Identifies the relationship of return on security and risk free rate of return. Beta is used to identify the systematic risk of the premium. The following equation is used for expected return. ERP = T + (Rm T) Rm = Return Of Market T = Risk Free Rate




The optimal portfolio concept falls under the modern portfolio theory. The theory assumes (among other things) that investors fanatically try to minimize risk while striving for the highest return possible. The theory states that investors will act rationally, always making decisions aimed at maximizing their return for their acceptable level of risk. The optimal portfolio was used in 1952 by Harry Markowitz, and it shows us that it is possible for different portfolios to have varying levels of risk and return. Each investor must decide how much risk they can handle and than allocate (or diversify) their portfolio according to this decision. The chart below illustrates how the optimal portfolio works. The optimalrisk portfolio is usually determined to be somewhere in the middle of the curve because as you go higher up the curve, you take on proportionately more risk for a lower incremental return. On the other end, low risk/low return portfolios are pointless because you can achieve a similar return by investing in risk-free assets, like government securities. 2m


(R T)Bim 2 ei __

Cj =

_ 1+ 2m


B2im 2ei

2m= variance of market index 2m=variance of a securitys movement that is not associated with the movement of the market index; this is the securitys unsystematic risk.


You can choose how much volatility you are willing to bear in your portfolio by picking any other point that falls on the efficient frontier. This will give you the maximum return for the amount of risk you wish to accept. Optimizing your portfolio is not something you can calculate in your head. There are computer programs that are dedicated to determining optimal portfolios by estimating hundreds (and sometimes thousands) of different expected returns for each given amount of risk.




Portfolio managers and investors who manage their own portfolios continuously monitor and review the performance of the portfolio. The evaluation of each portfolio, followed by revision and reconstruction are all steps in the portfolio management. The ability to diversify with a view to reduce and even eliminate all unsystematic risk and expertise in managing the systematic risk related to the market by use of appropriate risk measures, namely, betas. Selection of proper securities is thus the first requirement. Investment timing is a complex and difficult thing. Investor must decide how often the portfolio should be revised. If revision occurs too often, transaction and analysis costs may be high. If revision is attempted too infrequently, the benefits of timing may be foregone. Many experienced investors know it is easier to select the individual companies in which to invest than to determine the right time to invest. If investors want to maximize their profits, they must not only purchase the right security but must also know the right time to purchase and sell. Although all investors know the importance of timing, it is difficult for them to determine when it is the right time to buy or sell. Seasoned investors know that most stock prices fluctuate widely during a particular business cycle, but, nevertheless, they often react in a way opposite to one that would enable them to benefit from fluctuations.


METHODS OF EVALUATION SHARPE INDEX MODEL: It depends on total risk rate of the portfolio. Return of the security compare with risk free rate of return, the excess return of security is treated as premium or reward to the investor. The risk of the premium is calculated by comparing portfolio risk rate. While calculating return on security any one of the previous methods is used. If there is no premium Sharpe index shows negative value (-). n such a case portfolio is not treated as efficient portfolio. Sharpes ratio (Sp) = rp rf / p Where, Sp = Sharpe index performance model rp = return of portfolio rf = risk free rate of return p = portfolio standard deviation This method is also called reward to variability method. When more than one portfolio is evaluated highest index is treated as first rank. That portfolio can be treated as better portfolio compared to other portfolios. Ranks are prepared on the basis of descending order. TREYNORS INDEX MODEL It is another method to measure the portfolio performance. Where systematic risk rate is used to compare the unsystematic risk rate. Systematic risk rate is measured by beta. It is also called reward to systematic risk . Treynors ratio (Tp) = rp rf / p Where,

Tp = treynors portfolio performance model rp= return of portfolio rf= risk free rate of return p= portfolio standard deviation. If the beta portfolio is not given market beta is considered for calculation of the performance index. Highest value of the index portfolio is accepted. JANSENS INDEX MODEL It is different method compared to the previous methods. It depends on return of security which is calculated by using CAPM. The actual security returns is less than the expected return of CAPM the difference is treated as negative (-) then the portfolio is treated as inefficient portfolio. Jp=rp-[rf+ p (rm-rf)] Where, Jp = Jansens index performance model rp= return of portfolio rf= risk free rate of return p= portfolio standard deviation rm= return on market This method is also called reward to variability method. When more than one portfolio is evaluated highest index is treated as better portfolio compared to other portfolios. Ranks are prepared on the basis of descending order.




Having constructed the optimal portfolio, the investor has to constantly monitor the portfolio to ensure that it continues to be optimal. As the economy and financial markets are dynamic, the changes take place almost daily. The investor now has to revise his portfolio. The revision leads to purchase of new securities and sale of some of the existing securities from the portfolio. Need for revision: Availability of additional funds for investment Availability of new investment avenues Change in the risk tolerance Change in the time horizon Change in the investment goals Change in the liquidity needs Change in the taxes


FORMULA PLAN: To ease the problem of timing and minimize the emotions involved in investing, mechanical portfolio management techniques have been developed. These mechanical techniques are sometimes employed to beat the market through timing. Some sort of formula is used to alter exposure to the market from time to time, in the hope

of thereby taking advantage of market cycles. However, formula plans are primarily oriented to loss-minimisation rather than return maximization. The chapter will examine (1) Constant Rupee-Value, (2) Constant Ratio, and (3) Variable-Ratio formula plans, as well as another mechanical investment plan, rupee-cost averaging. Formula plans are efforts to make the decision on timing automatic. They consist of predetermined rules for both buying and selling of the stock. The selection of a formula plan and the determination of the appropriate ground rules cause the investor to consider and outline his investment objectives and policies. Once the plan is established, the investor is free from making emotional decisions based upon the current attitude of investors in the stock market.


1. Constant-Rupee-Value Plan: The constant rupee value plan specifies that the rupee value of the stock portion of the portfolio will remain constant. Thus, as the value of the stock rises, the investor must automatically sell some of the shares in order to keep the value of his aggressive portfolio constant. If the price of the stock falls, the investor must buy additional stock to keep the value of aggressive portfolio constat. By specifying that the aggressive portfolio will remain constant in money value, the plan also specifies that remainder of the total fund be invested in the conservative fund. The constant-rupee-value plans major advantage is its simplicity. The investor can clearly see the amount that he needed to have invested. However, the percentage of his total fund that this constant amount will represent in the aggressive portfolio will remain at different levels of his stocks values.

Main limitation of the constant rupee plan is that it requires some initial forecasting. However, it does not require forecasting the extent to which upward fluctuations may reach. In fact, a forecast of the extent of downward fluctuations is necessary since the conservative portfolio must be large enough so that funds are always available for transfer to the stock portfolio as its value shrinks. 2. CONSTANT RATIO PLAN: the constant ratio plan goes one step beyond the constant rupee plan by establishing a fixed percentage relationship between the aggressive and defensive components. Under both plans the portfolio is forced to sell stocks as their prices rise and to buy stocks as their prices fall. Under the constant ratio plan, however, both the aggressive and defensive portions remain in constant percentage of the portfolios total value. The problem posed by re-balancing may mean missing intermediate price movements. The constant ratio plan holder can adjust portfolio balance either at fixed intervals or when the portfolio moves away from the desired ratio by a fixed percentage. 3. VARIABLE RATIO PLAN: Instead of maintaining a constant rupee amount in stocks or a constant ratio of stocks to bonds, the variable ratio plan user steadily lowers the aggressive portion of the total portfolio as stock prices rise, and steadily increases the aggressive portion as stock price fall. By changing the proportions of defensive aggressive holdings, the investor is in effect buying stock more aggressively as stock prices fall and selling stock more aggressively as stock prices rise.



Another mechanical investment technique, which is not technically a formula plan, is rupee-cost averaging. It is a simple investment plan which helps the uninformed investor with the timing of his investments. This plan gives no clue as to what the investor should buy; it merely simplifies the problem of deciding when to buy. In essence a rupee cost averaging investment programme involves making periodic investments of equal rupee amount. Such a programme leads to the purchase of more shares when their price is cheap than when they are expansive. As a result, the average rupee cost per share is below the average of the intervening prices. The advantages of rupee cost averaging plan are: 1. Low average price 2. Easy use 3. Fixed limiting considerations 4. Applicability to both rising and falling markets There are several limitations of the plan. 1. The extra transaction costs associated with request, small purchases raise the price of the shares. 2. The higher per share commissions and addition add to fees encountered under this plan account for most of this expanse. 3. The plan contains no formal indication of when to sell 4. It is strictly a strategy for buying. 5. It does not eliminate the necessity for selecting the individual stocks that are to be purchased. 6. There is no indication of the appropriate interval between purchases.




So far in India, most of the middle class earners have been risk-averse and therefore park most of their savings in Fixed Deposits and Other Savings Accounts, though the yield from such investment avenues is very low. However, the recent trend has been such that more people have been attracted towards investment in Mutual Funds and Equities. It is in this light that Portfolio Management Companies have been gaining prominence in India. The trend is only set to go upwards in the years to come, as the Indian middle class becomes more risk friendly.




Books 1. Bhalla, vk, Investment management (security analysis and portfolio management), fifteenth edition 2009, 1157 pages. Web Site 1. 2. 3. 4. 5.