Portfolio
management
An
investor considering investment in securities is faced with the
problem of choosing from among a large number of securities. His
choice depends upon the risk-return characteristics of individual
securities. He would attempt to choose the most desirable securities
and like to allocate his funds over his group of securities. Again he
is faced with the problem of deciding which securities to hold and
how much to invest in each. The investor also faces an infinite
number of possible portfolios or group of securities to invest his
fund.
An
investor invests his funds in a portfolio expecting to get a good
return consistent with the risk that he has to bear. The return is
realized from the portfolio has to be measured and the performance of
the same has to be evaluated. Thus, portfolio management does it all.
It comprises all the processes involved in the creation and
maintenance of a portfolio.
Portfolio
management deals with the analysis of individual securities as well
as with the theory and practice of optimally combining securities
into portfolios. The risk and return characteristics of a portfolio
differ from those of individual securities combining to form a
portfolio. The investor tries to choose the optimal portfolio taking
into consideration the risk-return characteristics of all possible
portfolios.
PHASES
IN PORTFOLIO MANAGEMENT
There
are five phases in portfolio management
- Security Analysis
- Portfolio Analysis
- Portfolio Selection
- Portfolio Revision
- Portfolio Evaluation
Portfolio
selection
Portfolio
analysis provides the input for the next phase of portfolio
management, which is portfolio selection. The proper goal of
portfolio construction is to generate a portfolio that provides
highest return at a given level of risk. A portfolio having these
characteristics is known as efficient portfolio. The impute from
portfolio analysis can be used to identify the set if efficient
portfolios. From these set of portfolios, optimal portfolio has to be
selected for investment.
Risk
diversification
The
process of combining securities in a portfolio is known as
diversification. The aim of diversification is to reduce total risk
without sacrificing portfolio return. To understand the mechanism and
power of diversification, it is necessary to consider the impact of
covariance or correlation on portfolio risk more closely. We shall
examine three cases;
- When security returns are perfectly positively correlated
- When security returns are perfectly negatively correlated
- When securities are not correlated
Security
Returns Perfectly Positively Correlated
When
the security returns are perfectly positively correlated the
correlation coefficient between these two securities will be +1. The
returns of the two securities then move up and down together. Here
the diversification provides only risk averaging and no risk
reduction because the portfolio risk cannot be reduced below the
individual security risk. Hence, diversification is not a productive
activity when security returns are perfectly positively correlated.
Security
Returns Perfectly Negatively Correlated
When
security returns are perfectly negatively correlated, the correlation
coefficient between them becomes (-1). The two returns always move in
exactly negative direction. Here, although the portfolio contains two
risky assets, the portfolio has no risk at all. Thus the portfolio
may become entirely risk free when security returns are perfectly
negatively correlated. Hence diversification becomes highly
productive activity when security returns are perfectly negatively
correlated, because portfolio risk can be considerably reduced and
sometimes even eliminated. But in reality, it is rare to find
securities that are perfectly negatively correlated.
Security
Returns Uncorrelated
When
the returns of the securities are entirely uncorrelated, the
correlation coefficient would be zero. Here the portfolio standard
deviation is less than the standard deviation of individual
securities in the portfolio. Thus when security returns are
uncorrelated diversification reduces risk and is a productive
activity.
From
the above analysis we may conclude that diversification reduces risk
in all cases when the security returns are perfectly positively
correlated. As correlation coefficient decline from +1 to (-1), the
portfolio standard deviation also declines. But the risk reduction is
greater when the securities are negatively correlated.
The
benefits from diversification increase as more and more securities
with less perfectly positively correlated returns are included in the
portfolio. As the number of securities added to the portfolio
increases, the standard deviation of the portfolio becomes smaller
and smaller. Hence an investor can make the portfolio risk
considerably small by including a large number of securities with
negative or zero correlation in the portfolio.
But
in reality, no securities show negative or zero correlation.
Typically, they show some positive correlation, which is above zero
but less than perfectly positive value +1. As a result,
diversification results in some reduction in total portfolio risk but
not in complete elimination of risk. Moreover the effects of
diversification are exhausted fairly rapidly. Adding securities
beyond a limit (between 25 to 30 securities) brings out only marginal
reduction in portfolio standard deviation.
The
portfolio risk is reduced because the securities are not perfectly
positively correlated. But the diversification effects are exhausted
because they are positively correlated. If they are negatively
correlated, when we increase the size of portfolio the risk would
have been reduced. Thus in practice the benefits of diversification
are limited.
So,
in this way we construct and maintain a portfolio to reduce the risk
and increase the return of the fund of an investor. Now we will look
into financial derivatives which help the portfolio management and
portfolio diversification and risk management to increase their
potentiality.
Portfolio
risk and return
When
we consider risk and return of a portfolio it is somewhat related
with the risk and return of securities. Simply because, portfolio is
a collection of securities. The risk and return of a security will
reflect in a portfolio directly. But the difference will happen when
we combine different securities having different risk and return into
a single portfolio. The risk of the securities is traded off with
each other and it will reduce the risk and increase the return. The
process of reducing the risk of a portfolio by varying the securities
and their proportion is known as diversification of risk. This is
reviewed later in this chapter.The risk and return of portfolios are
calculated as follows;
Portfolio
Return
Rp = αp
+ (βp × Rm)
Where;
αp = Alpha
value of the portfolio
βp = Beta
value of the portfolio
Rm = Return
of the market index
Portfolio
Risk
σp2 = βp2σm2
+ ∑ωi2σei2
Where;
βp = Beta
value of the portfolio
σm2 = Variance
of market index
ωi = Weight
of the security
σei2 = Residual
variance of the security
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