Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.

Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Lecture 13

A Simple Ranking Technique For Tracing Markowitz Efficient Frontier

You have already learnt that by using Ri, VARi and COVi,j data as suggested by Markowitz, the
efficient frontier curve composed of efficient portfolios can be drawn on a graph paper. But there
are practical difficulties in that approach. Take for example a 800- stocks economy, the classical
formation of Markowitz requires solving 800 simultaneous equations; and each equation has 800
unknown Zi that would be estimated by solving 800 equations simultaneously. And then from Zs
thus found, you calculate weights (Xi) of stocks included in an efficient portfolio; and once
weights have been estimated then you can estimates expected Rp and VARp. The set of
simultaneous equations you need to solve in this case would look like:

R1 - Rf = Z1 COV 1,1 + Z2 COV 1, 2+.+ Z799 COV 1,799 + Z800COV 1,800

R2 R f = Z1 COV 2,1 + Z2 COV 2,2+.+ Z799 COV 2,799 + Z800COV 2,800

.
.
.
.
.
R799 - Rf = Z1 COV 799 , 1 + Z2 COV 799 , 2 +.+ Z799 COV 799 , 799 + Z800COV 799, 800
R800 - Rf = Z1 COV 800 , 1 + Z2 COV 800 , 2 +.+ Z799 COV 800 , 799 + Z800COV 800,800

Instead of solving such a large set of simultaneous equations, a simpler algorithm (method of
calculating) is presented here; this method uses Sharpes data of alpha, beta, VAR ei of stocks and
VARm to find weight of stocks included in an efficient portfolio. Again this efficient portfolio lies
at the tangency point of a straight line emerging from an assumed value of Rf at vertical axis and
just touching Markowitz efficient frontier. Assumptions of this simple ranking method are based
on Sharpes single market model for expected ROR of a stock. This model assumes a linear
relationship between ROR of a stock (Ri) and ROR of Stock Market (Rm). It is written as :

Ri = i + i Rm + e i whereas expected value of ei is zero though it has a variance, VAR e i.

A simple ranking technique for finding Zi and then Xi of each stock included in the efficient
portfolio is described below. As in simultaneous equation method, once Zi of each stock in the
efficient portfolio commensurate with your assumed Rf has be calculated then you can find Xi, Rp,
and SDp of that efficient portfolio in the same manner as you did previously while using
simultaneous equations method. And then repeat the whole process by assuming a different Rf

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
value to estimate weights (Xi) of another efficient portfolio, and so on, until you have five, six, 10
portfolios; then placing those portfolios as dots on graph paper in risk-return space and connecting
those dots you have traced efficient frontier curve.

The good news is that the use of this simple ranking technique does not require
solving simultaneous equations. In this simple ranking technique stocks are ranked in
their attractiveness as first, second, third, and so on according to their ratio of excess
return per unit of relevant risk; and this ratio is written as:

Excess returns per unit of relevant risk ratio = (Ri - Rf) / Bi

, and that is Step One

Excess return is (Ri - Rf), and it is expected ROR of a stock which is over and above risk free
ROR. Note that risk free rate of return (Rf) can be earned by anyone by investing in a risk free
asset such as t-bills. Investor expects to earn excess returns (Ri - Rf) from a stock because
investor deliberately decides to invest in a risky stock instead of investing in a risk free t-bill.
Therefore instead of expected returns of a stock, excess returns of a stock are used ; and these
excess returns are related to relevant risk of that stock in the form the above stated ratio. Then the
above stated ratio is used to rank the stocks as first, second, third, fourth, etc.

Please also note that the above stated excess return per unit of relevant risk ratio, (Ri - Rf)/Bi , is
in fact

( )
( )

but BRf is not written because by definition its value is zero, after all a risk free security cannot
have relevant risk.

(Ri - Rf)/(Bi - BRf) ratio is slope ( rise over run) of a straight line when on x-axis you have beta
(relevant risk) of that stock and on y-axis ROR of stock. Ri Rf is rise (vertical distance), and Bi
B Rf is run (horizontal distance), so

( )
( )

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

is slope of a straight line on a graph if beta is on x-axis and rate of return of a stock is on y-axis, and
the line emerges from Rf on y-axis. Ranking a stock higher if this ratio is higher means stocks
whose straight line has higher slope are more attractive. Since BRf is zero by definition therefore
it is not written and the ratio is written as:

(Ri - Rf)/Bi and it is called excess returns per unit of relevant risk.

For example excess returns per unit of relevant risk (beta) are given below for 2 stocks:

for Stock of CoA = (15 -3)/1 = 12% /1

and for Stock of CoB= (18 3)/2 = 7.5%/1

According to this ranking technique, Share of CoA is ranked higher because you expect to earn
more return over and above the risk free rate of return by investing in share of Co A (12%) than
from Co B (7.5%) if beta of both companies were same, that is one. Note that denominator 1 in
the answer is shown here deliberately to clarify the wording per unit of risk, otherwise 1 in
denominator is not written, rather it is known that it is there whenever you write any number , say
5, it means 5/1.

After ranking the securities according to this ratio, the ratio of each stock is compared with a cut
off rate called Ci of each stock, that is Step Two to decide whether a stock is included or not
included in the efficient portfolio. This method is demonstrated with the help of an example, data
is provided by your staff of security analysts.

The Case of Short Selling Not Allowed

When short selling is not allowed then investors can take only long position in a stock, i.e., they can
only buy it; but cannot borrow the stock and then sell it to raise cash. From time to time, and
mostly in bearish market, the regulators do prohibit short selling in Pakistan and in other countries
as well. Moreover there are certain institutional investors, such as mutual funds, which are not
allowed to indulge in short selling.

All those shares whose excess return per unit of relevant risk ratio , [(Ri - Rf)/Bi ] is greater than
their respective Ci are included in the efficient portfolio; and those stocks whose ratio of (Ri -
Rf)/Bi is less than their respective Ci are not included in the efficient portfolio if short selling is not
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 Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

allowed, that is Step Three , and it tells which stocks would be included in the efficient
portfolio and which stocks wont be included.

When short selling is not allowed C* is the Ci of the last ranked stock included in the efficient
portfolio; and C* is used in calculating Zi of each stock.

Exercise:

Suppose there are only 10 risky stocks in the country; to start the process of finding weights of
stocks included in an efficient portfolio, you need to assume a risk free rate of return (Rf). Let us
assume Rf is 5% . Your staff of security analysts have estimated total risk of stock market (VARm )
as 10 %2. Estimates of next years expected RORs of 10 stocks (Ri) , relevant risk of these 10
stocks (i) , and VAR ei (diversifiable risk) of 10 stocks are also estimated by your staff as shown
in the table below. In the second last column of the table below, excess return to beta ratio of each
stock is calculated, and in the last column each stock is assigned a rank, that is, 1st , 2nd, 3rd, etc,
based on this ratio; the stock with highest ratio being ranked as 1st , that is ICI; and stock with
lowest ratio being ranked as 9th and that is Fauji Fertilizer.

Un Ranked Data of 10 stocks. Rf is assumed 5%

Stocks Ri Ri - Bi VARei (Ri - Ranks
Rf Rf) / based on
Bi (Ri - Rf) /
Bi
Lever 17% 12% 1.5 40 8% 2nd
Hubco 17 12 2 10 6 4th
ICI 15 10 1 50 10 1st
Fauji 5.6 0.6 0.6 6 1 9th
Adamji 7 2 0.8 16 2.5 7th
Sui 11 6 1 40 6 4th
North
PTC 12 7 1 20 7 3rd
MCB 11 6 1.5 30 4 5th
PSO 11 6 2 40 3 6th
Engro 7 2 1 20 2 8th

In the following table the stocks are re-arranged in the first column from the highest ranked to the
lowest ranked: 1st being ICI and 9th being Fauji Fertilizer. Note: though there are 10 stocks but
ranks are only 9 because 2 stocks, Sui and HubCo, both have same rank 4th because both stock
have the same value of 6 for the ratio of excess return to beta. In the second column the ratio of

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Ranked (Ri- (Ri-Rf)Bi/ [(Ri- Bi2/VARei (Bi2/VARei) Ci

Stocks Rf)/Bi VARei Rf)Bi/VARei] Running
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
excess return to beta is given, and in the remaining columns some other ratios are calculated for
each of the ranked stock by using the data given in the previous table.

In the table above , the Ci of each stock was calculated as shown below:

( )
{ }

= 2

1 + [ {
}]

CICI = (10 * 0.2) / [1 + (10 * 0.02)] = 2/1.2 = 1.66

C Lever = (10 * 0.65) / [1 + (10 * 0.076)] = 6.5 /1.76 = 3.69

C PTC = (10 * 1) / [1 + (10 * 0.126)] = 10 /2.26 = 4.42

C Sui = (10 * 1.15) / [1 + (10 *0 .151)] = 11.5 /2.51 = 4.58

C HubCo = (10 * 3.55) / [1 + (10 * 0.551)] = 35.5 /6.51 = 5.45

C MCB = (10 * 3.85) / [1 + (10 * 0.626)] = 38.5 /7.26 = 5.30

C PSO = (10 * 4.15) / [1 + (10 * 0.726)] = 41.5 /8.26 = 5.024

C Adamjee = (10 * 4.25) / [1 + (10 * 0.766)] = 42.5 /8.66 = 4.907

C Engro = (10 * 4.35) / [1 + (10 * 0.816)] = 43.5 /9.16 = 4.748

C Fauji = (10 * 4.41) / [1 + (10 * 0.876)] = 44.1 /9.76 = 4.51

Now compare Ci of each stock with its (Ri - Rf)/Bi ratio. Since it is a case of SHORT SELLING NOT
ALLOWED, therefore in this case only those stocks are included in the efficient portfolio whose ratio of (Ri -
Rf)/Bi is greater than their respective Ci as shown below. C* is the Ci of last stock included in the efficient

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
portfolio, in this case it is HubCo as its (Ri - Rf)/Bi ratio is greater than its Ci, while stocks ranked below HubCo all
have their (Ri - Rf)/Bi ratio lesser than their respective Ci and therefore are not included in the efficient portfolio. All
stocks ranked below HubCo do not fulfill the condition stated above.

Stocks (Ri - Rf)/Bi Ci Zi Xi

ICI 10 > 1.66 Included .091 0.234

Lever 8 > 3.69 Included .096 0.246

PTC 7 > 4.42 Included .078 0.199

Sui 6 > 4.58 Included .013 0.035
Hubco 6 > 5.45 Included .11 0.283
Note: 5.45 is C*
MCB 4 < 5.30 Not Included Zi=0.3878 Xi=1
PSO 3 < 5.02 Not Included
Adamji 2.5 < 4.90 Not Included
Engro 2 < 4.74 Not Included
Fauji 1 < 4.51 Not Included

Zi of each included stock was calculated as shown below:

( )
= ( ) [{ } ]

Z ICI = (1/50)* [10 - 5.45] = 0.091

Z Lever = (1.5/ 40)* [8 - 5.45] = 0.0956

Z PTC = (1/ 20)* [7 - 5.45] = 0.0775

Z SUI = (1/ 40)* [6 - 5.45] = 0.0137

Z HUB = (2/ 10)* [6 - 5.45] = 0.11

Zi =0.3878

Xi of each stock was calculated as Xi = Zi / Zi

Xici=0.091/0.387=0.234

XLever=0.095/0.387=0.246

XPTC=0.77/0.387=0.199

XSUI=0.013/0.387=0.035

XHUB=0.11/0.387=0.283
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
Please check that sum of weights add up to one: Xi= 0.234 + 0.246 + 0.199 + 0.035 + 0.283 = 1

Now that weights of one efficient portfolio have been found, you can use these weights and the data given above to
work out expected rate of return (Rp) and total risk ( VARp) of this efficient portfolio.

11. Rp=XiRi

Rp =XICIRICI + XLevRLev+ XPTCRPTC + XSuiRSui + XHubRHub

Rp =(0.234*15%) + (0.246*17%) + (0.199*12%) + (0.035*11%) + (0.283*17%)

Rp =3.51 + 4.199 + 2.412 + 0.374 + 4.828

Rp =15.32%

VARp=(Rp - Rf ) /Zi

VARp =(15.3 - 5)/ 0.388

VARp =26.5%2

SDp= 26.5

SDp =5.15%

By doing the above calculations you have discovered weights of stocks included in an efficient portfolio, expected rate
of return (Rp), and total risk (VARp) of that efficient portfolio which lies tangent to a straight line emerging on y-axis
at 5% (Rf) in the graph where RORs are on y-axis and VARp is on x-axis.

To find weights of stocks , Xi , included in another efficient portfolio on Markowitz efficient set, assume another R f
and do the whole ranking exercise again to find weights (X i) of another efficient portfolio. Keep repeating the process
by assuming different Rf values , and keep finding weights (Xi) and Rp and VARp of efficient portfolios. Once you
have done so for five, six times; you can place the Rp and VARp of these portfolios on the graph paper and connect
these dots: you have made the Markowitz efficient frontier curve.

Summary of Steps Involved:

1. Calculate (Ri - Rf)/Bi ratio for each stock in the society, and rank them from highest to lowest. Please note that
if you are interested in a smaller subsample of stocks, you can use only those stocks to do the exercise; but the
resulting efficient frontier would be applicable to only portfolios made-up of those selected stocks.

2. Calculate (Ri - Rf)Bi/VARei for each stock

3. Calculate Bi2/VARei for each stock

4. Running summation of [(Ri - Rf)Bi /VARei] for each ranked stock

5. Running summation of Bi2 /VARei for each stock

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
6. Calculate C for each stock as:

( )
{ }

= 2

1 + [ { }]

7. Determine C* by comparing Ci of each stock with its ratio (Ri - Rf)/Bi. As long as (Ri - Rf)/Bi ratio of a
stock is greater than Ci of that stock, the stock is included in the efficient portfolio. C* is the Ci of the last
ranked stock whose (Ri-Rf)/Bi ratio is greater than its Ci . This holds for the condition when short selling is
not allowed.

8. Calculate Zi for each asset that is included in the portfolio, as :

( )
= ( ) [{ } ]

9. Calculate Zi

10. Calculate Xi for each asset as: Xi=Zi/Zi

You saw that when short selling is not allowed then only ICI, Lever ,PTC , Sui and HubCo are included in the
efficient portfolio that lies tangent to a straight line emerging at 5% Rf on the y-axis, as shown in table above.

The Case of Short Selling Allowed

When short selling is allowed, all stocks are included in the efficient portfolio; and C* is the C i of the last ranked
stock with the lowest excess return per unit of beta ratio [(Ri - Rf)/Bi ] in the whole list of stocks.

About Short selling there are two views: standard short selling and Lintners short selling. Standard short
selling assumes that short selling is a source of funds for investors; and Lintners short selling assumes that short
selling does not bring in funds for the investor, rather the funds generated by short selling certain shares by the
investor are kept by her broker as safety margin. Under both assumptions of short selling, C* is the Ci of the last
ranked stock in the whole long list of the ranked stocks. In our example it is stock of Fuji with Ci of 4.51 that is
last ranked among the 10 stocks, and therefore its Ci is the C*. When short selling is allowed in a country, all
stocks are included in the efficient portfolio; but some with positive weights (Xi) and other with negative weights,
and it is possible that some stocks weight comes out exactly zero and thus to build that particular efficient
portfolio you neither have to take long nor short position in such a stock . Positive weight for a stock means you

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
take long position in that stock, that is buy that stock; and negative weight means short position in that stock, you
do short selling of that stock.

Constraint For the programming problem:

For standard short selling allowed: weight of each stock in the efficient portfolio is: Xi = Zi /Zi and Sum of Xi
must add up to one; and it is no different than the short selling not allowed case. But for Lintners short selling
weight of each stock in the efficient portfolio is : Xi = Zi / | Zi| , and therefore constrain is: |Xi|= 1. Please note
again that in case of short selling allowed the C* for Zi calculations is the Ci of the last ranked stock; and in our
case it is Fauji with C Fauji 4.51 as you calculated above. Zi shown in the table below were calculated as follows.

( )
= ( ) [{ } ]

Z ICI = 1/50 [10 4.51] = 0.1098

Z Lever = 1.5/ 40 [8 - 4.51] = 0.1308

Z PTC = 1/ 20 [7 - 4.51] = 0.1245

Z SUI = 1/ 40 [6 - 4.51] = 0.0375

Z HUB = 2/ 10 [6 - 4.51] = 0.298

Z MCB = 1.5/ 30 [4 - 4.51] = -0.0255

Z PSO = 2/ 40 [3 - 4.51] = -0.0755

Z AdamJee = 0.8/ 16 [2.5 - 4.51] =- 0.1005

Z Engro = 1/ 20 [2 - 4.51] = -0.1255

Z FAUJI = .6/ 6 [1 - 4.51] =- 0.351

Zi=0.0226

Standard
Short
selling
Allowed Lintner's Short Selling
Absolute Absolute
Stocks Zi Xi= Zi/ Zi Zi Xi =Zi/|Zi| Xi
ICI 0.1098 4.85840708 0.1098 0.07964602 0.07964602
Lever 0.1308 5.78761062 0.1308 0.09487886 0.09487886
PTC 0.1245 5.50884956 0.1245 0.09030901 0.09030901
Sui 0.0375 1.65929204 0.0375 0.02720151 0.02720151
Hub 0.298 13.1858407 0.298 0.21616132 0.21616132
MCB -0.0255 -1.12831858 0.0255 -0.01849703 0.01849703
PSO -0.0755 -3.34070796 0.0755 -0.0547657 0.0547657
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
Adamjee -0.1005 -4.44690265 0.1005 -0.07290004 0.07290004
Engro -0.1255 -5.55309735 0.1255 -0.09103438 0.09103438
Fauji -0.351 -15.5309735 0.351 -0.25460612 0.25460612
Zi xi |Zi| |Xi|
0.0226 1 1.3786 1

Please note that in the table shown above, weights of different stocks (Xi) are unrealistically large in case of
standard short selling; for example X PTC is 5.5088 ; it means you need to invest in PTC shares an amount which is
almost 550% (or more than 5 times) of your equity to build this efficient portfolio. If you have 1 million rupees
OE then in PTC stock you need to invest 5.5088 million Rs.

Please also note that weights of different stocks are more realistic in case of Lintners short selling; for example X
PTC is 0.0903 which means you need to invest in PTC an amount equal to 9.03% of your OE to build this efficient
portfolio.

Rp

VARp

Now that you have found weights ( Xi) of one efficient portfolio with short selling allowed; you can trace the
whole curve of Markowitz efficient frontier. To do that please repeat the whole ranking process again and again by
assuming each time a different Rf instead of 5% Rf used in this example; and you will find Xi , Rp, and VARp of
Markowitz efficient portfolios. Finally you can place Rp & VARp of all these portfolios on a graph paper and
connect them. You have traced classical curved efficient frontier of Markowitz.

Be Aware of GIGO (Garbage-In Garbage-out)

Your estimated efficient set of portfolios or efficient frontier curve (as shown above) is as good as the estimated inputs
of stocks expected rate of return (Ri ), relevant risk of stocks (beta), diversifiable risk of stocks (VAR ei ), and total
risk of stock market ( VARm) . To re-emphasize the point about simplicity of this ranking technique of drawing the
efficient frontier of Markowitz, please note that data in puts requirements were simple:

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
1) Estimate of expected Ri of each stock

2) Estimate of Beta (relevant risk) of each stock

3) Estimate of VAR ei (diversifiable risk) of each stock

4) Estimate of total risk (VAR m) of the stock market.

Please note that you have learned in previous lectures all these calculations.

It is important to realize that the previous technique using simultaneous equations and this technique using a simple
ranking method, the data input requirements were not really very demanding. And the input data ( such as COV i,j ,
VARi, Ri, VAR ei , Betas, VARm) were easy to calculate by using data of historical return of stocks and stock market
index. In real life, security analysts working with mutual funds and other institutional investors use weekly stock
returns for last 60 weeks to estimate these inputs. The validity of betas of stocks estimated by using past returns data
has been questioned. But equally important, from the view point of quality of input data, is the issue of expected Ri of
any stock. As this depends on estimated DPS 1 and P1 for the next year; and usually these are estimated by applying
an estimated growth rate as:

DPS1 = DPS0 (1 + g)

P1 = P0 (1 + g); whereas growth rate is estimated as: g = ROE ( 1 - d)

Therefore an endlessly debated issue among the security analysts community is the correct estimate of growth rate to
be used for estimating expected return of a stock; and a lot of disagreement can be found among the security analysts
about their respective estimates of growth rate of any company at any given point in time. That is the reason why we
hear and read so much about the growth prospect of companies, industries, sectors of economies, and also of economies
(GNP) of different countries. Because it makes sense to analyze growth prospects of industries, sectors, and economy
as a whole before making projections about growth rate of a particular company operating in a certain industry which
belongs to a specific sector of economy of a particular country.

How to Build Your Clients Desired Optimal Portfolio

Now you have learnt to make efficient frontier curve of Markowitz, and each dot on that curve is an efficient portfolio.
As a reminder: you draw this curve now either by using simultaneous equations method or by using the simple ranking
technique. Therefore you are in a position to make any portfolio on the efficient frontier, i.e. , you can easily find
weights of stocks included in any efficient portfolio(Xi), expected rate of return of that efficient portfolio ( Rp ) and
total risk ( VARp ) of that efficient portfolio.

For example you show to a client the latest efficient frontier curve generated by your computer using the most up-to-
date in-puts of betas, VARe i, VARm, Ri, etc.; and you tell her: these are the efficient risk return combinations

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
available in Pakistan. Then you offer her to choose one efficient portfolio from the millions of portfolio available on
the efficient curve by placing her finger at any point on the curve. This would be the clients optimal portfolio, and
your job is to build it for the client. How would you build it?

Draw a tangent (straight line) from the clients chosen optimal portfolio toward y-axis and see the reading on y-axis
where this straight line hits the vertical axis. This is the Rf commensurate with the clients chosen portfolio. Now by
inserting this value of Rf in generalized solution of simultaneous equations , you can find values of Zi for each stock
in the clients optimal portfolio, and from there you can find Xs of clients optimal portfolio; and can advise her exactly
how to invest her OE by identifying exact amount to be invested in each stock along with the fact that in certain stocks
she need not invest at all as Xs of those stocks are not part of your solution. Or if you want to apply simple ranking
technique then the Rf value would be used in calculating excess return to beta ratio of each stock, and from there
onward you would complete the whole set of calculation arriving at the Ci, Zi, Xi, Rp, and VARp of the clients chosen
optimal portfolio. Thus you would be able to advise the client precisely how she should divide (percentage wise) her
OE among different stock, (Xi of different stocks) to build an efficient portfolio whose expected Rp (return) and VARp (
risk) she has found appealing for meeting her personal investment objectives. In short you are able to answer the
question: What Combination To Buy?

State of Investment Advisory Practice In Pakistan

In real life, especially in Pakistan, do you find among the brokerage houses the practice of constructing efficient
frontier, and building efficient portfolios? I suspect your answer is No. Then it is justified to raise a question about
the quality of advice given by brokerage houses to their clients who want to invest their funds based on the
recommendations given by the staff of brokerage houses. Usually this investment advice is in the form of BUY and
SELL advice for individual stocks given by research departments of brokerage houses; and this advice is usually
based upon stock research reports prepared by them. The whole idea of portfolio and especially an efficient portfolio
is neglected. The same is true about consideration to the issue of diversification and commensurate risk reduction: the
issue is simply ignored. Such a mind set (which can be called casual or ignorant) of brokerage houses implicitly
assumes that the concept of building portfolio and the resulting diversification effect in terms of risk reduction is not
factored-in by them in any explicit, let alone quantitative, manner while advising their clients. And therefore such
advice, at best, be categorized as half truth; because focusing on rate of return and ignoring the risk while making
investment decision is tantamount to seeing only half the reality while ignoring as irrelevant the other half.

On the other hand, in this course you are learning that investment decisions made without giving due attention to
risk along with returns are not good investment decisions. The fact that no licensing requirements are in place for the
investment advising business is one reason for this casual attitude of the so called experts while advising their
prospective clients. In USA, Chartered Financial Analysts (CFAs) are licensed to give investment advice about all
types of investment instruments, but there are other more restricted licenses as well which allow the license holder to
give investment advice about a specific instrument such as shares, or bonds, or futures contracts, or annuities, or
currencies, such as series 6, series 27, etc licences.

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
There is an urgent need in Pakistan to put in place licensing requirements so that before a person can give investment
advice to unsuspecting members of investing public at least he/she has some credentials to do so. Lately both SECP and
Karachi Stock Exchange hve shown some interest in making progress in this direction, and that is a good sign.

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