Retail Banking Assignment

Yashkumar Patel

17020942046

Q.1) Explain the Modern Portfolio Theory how can it be implemented in creating an efficient
portfolio.

Ans. Modern Portfolio Theory

Markowitz created a formula that allows an investor to mathematically trade off risk tolerance
and reward expectations, resulting in the ideal portfolio.

This theory was based on two main concepts:

1. Every investor’s goal is to maximize return for any level of risk

2. Risk can be reduced by diversifying a portfolio through individual, unrelated securities
MPT works under the assumption that investors are risk-averse, preferring a portfolio with less
risk for a given level of return. Under this assumption, investors will only take on high-risk
investments if they can expect a larger reward.

Consider the following example:

A “rational investor” is asked to choose between two investments: Investment A and

Investment B. Both are expected to increase in value by 6 percent each year. However,
Investment B is considered twice as volatile as Investment A, meaning its value fluctuates at
twice the magnitude of Investment A’s value fluctuations.

MPT suggests that a rational investor will always choose the less volatile asset, in this case
Investment A, so long as both options provide an equivalent expected return.

A portfolio’s overall risk is computed through a function of the variances of each asset, along
with the correlations between each pair of assets. Asset correlations affect the total portfolio
risk, formulating a smaller standard deviation than would be found by a weighted sum.

Under the MPT—or mean-variance analysis—an investor can hold a high-risk asset, mutual
fund, or security, so long as this high-risk investment is minimized by all underlying assets. The
portfolio itself is balanced in a way that its overall risk is lower than some of its underlying
investments. Risk is defined as the range by which an asset’s price will vary on average, but
Markowitz split risk into two subsequent categories.

Two Components of Risk

• Systematic Risk: This refers to market risks that cannot be reduced through diversification, or
the possibility that the entire market and economy will show losses that negatively affect
investments.

• Unsystematic Risk: Also called specific risk, unsystematic risk is specific to individual stocks,
meaning it can be diversified as you increase the number of stocks in your portfolio.

In a truly diversified combination of assets—or portfolio—the risk of each asset itself

contributes very little to overall portfolio risk. Rather, the covariances among the individual
assets determine more of the overall portfolio risk.

Therefore, investors can reduce individual asset risk by combining a diversified portfolio of
assets.

The Efficient Frontier

While the benefits of diversification are clear, investors must determine the level of
diversification that best suits them. This can be determined through what is called the Efficient
Frontier, a graphical representation of all possible combinations of risky securities for an
optimal level of return given a particular level of risk.

• At every level of return, investors can create a portfolio that offers the lowest possible risk.
• For every level of risk, investors can create a portfolio that offers the highest return.
Any portfolio that falls outside the Efficient Frontier is considered sub-optimal for one of two
reasons: it carries too much risk relative to its return, or too little return relative to its risk. A
portfolio that lies below the Efficient Frontier doesn’t provide enough return when compared
to the level of risk. Portfolios found to the right of the Efficient Frontier have a higher level of
risk for the defined rate of return.

At every point on the Efficient

Frontier, investors can construct
at least one portfolio from all
available investments that
features the expected risk and
return corresponding to that
point. A portfolio found on the
upper portion of the curve is
efficient, as it gives the
maximum expected return for
the given level of risk.

The Efficient Frontier offers a

clear demonstration of the
power behind diversification.
There’s no singular Efficient
Frontier, because investors can alter the number and characteristics of the assets to conform to
their needs.

How to Apply MPT

MPT requires an investor take the time to define

Time horizon
For a person saving for retirement, it might be several years, or even a decade or more. For an
institutional portfolio manager, it might be one to three years. For a hedge fund, the horizon
might be a day, a week, or a quarter. For an institutional endowment, it can be forever.

Sources of return
For a person saving for retirement, they probably consist of the asset classes that the portfolio
will comprise. For a portfolio manager hoping to beat a benchmark, they might consist of
sources of return believed to lead to higher performance (these days the sources are often
called “smart betas.”) For an endowment, they might also include other factors, such as credit
or illiquidity.

Sources’ expected returns

MPT encourages the investor use judgment. If asset valuations seem high, the experienced
investor might reason that future returns may be lower than in the past. Although the examples
in the 1950s paper and book use historical data for the purpose of illustration, MPT does not
tell you how to set expected returns.

Sources’ expected covariances with each other

MPT encourages the investor to consider as much historical information as possible. This does
not necessarily mean, however, using a snapshot of the historical record as the expected risks
of the future. Volatility varies with time; take special care to calibrate volatility expectations
from sources whose historical data are different lengths.

Sources’ expected ratio of return to risk

MPT is very sensitive to assumptions! When plotted on a graph of expected return vs. expected
risk, are the plots more or less linear? If not, you can almost guess by visual inspection which
sources will appear in the optimal solution: those with the highest ratio of expected return to
risk (however defined). Consider whether that is reasonable, or whether your assumptions are
overfitted (that is, they depend too much on past results). Repeat the above steps as often as
necessary to limit the degree of overfit in your assumptions.

Constraints
Whether legal, regulatory, or cultural, different investors have different constraints. MPT
accommodates different types of constraints, whether based on absolute weights, relative
weights, or transactions.
Maximize expected utility
This is the step that most people forget about MPT (even practitioners!): The above steps will
generate an efficient frontier, subject to your constraints. Now MPT recommends you choose
the point on the frontier that maximizes expected utility, a formula stating your preference for
return versus risk.

Rebalance
Rebalancing to your optimal portfolio weights periodically will allow your portfolio to sell
relatively high and buy relatively low. Over time this practice can reap an extra return that
builds over time.

Using MPT for Retirement Investing

An estimated $7 trillion in institutional assets are invested under the tenets laid out by MPT.
This financial tool permits a financial or retirement advisor to create a client’s optimal portfolio
by balancing risk and return.
Once you’ve informed your adviser about the level of risk you’re comfortable with, he or she
can construct a portfolio using MPT that maximizes the expected return for the defined risk.

Investors who diversified their portfolios still saw a loss, but a significantly smaller loss than
investors who didn’t.

Ultimately, using MPT for your portfolio management is dependent on your desires as an
investor. If you’re looking for greater return on average, you’ll have to accept greater risk. If you
want to incur fewer month-to-month or year-to-year fluctuations, you’ll have to accept less
return over time. Either way, MPT can identify the optimal allocation to assets according to
your preference.

Q.2) Explain how beta help in stock selection

Ans. It’s a measure of individual stock risk relative to the overall stock market risk. It’s
sometimes referred to as financial elasticity. It’s just one of several values that we can use to
get a better feel for a stock’s risk profile. Before investing in a company’s stock, the beta
analysis allows an investor to understand if the price of that security has been more or less
volatile than the market itself. Taking decision based on a sound beta analysis will definitely
enhance the portfolio performance.

Interpretation:

The interpretation of Beta values is also easy. In simple words, if the stock’s price experiences
movements greater (more volatile) than the stock market, then the beta value will be greater
than 1. If a stock’s price movements are less than the market fluctuations then the beta value
will be less than 1. And if the stock price is moving along with the market movement then the
beta will be near about 1. Since beta also represents risk factor then a beta value higher than 1
will indicate more risk and in turn more expected return for investors (similar to more risk more
gain funda!!!) The reverse is also true of a stock’s beta is less than 1, in that case we’d expect
less volatility, lower risk, and therefore lower overall returns.

Companies’ growth opportunities are a very important determinant of their beta value.
Generally firms with more growth opportunities tend to have higher betas. Since the expected
growth is also associated with uncertainty and risk. For example, a firm’s growth opportunities
usually depend on the new project, product development and expansion plan.

How to use Beta?

How we use beta for investment in stocks is very much dependent on our risk appetite. Like I
said, beta measures a stock’s association with market movements and represents volatility and
thus risk associated with that stock.

Choosing company which has beta more than 1 means we are selecting more volatile stock. For
example, an early-stage technology company’s stock will have a beta greater than 1. This
company’s stock price will bounce up and down more than the market. Definitely these kinds of
companies will be riskier than, say; utility industry stocks which have low beta or beta close to
1. Of course, here risk also implies return. Stocks with a high beta usually give a higher return
than the market.

A risk-averse investor may like to look for companies which have beta 1 or very close to 1.
Generally most blue chip companies have beta close to 1 or lower than 1. And because of this
these companies are considered as safe bets in a volatile market.

Limitations:

Beta value of a stock is dependent on historical price movements and history is not always an
accurate predictor of the future. Second problem with beta is that it doesn’t account for
changes that are in the works, such as new lines of business or heavy debt taken by a company.
These issues get reflected only after some time.

It does not include any sudden fall in price of a stock (for some sudden development). For
example a company which has a very high beta (say 1.5) will be termed as a risky bet. Now
suppose its price starts falling (say, due to heavy sell out by FIIs). For any value investor this
huge fall in prices will be an opportunities whereas beta will still term as a risky bet despite the
fact that here risk factor has come down due to fall in prices.