Portfoli

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Anaysi
s Gaurav Pansari
Roll 65

Portfolio analysis &

Room 06
revision is required to
maximize the value of the
portfolio. It is considered
that active management of
Financial Sem VI
a portfolio will add more
value to portfolio than
Passive management. The
manageme
report analyses the
meaning and importance
of portfolio analysis
nt
Introduction
In financial terms, ‘portfolio analysis’ is a study of the performance of specific portfolios
under different circumstances. It includes the efforts made to achieve the best trade-off
between risk tolerance and returns. It attempts to maximize portfolio expected return for a
given amount of portfolio risk, or equivalently minimize risk for a given level of expected
return, by carefully choosing the proportions of various assets.

What is Portfolio Analysis?

Portfolio analysis involves quantifying the operational and financial impact of the portfolio.
It is vital to evaluate the functioning of investments and timing the returns effectively.

The analysis of a portfolio extends to all classes of investments such as bonds, equities,
indexes, commodities, funds, options and securities. Portfolio analysis gains importance
because each asset class has peculiar risk factors and returns associated with it. Hence, the
composition of a portfolio impacts the rate of return on the overall investment.

What is involved in Portfolio Analysis?

Portfolio analysis is broadly carried out for each asset at two levels:

Risk aversion: This method analyzes the portfolio composition while considering the risk
appetite of an investor. Some of the investors may prefer to play safe and accept low profits
rather than invest in risky assets generating high returns.

Analyzing returns: While performing portfolio analysis, prospective returns are calculated
through the average and compound return methods. An average return is simply the
arithmetic average of returns from individual assets. However, compound return is the
arithmetic mean that considers the cumulative effect on overall returns.

The next step in portfolio analysis involves determining dispersion of returns. It is the
measure of volatility or standard deviation of returns for a particular asset. Simply put,
dispersion refers is the difference between the real interest rate and the calculated average
return. Measuring the recovery period after a negative market cycle is equally important.

Modern portfolio theory

Modern portfolio theory (MPT) is a theory of investment which attempts to maximize
portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk
for a given level of expected return, by carefully choosing the proportions of various assets.
Although MPT is widely used in practice in the financial industry, in recent years the basic
assumptions of MPT have been widely challenged by fields such as behavioral economics.
MPT is a mathematical formulation of the concept of diversification in investing, with the
aim of selecting a collection of investment assets that has collectively lower risk than any
individual asset. That this is possible can be seen intuitively because different types of assets
often change in value in opposite ways. For example, as prices in the stock market tend to
move independently from prices in the bond market, a collection of both types of assets can
therefore have lower overall risk than either individually. But diversification lowers risk even
if assets' returns are not negatively correlated—indeed, even if they are positively
correlated.

More technically, MPT models an asset's return as a normally distributed function (or more
generally as an elliptically distributed random variable), defines risk as the standard
deviation of return, and models a portfolio as a weighted combination of assets so that the
return of a portfolio is the weighted combination of the assets' returns. By combining
different assets whose returns are not perfectly positively correlated, MPT seeks to reduce
the total variance of the portfolio return. MPT also assumes that investors are rational and
markets are efficient.

MPT was developed in the 1950s through the early 1970s and was considered an important
advance in the mathematical modelling of finance. Since then, many theoretical and
practical criticisms have been levelled against it. These include the fact that financial returns
do not follow a Gaussian distribution or indeed any symmetric distribution, and that
correlations between asset classes are not fixed but can vary depending on external events
(especially in crises). Further, there is growing evidence that investors are not rational and
markets are not efficient.

Risk and expected return

MPT assumes that investors are risk averse, meaning that given two portfolios that offer the
same expected return, investors will prefer the less risky one. Thus, an investor will take on
increased risk only if compensated by higher expected returns. Conversely, an investor who
wants higher expected returns must accept more risk. The exact trade-off will be the same
for all investors, but different investors will evaluate the trade-off differently based on
individual risk aversion characteristics. The implication is that a rational investor will not
invest in a portfolio if a second portfolio exists with a more favourable risk-expected return
profile – i.e., if for that level of risk an alternative portfolio exists which has better expected
returns.