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Market

Introduction To
Portfolio Management
Theory
What is a Portfolio ?
A portfolio refers to a collection of investment tools such as stocks, shares, mutual funds, bonds, cash and so
on depending on the investors income, budget and convenient time frame. Following are the two types of
Portfolio:

Market Portfolio

Zero Investment Portfolio

What is Portfolio Management ?


The art of selecting the right investment policy for the individuals in terms of minimum risk and
maximum return is called as portfolio management. Portfolio management refers to managing an
individuals investments in the form of bonds, shares, cash, mutual funds etc. so that he earns the
maximum profits within the stipulated time frame.

Harry Markowitz developed the portfolio model. This model includes not only expected return, but
also includes the level of risk for a particular return. Markowitz assumed the following about an
individual's investment behaviour:

Given the same level of expected return, an investor will choose the investment with the lowest
amount of risk.

Investors measure risk in terms of an investment's variance or standard deviation.

For each investment, the investor can quantify the investment's expected return and the
probability of those returns over a specified time horizon.

Investors seek to maximize their utility.

Investors make decision based on an investment's risk and return, therefore, an investor's utility
curve is based on risk and return.

Risk and return are the two most important attributes of an


investment.
Return
%

Research has shown that the two are linked in the capital
markets and that generally, higher returns can only be
achieved by taking on greater risk.
Risk isnt just the potential loss of return, it is the potential
loss of the entire investment itself (loss of both principal
and interest).

Risk
Premium

R
F

Real Return
Expected Inflation Rate

Risk

UNSYSTEMATIC RISK

SYSTEMATIC RISK

Systematic risk refers to the risk which


affects the whole stock market and
therefore it cannot be reduced or
diversified away
This type of risk is called non
diversifiable risk because no amount of
diversification can reduce risk
This risk are external in nature and
cannot be avoided but can be reduced

Unsystematic risk is the extent to


variability in the stock or securitys return
on account of factors which are unique to
a company

This type of risk can be diversified away


by investing in more than one company.

This is purely internal risk which can be


avoidable by effective management

A model that describes the relationship between risk and expected return and that is used in the pricing of
risky securities.

CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus
a risk premium.

Capital asset pricing model was developed by building on the portfolio theory pioneered by Markowitz.
William Sharpe in 1964, John Lintner in 1965, and Jan Mossin in 1967 laid the basis for the capital asset
pricing model (CAPM).

CAPM provides explicit implications with respect to


the behavior of security prices,

the sort of risk-return relationship that one would expect,

and the appropriate measure of risk for securities.

Price-Earnings Ratio (P/E): This number tells you how many years worth of profits youre
paying for a stock and you calculate it by dividing earnings per share by the stock price.
The lower the P/E the better.
Benjamin Graham, the legendary investor and Warren Buffetts teacher at Columbia
University, postulated that stocks should trade for a P/E multiple equal to 8.5 times
earnings plus two times the growth rate of earnings.
The average P/E since 1935 is 15.86, suggesting the market is a bit pricey.

Thank
You