Chapter 15 Portfolio Planning

UNIT-IV
Portfolio Revision: Need for revision, different techniques of

revision- formula plan: constant dollar value plan, constant ratio
plan, variable ratio plan; Modified formula plan: Dollar cost
Averaging; practical problems in portfolio revision
Portfolio Evaluation: Need for evaluation, time horizon for portfolio
evaluation, Measuring and evaluating portfolio performance:
measurement of return, consideration of risk: Sharpe’s, Treynor’s
and Jensen’s measure, Eugene Fama’s portfolio decomposition,
Risk adjusted performance measures.
Portfolio Management: Equity portfolio management-Active Vs
Passive management strategies,
Bond portfolio management- Active Vs Passive management
strategies, Immunization, Bond Swaps.
Portfolio Planning & Management
• The efficient frontier and investor choices

• Simple mathematical model for choosing
an optimum stock portfolio
• Portfolio management for individuals
-their objectives & constraints
-risk taking ability
-asset allocation
Security Analysis & Portfolio Management Chapter 15

EXCEL BOOKS Portfolio Planning
Investor’s Risk and Return preferences
• Higher indifference curve- more utility

• Higher return with same risk always preferable
• Steeper line- more risk averse

Straight lines - risk return trade off is constant irrespective
of the absolute amount of risk involved
Upward sloping curves - more compensation required as
total risk increases

Indifference Curves and the Efficient Frontier
Aim - find a point on the efficient frontier to put investor on the highest possible indifference curve
Limitation –difficult to draw these curves in practice

Risk Aversion
What would you prefer ?
• Rs 9000 with 100 % probability or Rs 10,000
with 90% probability
• Losing Rs. 9000 with 100% probability or losing
Rs. 10,000 with 90% probability
• An insurance policy -incur a cost of Rs 100 or a
loss of Rs. 100,000 with 0.1% probability
What is the decision using EMV?
Lower tolerance for risk can lead to over pricing
of stocks with good past performance

Portfolio Beta
• Portfolio beta = weighted average of
individual stock betas
• Co-movement with the market index
• If market expected to boom increase beta
• If market expected to fall sell stocks as
negative betas are rare
• However forecasts and beta need to be
accurate
Estimating Beta
• Estimated from historical data
• Studies show beta stationary increases
with the length of period and size of
portfolios
• Beta varies with the interval period
• Beta may need adjustment keeping in
mind macroeconomic effects, industry
norms, company growth rate, leverage etc.
Practical Portfolio Management
Aim- provide enough for daily needs & emergencies and build
up security for the future
Individual Objectives and constraints –

See current and future requirements (including inflation) &
contingencies
Trade off between current income and capital growth (future
income)
Longer time horizon- can have more of risky assets, can invest
in long term assets like property
Tax status-choose between income and capital gains tax
Liquidity requirement at various points of time– suitable assets

Risk taking ability-
Higher expected future sources of income-can take risk
Age and health- determines future earning capability
Dependants and their requirements
Current net worth and consequences of loss
Individual attitude to risk
Investment advisors can also assess risk taking ability

based on desire for job security, past investment patterns,
investor knowledge and comfort in various types of
investments etc.

Investor Life Cycle Approach
Classify resources and risk taking ability
Early career- current aspirations (vehicle)+ long
term(house, life insurance),debt>net worth, long
career ahead so can take risk
Mid career-satisfied current aspirations, partly paid
house etc., still capable of earning so moderate risk
Retirement –no debt, high net worth, some limited
regular income if there is pension, need to preserve
capital and provide for increased medical expenses
etc.

Risk Management
Higher return - higher risk

Avoid all risk-low return
Include risk free assets in portfolio

Diversify within asset classes
Take insurance where available
Protect downside in stock market with put options

Asset Allocation
Decide proportion in each asset class, choice of sector and country, specific
asset /security to be bought
(Asset allocation is also influenced by social, political and tax considerations)
High risk, high potential return
Art
Derivatives
Equity and growth funds,

Real
estate, Bonds
and bond funds
Low risk low return

Savings and fixed deposits, Government bonds
and saving schemes, saving linked life insurance
schemes, fixed pension schemes, money market mutual f unds,
Asset Allocation Pyramid

Consider the current and expected financial
environment Returns on the
Sensex
Yield of Government of India Securities Annual
1 year 5 year 10 year 15 year 20 year 25 year 30 year Year Return %
1990 18.58
Mar-97 10.6 12.96 13.43 1991 68.84
Mar-98 10.49 11.48 12.12 1992 36.28
1993 36.95
Mar-99 10.65 11.48 12.12
1994 13.4
Mar-00 10.39 10.45 10.86 11.02 1995 -23.15
Mar-01 9.14 9.61 10.27 10.88 1996 -1.04
1997 20.05
Mar-02 5.76 6.62 7.34 7.66 7.88 7.97 1998 -18.08
Mar-03 5.62 5.91 6.2 6.6 6.78 6.78 6.85 1999 67.42
Mar-04 4.45 4.89 5.15 5.6 5.89 5.97 2000 -14.65
2001 -16.18
Mar-05 5.52 6.37 6.69 7.07 7.14 7.16 7.18
2002 3.25
Mar-06 6.42 7.24 7.53 7.67 7.72 7.77 7.82 2003 71.9
Mar-07 7.89 7.97 7.94 8.13 8.2 8.27 8.34 2004 10.68
Based on SGL transactions 2005 36.34
2006 39.83
2007 14.18

Portfolio Management Strategies
Passive
Buy and hold
Track the index – normally through an index
fund. Tracking error and commissions.
Systematic investment plans- over a long
period results in lower average cost than
fixed number of shares.

Active
Market timing-anticipate direction of market,
shift funds between stocks and bonds,
between countries, sectors, bonds
maturities, high/low beta stocks, etc.
Style investing- look for undervalued stocks
or those expected to do well
Low P/E and high B/M (temporary phase)
High P/E or EPS growth (will continue)
Low market Cap (but may have more risk)

Formula plans for planning and revising portfolios.
1.Dollar Cost Averaging or Rupee Cost Averaging
– systematic investment plan where a fixed sum of
money is invested every period in the same share
or mutual fund. The result is that more number of
shares are purchased when prices are low and
less when prices are high. So weighted average
cost is lower than if a fixed number of shares is
bought every period.
Only for investment …. Not periodical revision of
portfolio

Formula plans……
2. Constant Rupee plan – the rupee value of
investment in shares is held constant. So if
price of shares rise some have to be sold
and if prices fall some need to be bought.
Basically buy when cheap sell when
expensive. However trigger points need to
be specified as prices fluctuate. So the
trigger may be +- 20 % of the decided value.
But not a good idea in an extended bull run.
Buy and hold may be better.

Formula plans……
3. Constant Ratio plan – the ratio of the rupee
value of investment in shares to bonds is
held constant. So if price of shares rise the
ratio of shares increases and some have to
be sold and if prices fall some need to be
bought. Again like the constant rupee plan
buy when cheap sell when expensive. Again
trigger points need to be specified as prices
fluctuate. So if the ratio was 1:1 the trigger
may .9 or 1.1. Again this is not a good idea in
an extended bull run. Buy and hold may be
better.
Formula plans……
4. Variable Ratio plan – the ratio of the rupee
value of investment in shares to bonds is
changed according to a preset formula based
on some trigger points . Eg if upper level of
ratio fixed at 7:3 and value of shares rise more
than 20 % of value at this level, ratio to 5:5
(1:1) but if prices fall by more than 20 % of
value at this level of 1.1 have ratio of 7:3 These
rules can be fixed according to simulation or
past experience. Since there is no limit to the
type of plans possible we cannot comment on
when buy and hold may be better .
Formula plans……
Just because we have studied formula plans
it does not mean they are superior to
passive investing.

Rupee Cost Averaging periodical investment Rs 10000
Period Price Amt/price Purchase Total invested Total shares Average/share
1 1000 10 10 10000 10 1000
2 1050 9.52 9 19450 19 1023.68
3 1100 9.09 9 29350 28 1048.21
4 950 10.53 10 38850 38 1022.37

If fixed number of shares purchased per period=add prices/no of periods 1025

Constant Rupee Plan - amount in shares rest in bonds action points are +- 20%
Say total value to invest = 100000 Fixed amt in shares = 50000
action to restore amount in shares if value above/below 60000 40000
Assume shares are divisible for simplicity
Price Rs in Shares No of shares Bonds Rs Total
250 50000.00 200 50000.00 100000.00
220 44000.00 200 50000.00 94000.00
Trigger 200 40000.00 200 50000.00 90000.00
Reset 200 50000.00 250 40000.00 90000.00
220 55000.00 250 40000.00 95000.00
Trigger 240 60000.00 250 40000.00 100000.00
Reset 240 50000.00 208.33 50000.00 100000.00
260 54166.67 208.33 50000.00 104166.67
Trigger 288 60000.00 208.33 50000.00 110000.00
Reset 288 50000.00 173.61 60000.00 110000.00
260 45138.89 173.61 60000.00 105138.89

If buy and hold no of shares= 200.00 value= 52000.00
Total portfolio including bonds 102000.00

If buy and hold all in shares = 104000

Constant Ratio Plan desired ratio of shares to bonds =1:1 1 1
Say total value to invest = 200000 Starting amt in shares 100000
action to restore proportion in shares if ratio goes above or below 1.1 0.9
Assume shares are divisible for simplicity
Price Rs in Shares No of shares Bonds Rs Total ratio of shares
250 100000.00 400 100000.00 200000.00 1
230 92000.00 400 100000.00 192000.00 0.92
Trigger 225 90000.00 400 100000.00 190000.00 0.9
Reset 225 95000.00 422.2222222 95000.00 190000.00 1
Trigger 202.5 85500.00 422.2222222 95000.00 180500.00 0.9
Reset 202.5 90250.00 445.6790123 90250.00 180500.00 1
200 89135.80 445.6790123 90250.00 179385.80 0.987654321
Trigger 224 99832.10 445.6790123 90250.00 190082.10 1.10617284
Reset 224 95041.05 424.290399 95041.05 190082.10 1

If buy and hold no of shares= 400.00 value= 89600.00
Total portfolio= 189600
If all in shares buy and hold = 179200
Variable ratio plan
Variable ratio plan 5:5 and 7:3 start with 1:1 1 1
Say total value to invest = 200000 Starting amt in shares 100000
Trigger to restore other ratio, if ratio goes above or below 0.75 0.45
Assume shares are divisible for simplicity, restore to 0.5 0.7
No of
Price Rs in Shares shares Bonds Rs Total ratio of shares
250 100000 400 100000 200000 0.5
220 88000 400 100000 188000 0.47
trigger 200 80000 400 100000 180000 0.44
reset 200 126000 630 54000 180000 0.70
prev total*.7
220 138600 630 54000 192600 0.72
250 157500 630 54000 211500 0.74
trigger 288 181440 630.00 54000 235440 0.77
reset 288 117720 408.75 117720 235440 0.50
prev total*.5
Buy and hold .5 ratio shares= 112000 add original bonds total= 212000.00
Buy and hold only shares= 230400
Stock Portfolio Optimisation c*
(not in syllabus)
Based on the Sharpe single index model
Rank according to the excess return to beta
ratio
Determine a cut off point based on return
and risk
Calculate the proportion of each stock in the
portfolio

Data for Ranking of Stocks 2
 m=10.00 Rf=5.00
Stock Ri i ei (Ri-Rf)/Bi
A 15 1.3 10 7.69
B 14 1.5 30 6
C 13 1.8 20 4.44
D 12 0.8 20 8.75
E 11 1 40 6
F 10 1.2 10 4.17

Calculations for Determination of Optimum Portfolio 2
 m=10.00 Rf=5.00
 2 3 4 5 6 7 8 9 10 11 12 13 14
Stock Ri i ei (Ri-Rf)/Bi (Ri-Rf) i/2ei 2 2
i / ei Ci (Ri-Rf)/Bi C* Zi Xi %
Vs Ci
2
Cu Cu  m*col 8/ Cl 5 vs Z i=(Bi/2ei)
2
Col 6 Col 7 (1+ m*Col 9) Cl 10 *Col 5 -C* Xi=(Cl 13/  Z i)
D 12 0.8 10 8.75 0.56 0.06 0.56 0.06 3.41 greater 0.29 56.99
A 15 1.3 30 7.69 0.43 0.06 0.99 0.12 4.51 greater 0.11 21.82
B 14 1.5 20 6 0.68 0.11 1.67 0.23 5.01 greater 0.06 12.71
E 11 1 20 6 0.3 0.05 1.97 0.28 5.14 greater 5.14 0.04 8.47
C 13 1.8 40 4.44 0.36 0.08 2.33 0.36 5.02 smaller
F 10 1.2 10 4.17 0.6 0.14 2.93 0.51 4.82 smaller
Total 0.51 100
To insert formula
Limitations: Can be used only for a portfolio of stocks. Dependant on beta


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UNIT-IV

Portfolio Revision: Need for revision, different techniques of

• The efficient frontier and investor choices

Security Analysis & Portfolio Management Chapter 15

• Higher indifference curve- more utility

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Individual Objectives and constraints –

Security Analysis & Portfolio Management Chapter 15

Investment advisors can also assess risk taking ability

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Higher return - higher risk

Include risk free assets in portfolio

Security Analysis & Portfolio Management Chapter 15

High risk, high potential return

Equity and growth funds,

Low risk low return

Asset Allocation Pyramid

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Period Price Amt/price Purchase Total invested Total shares Average/share

1 1000 10 10 10000 10 1000

2 1050 9.52 9 19450 19 1023.68

3 1100 9.09 9 29350 28 1048.21

4 950 10.53 10 38850 38 1022.37

If fixed number of shares purchased per period=add prices/no of periods 1025

Security Analysis & Portfolio Management Chapter 15

Total portfolio including bonds 102000.00

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Security Analysis & Portfolio Management Chapter 15

Limitations: Can be used only for a portfolio of stocks. Dependant on beta

Security Analysis & Portfolio Management Chapter 15

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