Chapter 7: Portfolio Management

Introduction

• Portfolio management is the art and science of

selecting and overseeing a group of investments
that meet the long-term financial objectives and
risk tolerance of a client, a company, or an
institution.
• Portfolio management requires the ability to
weigh strengths and weaknesses, opportunities
and threats across the full spectrum of
investments.
• After establishing the asset allocation, the investor
has to decide how to manage the portfolio over
time.
 …
 Investor can adopt passive approach or active
approach towards the management of the
portfolio.
 In the passive approach, the investor would
maintain the percentage allocation for asset
classes and keep the security holdings within its
place over the established holding period.
 In the active approach, the investor continuously
assess the risk and return of the securities within
the asset classes and changes them.
 …

 In portfolio management, the investor would be

studying the risks (1) market related (2) group
related and (3) security specific and then changes
the components of the portfolio to suit his
objectives.
 7.1. Elements of portf olio management

• the most successful portfolio management

approaches include four elements: effective
diversification, active management of asset
allocation, evaluate weather cost efficiency and
tax efficiency.
Diversification

• This is the prudent approach to create a basket of

investments that provides broad exposure within
an asset classes.
• Diversification involves spreading the risk and
reward of individual securities within an asset
class, or between asset classes.
• Because it is difficult to know which subset of an
asset class or sector is likely to outperform
another, diversification seeks to capture the
returns of all of the sectors over time while
reducing volatility at any given time.
 Asset Allocation
• Asset allocation is based on the understanding
that different types of assets do not move in
same concert, and some are more volatile than
others. A mix of assets provides balance and
protects against risk.
• Investors with a more aggressive profile weight
their portfolios toward more volatile investments
such as growth stocks.
• Investors with a conservative profile weight their
portfolios toward stable investments such as
bonds and blue-chip stocks.
 Rebalancing

• Rebalancing is used to return a portfolio to its original

target allocation at regular intervals, usually annually.
• Rebalancing generally involves selling high-priced
securities and putting that money to work in lower-
priced and out-of-favor securities.
• This is done to reinstate the original asset mix when
the movements of the markets force it out of kilter.
• For example, a portfolio that starts out with a 70%
equity and 30% fixed-income allocation could, after an
extended market rally, shift to an 80/20 allocation.
The investor has made a good profit, but the portfolio
now has more risk than the investor can tolerate.
 Key Elements of Project Portfolio Management
• The key elements of project portfolio management
enable organizations to connect strategic plans to
the execution of projects, giving leaders a
mechanism to ease project selection decisions.
• Define business objectives: Clarifying business
objectives is a critical first step in project portfolio
management.
• Inventory projects and requests: Decision-makers
need to create an inventory of potential projects,
including in-flight projects, project requests, and
ideas for new projects.
 …
• Prioritize projects: Based on the project data collected
during the inventory phase, begin prioritizing projects
that create the most value for and balance the
portfolio depending on the valuation criteria,
• Validate project feasibility and initiate projects: Even a
maximized and balanced portfolio may not be feasible
due to bottlenecks and constraints. Initiate validated
projects by entering them into the project
management system.
• Manage and monitor the portfolio: The project
manager will manage individual projects, while the
portfolio manager will monitor execution progress and
continued alignment of projects across the portfolio.
 7 . 2 . Po r tf o l i o M o n i to r i n g

• Portfolio monitoring acknowledges that the

markets and clients change and that both must
be reviewed periodically to ensure that the
portfolio remains appropriate for the client's
situation.
• "Portfolio monitoring" informs you by email and
online about shifts in your asset allocation.
• The alerts allow you to react quickly to changes
and to rebalance your portfolio. ... You can even
steer your portfolio by setting individual
thresholds for asset classes.
 …

• Portfolio performance monitoring tells an

investor what type of investments are doing well,
what characteristics of the market need to be
avoided, and if there are any changes in the
themes of the portfolio.
 7.3. Markowitz model

• Markowitz Model suggests that a smart investor

buys and holds well-diversified portfolio, using
index funds.
• Markowitz says that equity portfolios should be
diversified with different types of stocks like large-
cap, small-cap, value, growth, foreign and
domestic stocks. So that, your portfolio should
also be efficient.
• So, Markowitz provides an answer for building up
the optimal portfolio with the help of risk and
return relationship.
 Assumptions of Markowitz Model:

i. The individual investor estimates risk on the basis

of variability of returns i.e. the variance of returns.
Investor’s decision is solely based on the expected
return and variance of returns only.
ii. For a given level of risk, investor prefers higher
return to lower return. Likewise, for a given level of
return, investor prefers lower risk than higher risk.
 The Concept of Markowitz model
 In developing his model, Markowitz had given up
the single stock portfolio and introduced
diversification.
 The single security portfolio would be preference if
the investor is perfectly certain that his expectation
of highest return would be real.
 But, in the world of uncertainty, most of the risk
averse investors would like to join Markowitz rather
than keeping a single stock, because diversification
reduces the risk.
 This concept can be shown with the help of the
following illustration:
 Example;
• Take the stock of ABC company and XYZ company. The returns expected from
each company, their probabilities of occurrence, expected returns and the
variances are given. The calculation procedure is given in the below table.
Variables Stock ABC Stock XYZ
Return % 11 or 17 20 or 8
Probability .5 each return .5 each return
Expected Return 14 14
Variance 9 36
Standard deviation 3 6

ABC Expected return =.5 X 11 + .5 X 17 = 14%

XYZ Expected return = .5 X 20 + .5 X 8 = 14%
ABC variance = .5 (11-14)2 + .5 (17-14)2 = 9
XYZ variance = .5 (20-14)2 + .5 (8-14)2 = 36
ABC standard déviation = √Variance = √9 = 3%
XYZ standard déviation = √ Variance =√36 = 6%
 …

• ABC and XYZ companies stocks have the same expected

return of 14%.
• XYZ company’s stock is much riskier than ABC stock,
because the standard deviation of the former being 6
and the latter 3.
• When ABC return is high, XYZ return is low and vice-
versa (i.e. when there is 17% return from ABC, there
would be 8% return from XYZ). Likewise when ABC
return is 11%, XYZ return is 20%.
• If a particular investor holds only ABC or XYZ, he would
stand to lose in the time of bad performance.
• But, holding the two Co.s’ security reduces his risk &
maximizes his return.
 7.4. Evaluation of portfolio performance
• The evaluation of the portfolio provides a feed
back about the performance to evolve better
management strategy.
• Even though evaluation of portfolio performance
is considered to be the last stage of investment
process, it is a continuous process.
• Portfolio manager evaluates his portfolio
performance and identifies the sources of
strength and weakness.
• The managed portfolios are commonly known as
mutual funds.
 …

• Various managed portfolios are prevalent in the

capital market.
• Their relative merits of return and risk criteria
have to be evaluated.
 Mutual Fund
 Mutual fund is an investment vehicle that pools
together funds from investors to purchase stocks,
bonds or other securities.
 An investor can participate in the mutual fund
by buying the units of the fund.
 Each unit is backed by a diversified pool of assets,
where the funds have been invested.
 A closed-end fund has a fixed number of units
outstanding.
 It is open for a specific period. During that period
investors can buy it.
 …

 The closed-end schemes are listed in the stock

exchanges.
 The investor can trade the units in the stock
markets just like other securities.
 The prices may be either quoted at a premium or
discount.
• Portfolio performance evaluation is based on two
fundamental concepts-
1. Return is related to risk and thus performance of a
portfolio cannot be evaluated on its return alone.
2. The view that passive and active management are
two mutually exclusive and exhaustive approaches
to portfolio management.
• Active management comes at a price: the portfolio
could underperform in a passively managed
portfolio and transaction costs increase with trading
activity.
End of the course !!