Portfolio Management

Meaning and objective

• It means a collection of investments in a set of
securities. It could cover investment in different
asset classes or within the same class indifferent
markets, sectors or companies’
• The objective is basically to diversify risk and
based on the principle of not putting all eggs in a
single basket
• The objective also includes earning the
maximum return with minimum risk
• A good portfolio should achieve a sound balance
between the competing objectives
 Some important objectives
1. Safety: This fact assumes the highest importance over
all other investor needs such as income, growth etc.
2. Stable return: a good portfolio should at least recover
the opportunity cost of investment by way of dividend,
interest etc.
3. Capital appreciation: The portfolio should provide
investors a hedge against inflation. e.g. investment in
gold, real estate, growth shares etc.
4. Marketability: a good portfolio should have investments
that are marketable or saleable with out much difficulty.
Shares of unlisted companies will not qualify on this
count. Switching from one investment to another
should not be a problem.
 Contd….
5.Liquidity: A good portfolio should have proper
liquidity to take care of the opportunities that
may come. Illiquid investments like real estate,
unlisted shares pose problems in the
management of the portfolio.
6.Tax planning : The portfolio should provide a
proper tax shelter for the investor.
7. Minimising risk: The main objective of portfolio
management is to minimise the risk at maximise
the return
 Factors affecting the portfolio
composition
• In case of individuals the following factors affect the
asset allocation pattern
• Attitude towards risk. Depends on the temperament of
the investor
• Personal habits. Some investors will be interested in
quick returns. Some may be ready to wait for longer
period to reap the benefits of staying inveted.
• Age and health
• Family responsibilities
• Individual needs
• Thus the level of risk taking capacity and return
requirements vary from person to person
 Types of risk
• An investor has to take the following risks when
he chooses to invest in various securities or
portfolios
• Inflation risk
• Interest rate risk: relevant for debt securities
• Social and political risk
• Market risk
• Business risk
• Leverage risk – level of borrowings in the total
capital employed.
 Systematic and unsystematic risk
• The total market risk can be divided into 2 portions. One is
systematic and the other is unsystematic.
• Systematic risk is that portion of the market risk which
affects all the securities at the same time in the market. E.g
natural calamity, political turmoil, civil war, recession in the
economy, change in Govt , revision in bank rate etc.
• Unsystematic risk, on the other hand is due to the facts that
affect directly a particular company or an industry. E.g.
Recession in a particular industry, Govt policy change wrt
certain industries, lock out in a company, change of
management etc. It is also known as unique risk.
• It is possible to reduce the unsystematic risk significantly by
diversification. But systematic risk can not be controlled.
 Approaches in Equity portfolio
management
• There are 2 broad methods
1. Passive strategy: The followers of this are strong
believers that the market is efficient They normally
follow buy and hold strategy and indexing technique.
Under this once the portfolio is constructed there is no
active buying and selling. Hold the portfolio over an
investment horizon.
Indexing strategy is one where the investor exactly
mimics any selected index say sensex or nifty in both
the contents and weighatges. An advantage in this
approach it takes care of the sectoral and within the
sector company wise diversification. The investor are
atleast assured of the returns as that of the market
(index). Index funds of MF is an example for this.
 contd….
• Active strategy: Generally followed by investment
professionals and aggressive investors who wants to
make superior returns. They follow the following on a
continuous basis
-Believes in market timing to buy and sell. Use both
fundamental and technical analysis. Portfolio turnover
will be higher due to continuous shuffling of the portfolio.
-Sector rotation: Keeps changing the asset allocation to
various sectors on the basis of their assessed outlook.
-Security selection: Always in search of under priced
stocks to add into the portfolio
-Use specialised concepts to achieve superior returns
 Portfolio management process
• Define the investment objective- whether the focus is on
current income or yield, capital appreciation, safety of
the principal, time horizon, liquidity, tax savings etc.
• Decide on the asset mix depending on the objective
• Formulate the portfolio strategy- active or passive. It
depends risk taking capacity and desired rate of return of
the investor
• Selection of securities : Keeping in view of various
factors like the sectoral allocation, yield requirements,
credit rating, term to maturity etc.
• Portfolio execution: This is the actual step of
implementing the above decisions into action
 Contd…
• Portfolio revision: This is a very important step in the
portfolio management process. For making the portfolio
management into a success, ongoing monitoring is
required.
Depending upon the developments in the performance of
the company, changes in the economy, Govt. policy,
interest rate etc. periodic rebalancing of the portfolio has
to be done. The shift could be from one asset class to
another, sectoral rotation or from one scrip to another.
• Performance evaluation: should carried out at regular
intervals. The return should be commensurate with the
risk taken. This will provide a useful feed back to the
fund manager to improve the quality.
Forecasting the stock market return
• Stock market returns are determined by the interaction of
two factors namely investment returns and speculative
returns.
• Investment returns are represented by the sum of dividend
yield and earnings growth.
• Speculative earnings are represented by the change in the
PE ratios
• By putting in a formula
– SMRn = {DYn+EGn} + {(PEn / PEo)1/n – 1}
– In the above the 1st term indicates the investment return
while the 2nd one refers to the speculative return.
– DYn is the annual dividend yield and EGn earnings
growth in “n” years. PEn is the PE ratio after “n” years
and PEo is the PE ratio at the beginning
 Contd….
• Suppose the annual dividend yield estimated for
the next 5 years is 2.5%, earnings growth
estimated is 12.5% for the same 5 years.
Current PE ratio is 15 and is expected to reach
18 after 5 years
• The forecast of the annual aggregate return from
the market is
=(0.025+0.125) + {(18-15)1/5 – 1}
=0.15+0.037 =0.187 = 18.7%
• Thus it is possible to fairly estimate or forecast
the future total returns of the market.