NPTEL Course

Course Title: Security Analysis and Portfolio Management Course Coordinator: Dr. Jitendra Mahakud

Module-11 Session-21 Introduction to Portfolio Management

21.1. Introduction
One basic assumption of portfolio theory is that an investor wants to maximize the returns from your investments for a given level of risk. This section deals with the one fundamental aspect of the investment management (individual investment or a portfolio) i.e., what we mean by the terms risk. The fundamental aspects that a risk return model should able to address are as follows: (i). A measure of risk that applies to all assets and not be asset-specific. (ii). Clearly explain what types of risk are rewarded and what are not (iii). Must provide a standardized risk measures, i.e., an investor presented with a risk measure for an individual asset should be able to draw conclusions about whether the asset is above-average or below-average risk. (iv). Translate the measure of risk into a rate of return as a compensation for bearing the risk. One of the best-known measures of risk is the variance, or standard deviation of expected returns. We will consider the variance and standard deviation as one measure of risk because the standard deviation is the square root of the variance. Although there are numerous potential measures of risk, we will use the variance or standard deviation of returns because (1) this measure is somewhat intuitive, (2) it is a correct and widely recognized risk measure, and (3) it has been used in most of the theoretical asset pricing models.1

21.2. Calculation of the expected rate of return

The expected rate of return for an individual investment or portfolio can be computed as follows:

Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition, Thomson Soth-Western.

E(R por i ) Wi R i
i 1

where: Wi the percent of the portfolio in asset i E(R i ) the expected rate of return for asset i
Expected rate of return for an individual investment based on an assumption of equal probabilities can be shown with the following example:
Possible Rate of Return (%) .60 .12 .09 .35 Probability 0.25 0.25 0.25 0.25 E (R ) Expected Return (%) 0.15 0.03 0.02 0.09 0.29

Following the above specification the expected rate of return for a portfolio of investments is simply the weighted average of the expected rates of return for the individual investments in the portfolio. The weights are the proportion of total value for the investment. The weights can be of equal weighted or value weighted. (price weighted portfolio).
Expected Security Return (%) .60 .12 .09 .35 Market Capitalisation Rs. 2,00,000 Rs. 4,00,000 Rs. 11,00,000 Rs. 3,00,000 Weight i.e., % of portfolio (value weighted) 0.10 0.20 0.55 0.15 E(Rport) Weight i.e., % of portfolio (Equal weighted) 0.25 0.25 0.25 0.25 E(Rport) Expected Return (%) 0.06 0.02 0.05 0.05 0.19 Expected Return (%) 0.15 0.03 0.02 0.09 0.29

Expected Security Return (%) .60 .12 .09 .35

Market Capitalisation Rs. 2,00,000 Rs. 4,00,000 Rs. 11,00,000 Rs. 3,00,000

In case of an equal weighted portfolio all securities in the portfolio gets the equal weight (1/number of stocks) irrespective of their size or market capitalisation (number of shares x share price). In case of a value weighted portfolio stocks/securities in the portfolio get the weight (market capitalisation of a stock/total market capitalisation of the portfolio) as per their market capitalisation. In the following example it can be observed that equal weighted portfolio out perform the value weighted portfolio. Market cap

weighted or price weighted portfolio suffer from a systematic flaw i.e., they increase the amount they own of a particular company as that companys stock price increases. An equally-weighted portfolio will own too much of overpriced stocks and too little of low priced stocks. It has been found by many researchers that the equal-weighted portfolio with monthly rebalancing strategy outperforms the value or price-weighted portfolios in terms of total mean return even though the equal-weighted portfolio has greater portfolio risk and high transaction costs. The higher return of the equal-weighted portfolio arises from its higher exposure to the market, size, and value factors.

21.3. Variance (Standard Deviation) of Returns for an Individual Investment

In this section we will discuss upon the standard deviation of return (square root of the variance) as the measure of risk for an individual investment. The variance, or standard deviation, is a measure of the variation of possible rates of return ( 2 ) , Ri, from the expected rate of return [E(Ri)] as follows:

( 2 ) [R i -E(R i )]2 Pi
i 1

Where, Pi is the probability of the possible rate of return, Ri. The standard deviation ( ) in this regard will be:

[R
i 1

-E (R i )] 2 Pi

Computation of the variance of the expected rate of return of an individual investment: Suppose the individual investment is having the following details:
Possible Rate of Return (%) .60 .12 .09 .35
Possible Rate of Return (%) Ri Expected Return (%) E ( Ri )

Probability 0.25 0.25 0.25 0.25 E (R )

Expected Return (%) 0.15 0.03 0.02 0.09 0.29

Ri - E ( Ri )
0.31 -0.17 -0.20 0.06

[ Ri E ( Ri )]2

Pi
.25 .25 .25 .25

[ Ri E ( Ri )]2 Pi

.60 .12 .09 .35

0.29 0.29 0.29 0.29

0.0961 0.0289 0.04

0.024025 0.007225 0.01 0.0009 0.04215

0.0036 Variance ( 2 )

So the standard deviation of this individual investment can be calculated as follows: Standard Deviation ( ) = 0.18

21.4. Covariance of Returns

Covariance of returns measures the degree to which two variables (in this case return of two assets) move together relative to their individual mean values over time. Covariance can be positive or negative. A positive covariance means that the rates of return for two investments tend to move in the same direction relative to their individual means during the same time period. On the other hand a negative covariance indicates that the rates of return for two investments tend to move in different directions relative to their means during specified time intervals over time. For two assets, j and k, the covariance of rates of return can be defined as:

Cov jk E{[ R j E ( R j )][ Rk E ( Rk )]} The monthly covariance between the rates of return for these two assets is:
1 n [ R j E ( R j )][ Rk E ( Rk )] 12 j 1

If the rates of return for one asset/stock are above (below) its mean rate of return during a given period and the returns for the other asset are likewise above (below) its mean rate of return during this same period, then the product of these deviations or the covariance is positive. Similarly, if the rate of return for one of the asset is above its mean return while the return on the other asset is below its mean return, the product will be negative. If this contrary movement happened consistently, the covariance between the rates of return for the two assets would be a large negative value.

21.5. Covariance and Correlation Coefficient

The correlation between the two assets is calculated by considering the variability of the two return series of different assets or by standardising their covariance measure. The purpose for looking in to the correlation coefficient is to get the single point of reference as to whether the two assets have any kind of correlation in their movement or not. Usually the covariance figure between the two assets gives a broad idea about the variability of returns, whereas the correlation coefficient gives a microscopic view as to whether there is a positive or negative correlation between the two assets movement.

Usually if the stocks or securities belong to the same industry then the correlation is generally high as compared to the stock selected from different industries. A correlation of +1.0 would indicate perfect positive correlation, and a value of 1.0 would mean that the returns moved in a completely opposite direction. A value of zero would mean that the returns had no linear relationship, that is, they were uncorrelated statistically. That does not mean that they are independent. The correlation coefficient for the above mentioned two assets can be measures as follows:

rjk

Cov jk

j k

i.e.,

rjk

1 n [ R j E ( R j )][ Rk E ( Rk )] 12 j 1

j k

21.6. Standard Deviation of a Portfolio

The measure of risk for a portfolio is given as the standard deviation of returns for a portfolio of assets. Following the Markowitz the standard deviation of a portfolio of assets can be computed as follows:

port

w i2 i2 w i w jCov ij
i 1 i 1 i 1

where: port the standard deviation of the portfolio Wi the weights of the individual assets in the portfolio, where weights are determined by the proportion of valu e in the portfolio

i2 the variance of rates of return for asset i

Cov ij the covariance between the rates of return for assets i and j, where Cov ij rij i j
The above mentioned formula indicates that the standard deviation for a portfolio of assets is a function of the weighted average of the individual variances (where the

weights are squared), plus the weighted covariances between all the assets in the portfolio. The standard deviation for a portfolio of assets encompasses not only the variances of the individual assets but also includes the covariances between pairs of individual assets in the portfolio.2 Any asset of a portfolio may be described by two characteristics: (1) the expected rate of return; (2) The expected standard deviations of returns. Assets may differ in expected rates of return and individual standard deviations. The correlation, measured by covariance, affects the portfolio standard deviation. Low correlation reduces portfolio risk while not affecting the expected return. Negative correlation reduces portfolio risk and combining two assets with -1.0 correlations reduces the portfolio standard deviation to zero only when individual standard deviations are equal.

Two Special Cases

____________________________________________________________
2

Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition, Thomson Soth-Western.

Additional Readings:

Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V., Fundamentals of Investment, 3rd Edition, Pearson Education. Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P. Investments, 6th Edition, Tata McGraw-Hill.
Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India).

Fisher D.E. and Jordan R.J., Security Analysis and Portfolio Management, 4th Edition., Prentice-Hall. Jones, Charles, P., Investment Analysis and Management, 9th Edition, John Wiley and Sons. Prasanna, C., Investment Analysis and Portfolio Management, 3rd Edition, Tata McGraw-Hill. Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition, Thomson Soth-Western.

____________________________________________________________ Additional Questions with Answers

Session 21: Introduction to Portfolio Management

_____________________________________________________________ 1. Explain the meaning of Variance of Returns for an Individual Investment?

Variance (Standard Deviation) is a measure of the variation of possible rates of return Ri, from the expected rate of return [E(Ri)]. Standard deviation is the square root of the variance Variance ( 2 ) [R i - E(R i )]2 Pi
i 1 n

Where, Pi is the probability of the possible rate of return, Ri

Example: Poss ible Rate

of Return (Ri ) 0.08 0.10 0.12 0.14

Expe cted Re turn E(Ri ) 0.11 0.11 0.11 0.11 R i - E(Ri ) 0.03 0.01 0.01 0.03 [Ri - E(R i )] 0.0009 0.0001 0.0001 0.0009
2

Pi 0.25 0.25 0.25 0.25

[R i - E(Ri )] Pi 0.000225 0.000025 0.000025 0.000225 0.000500

Variance ( 2 ) = .0005 Standard Deviation ( ) = .02236 2. What is the relationship between Relation between Covariance and Correlation Coefficient? 7

Ans. The correlation coefficient is obtained by standardizing (dividing) the covariance by the product of the individual standard deviations.
rij Cov ij

i j

where : rij the correlation coefficient of returns

i the standard deviation of R it j the standard deviation of R jt

Correlation coefficient only in the range +1 to -1. A value of +1 would indicate perfect positive correlation. This means that returns for the two assets move together in a completely linear manner. A value of 1 would indicate perfect correlation. This means that the returns for two assets have the same percentage movement, but in opposite directions. 3. How you will explain Portfolio Risk? Ans. Any asset of a portfolio may be described by two characteristics: The expected rate of return The expected standard deviations of returns The correlation, measured by covariance, affects the portfolio standard deviation. Low correlation reduces portfolio risk while not affecting the expected return Portfolio Risk:

port
where:

wi2 i2 wi w jCovij
i 1 i 1 i 1

port the standard deviationof the portfolio

Wi the weights of the individualassets in the portfolio,where weights are determinedby the proportionof valuein the portfolio

i2 the varianceof rates of return for asset i

Covij the covariancebetween th e rates of return for assets i and j, where Covij rij i j