Portfolio risk and return

A portfolio is composed of two or more securities. Each

portfolio has risk-return characteristics of its own. A portfolio
comprising securities that yield a maximum return for given
level of risk or minimum risk for given level of return is termed
as ‘efficient portfolio’.
In their Endeavour to strike a golden mean between risk and
return the traditional portfolio managers diversified funds over
securities of large number of companies of different industry
groups.
Portfolio Return:
The expected return of a portfolio represents weighted average
of the expected returns on the securities comprising that
portfolio with weights being the proportion of total funds
invested in each security (the total of weights must be 100).

Portfolio Risk:
Unlike the expected return on a portfolio which is simply the
weighted average of the expected returns on the individual
assets in the portfolio, the portfolio risk, σp is not the simple,
weighted average of the standard deviations of the individual
assets in the portfolios.

MARKOWITZ PORTFOLIO MODEL

The modern portfolio theory (MPT) is a practical method for

selecting investments in order to maximize their overall returns
within an acceptable level of risk.
American economist Harry Markowitz pioneered this theory in
his paper "Portfolio Selection," 

A key component of the MPT theory is diversification. Most

investments are either high risk and high return or low risk and
low return. Markowitz argued that investors could achieve
their best results by choosing an optimal mix of the two based
on an assessment of their individual tolerance to risk.
The modern portfolio theory argues that any given
investment's risk and return characteristics should not be
viewed alone but should be evaluated by how it affects the
overall portfolio's risk and return. That is, an investor can
construct a portfolio of multiple assets that will result in
greater returns without a higher level of risk.

The Portfolio Theory of Markowitz is based on the following

assumptions:
(1) Investors are rational and behave in a manner as to
maximise their utility with a given level of income or money.

(2) Investors have free access to fair and correct information on

the returns and risk.

(3) The markets are efficient and absorb the information quickly
and perfectly.

(4) Investors are risk averse and try to minimise the risk and
maximise return.
Efficient frontier and optimum portfolio
The efficient frontier is the set of optimal portfolios that offer
the highest expected return for a defined level of risk or the
lowest risk for a given level of expected return. Portfolios that
lie below the efficient frontier are sub-optimal because they do
not provide enough return for the level of risk. Portfolios that
cluster to the right of the efficient frontier are sub-optimal
because they have a higher level of risk for the defined rate of
return.

The efficient frontier graphically represents portfolios that

maximize returns for the risk assumed. Returns are dependent
on the investment combinations that make up the portfolio. 
Optimum Portfolio
An optimal portfolio is one that occupies the ‘efficient’ parts of
the risk-return premium spectrum. It satisfies the requirement
that no other collection exists with a higher expected return at
the same standard deviation of the return (risk measure).
Different combinations of assets produce different levels of
return. The optimal portfolio concept represents the best of
these combinations, those that provide the maximum possible
expected return for a given level of acceptable risk.

Market Model
The market model says that the return on a security depends
on the return on the market portfolio and the extent of the
security's responsiveness as measured by beta. The return also
depends on conditions that are unique to the firm. The market
model can be graphed as a line fitted to a plot of asset returns
against returns on the market portfolio. This relationship is
sometimes called the single-index model.

Investor risk and return preferences

The risk-return tradeoff states that the potential return rises
with an increase in risk. Using this principle, individuals
associate low levels of uncertainty with low potential returns,
and high levels of uncertainty or risk with high potential
returns. According to the risk-return tradeoff, invested money
can render higher profits only if the investor will accept a
higher possibility of losses .
The risk-return trade-off is the trading principle that links high
risk with high reward. The appropriate risk-return trade-off
depends on a variety of factors including an investor’s risk
tolerance, the investor’s years to retirement and the potential
to replace lost funds. Time also plays an essential role in
determining a portfolio with the appropriate levels of risk and
reward. For example, if an investor has the ability to invest in
equities over the long term, that provides the investor with the
potential to recover from the risks of bear markets and
participate in bull markets, while if an investor can only invest
in a short time frame, the same equities have a higher risk
proposition.

Traditional portfolio management

Traditional portfolio management is a nonquantitative
approach to balancing a portfolio with different assets, such as
stocks and bonds, from different companies and different
sectors as a way of reducing the overall risk of the portfolio.
The main objective is to select assets with little or negative
correlation with each other, so that the overall diversifiable risk
is reduced.
Asset allocation pyramid
An investment pyramid, or risk pyramid, is a portfolio strategy
that allocates assets according to the relative risk levels of
those investments. The risk of an investment is defined in this
strategy by the variance of the investment return, or the
likelihood the investment will decrease in value to a large
degree.
The bottom and widest part of the pyramid is comprised of low-
risk investments, the mid-portion is composed of growth
investments, and the smallest part at the top is allocated to
speculative investments.
The base (i.e. the widest part of the pyramid) would contain the
highest allocation of assets and would include cash and CDs,
short-term government bonds, and money market securities.
The middle part of the pyramid would include a moderate
allocation to corporate bonds, stocks, and real estate. These
assets are somewhat risky and have some probability of losing
value, although over time they have positive expected returns.
The top would include the smallest allocation weights and
include highly risky, speculative investments that have a high
chance of loss, but may also produce above-average returns.
These would include derivatives contracts like options and
futures (not used for hedging purposes), alternative
investments, and collectibles such as artwork.
Investor life cycle approach
Individual investor life cycle indicates the investment behavior
of investor over the different age of their life. The investment
decision is based on the age, financial condition, future plans
and risk characteristics of an individual.
An investor passes through four different phases in life
Accumulation Phase
Consolidation Phase
Spending Phase
Gifting Phase
Accumulation Phase- Investor early or middle to their career
tries to accumulate fund so that individual can have money to
spend in the later phase of their life. Some people accumulate
the fund to buy house, car or other important assets and some
people accumulate for their children’s education cost, life
peaceful life after retirement.
Funds invested in the early phase of life gives an investor a
huge amount of fund which is compounding over the years.
Consolidation Phase-Consolidation phase is the midpoint of
their career, in this phase, they earn more, spends more and
pay off all their debts. In this phase moderately high risk taken
by the investor but for capital reservation some investor
prefers lower risk investor. Individual invest in the capital
market and investment securities.
Spending Phase-This phase starts when an individual retires
from the job. Their overall portfolio is to be less risky than the
consolidation phase; they prefer low risky investment or risk-
free investment. People prefer fixed income securities like a
bond, debenture, treasury bills etc. In this phase, they need
some risky investor if they have extra money so that future
inflation can be adjusted.
Gifting Phase- If individuals believe that they have enough
extra funds to meet their current and future expenses then
they go for gifting money to their friends, family members or
establish charitable trusts. These can reduce their income taxes
and they also keep some fun for future uncertainties.
Portfolio Management services
Portfolio Management Services (PMS), service offered by the
Portfolio Manager, is an investment portfolio in stocks, fixed
income, debt, cash, structured products and other individual
securities, managed by a professional money manager that can
potentially be tailored to meet specific investment objectives.
Index Funds- An index fund is a type of mutual fund or
exchange-traded fund (ETF) with a portfolio constructed to
match or track the components of a financial market index,
such as the Standard & Poor's 500 Index (S&P 500). An index
mutual fund is said to provide broad market exposure, low
operating expenses, and low portfolio turnover. These funds
follow their benchmark index regardless of the state of the
markets.
Systematic investment plan- A systematic investment plan (SIP)
is a plan in which investors make regular, equal payments into a
mutual fund, trading account, or retirement account such as a
401(k). SIPs allow investors to save regularly with a smaller
amount of money. SIPs give investors a chance to invest small
sums of money over a longer period of time rather than having
to make large lump sums all at once. Most SIPs require
payments into the plans on a consistent basis—whether that's
weekly, monthly, or quarterly.

Style Investing- Style investing is an investment approach in

which rotation among different "styles" is supposed to be
important for successful investing. As opposed to investing in
individual securities, style investors can decide to make
portfolio allocation decisions by placing their money in broad
categories of assets, such as "large-cap", "growth",
"international", or "emerging markets".
Style investing is of interest to economists because it serves as
a useful framework for identifying anomalous price movements
in stocks, such as those observed when a stock is added or
removed from the S&P 500 index.
Style investing is the study of asset prices in an economy where
some investors classify risky assets into different styles and
move funds back and forth between these styles depending on
their relative performance.
Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) describes the
relationship between systematic risk and expected return for
assets, particularly stocks. CAPM is widely used throughout
finance for pricing risky securities and generating expected
returns for assets given the risk of those assets and cost of
capital.
The formula for calculating the expected return of an asset
given its risk is as follows:
ERi =R f+β i (ER m −R f)
where:ER i=expected return of investment
R f =risk-free rate
β i=beta of the investment
(ERm −R f) =market risk premium
Investors expect to be compensated for risk and the time value
of money. The risk-free rate in the CAPM formula accounts for
the time value of money. The other components of the CAPM
formula account for the investor taking on additional risk.
The beta of a potential investment is a measure of how much
risk the investment will add to a portfolio that looks like the
market. If a stock is riskier than the market, it will have a beta
greater than one. If a stock has a beta of less than one, the
formula assumes it will reduce the risk of a portfolio.

A stock’s beta is then multiplied by the market risk premium,

which is the return expected from the market above the risk-
free rate. The risk-free rate is then added to the product of the
stock’s beta and the market risk premium. The result should
give an investor the required return or discount rate they can
use to find the value of an asset.
The goal of the CAPM formula is to evaluate whether a stock is
fairly valued when its risk and the time value of money are
compared to its expected return.
For example, imagine an investor is contemplating a stock
worth $100 per share today that pays a 3% annual dividend.
The stock has a beta compared to the market of 1.3, which
means it is riskier than a market portfolio. Also, assume that the
risk-free rate is 3% and this investor expects the market to rise
in value by 8% per year.
The expected return of the stock based on the CAPM formula is
9.5%:
9.5%=3%+1.3×(8%−3%)
The expected return of the CAPM formula is used to discount
the expected dividends and capital appreciation of the stock
over the expected holding period. If the discounted value of
those future cash flows is equal to $100 then the CAPM formula
indicates the stock is fairly valued relative to risk.

Assumptions of CAPM

Investors hold diversified portfolios-This assumption means

that investors will only require a return for the systematic risk
of their portfolios, since unsystematic risk has been diversified
and can be ignored.

Single-period transaction horizon-A standardised holding

period is assumed by the CAPM to make the returns on
different securities comparable. A return over six months, for
example, cannot be compared to a return over 12 months. A
holding period of one year is usually used.

Investors can borrow and lend at the risk-free rate of return-

This is an assumption made by portfolio theory, from which the
CAPM was developed, and provides a minimum level of return
required by investors. The risk-free rate of return corresponds
to the intersection of the security market line (SML) and the y-
axis (see Figure 1). The SML is a graphical representation of the
CAPM formula.
Perfect capital market-This assumption means that all
securities are valued correctly. A perfect capital market
requires the following: that there are no taxes or transaction
costs; that perfect information is freely available to all investors
who, as a result, have the same expectations; that all investors
are risk averse, rational and desire to maximise their own
utility; and that there are a large number of buyers and sellers
in the market.

Characteristic line
A characteristic line is a straight line formed using regression
analysis that summarizes a particular security's systematic risk
and rate of return.
The characteristic line is created by plotting a security's return
at various points in time. The y-axis on the chart measures the
excess return of the security. Excess return is measured against
the risk-free rate of return. The x-axis on the chart measures
the market's return in excess of the risk free rate.
The characteristic line presents a visual representation of how a
specific security or other asset performs when compared to the
performance of the market as a whole.
Capital Market Line
The capital market line (CML) represents portfolios that
optimally combine risk and return. It is a theoretical concept
that represents all the portfolios that optimally combine the
risk-free rate of return and the market portfolio of risky assets.
Under the capital asset pricing model (CAPM), all investors will
choose a position on the capital market line, in equilibrium, by
borrowing or lending at the risk-free rate, since this maximizes
return for a given level of risk.
Portfolios that fall on the capital market line (CML), in theory,
optimize the risk/return relationship, thereby maximizing
performance. The capital allocation line (CAL) makes up the
allotment of risk-free assets and risky portfolios for an investor.
Security market line
Security market line (SML) is the representation of the capital
asset pricing model. It displays the expected rate of return of an
individual security as a function of systematic, non-diversifiable
risk. The risk of an individual risky security reflects the volatility
of the return from security rather than the return of the market
portfolio. The risk in these individual risky securities reflects the
systematic risk.
Expected return-The expected return is the amount of profit or
loss an investor can anticipate receiving on an investment.
Required return- The required rate of return (RRR) is the
minimum return an investor will accept for owning a company's
stock, as compensation for a given level of risk associated with
holding the stock. The RRR is also used in corporate finance to
analyze the profitability of potential investment projects.
Undervalued assets- Undervalued is a financial term referring
to a security or other type of investment that is selling in the
market for a price presumed to be below the investment's true
intrinsic value. The intrinsic value of a company is the present
value of the free cash flows expected to be made by the
company.
Overvalued Assets- An overvalued asset is an investment that
trades for more than its intrinsic value. For example, if a
company with an intrinsic value of $7 per share trades at a
market value $13 per share, it is considered overvalued.