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A project on protfolio management

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A project on protfolio management

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A project on protfolio management

  1. 1. Projectsformba.blogspot.com Profile and Historical Background of the ‘Shrishma Portfolio & Investment services Ltd.’Address: 1/D Priya Apt., Opp. Old civil court, Nanpura, Surat. Shrishma Portfolio & Investment Services Ltd. is an InvestmentCompany registered under Companies Act 1956 since 1995. It provides aproper solution to the investors regarding any investment related queries.The company has all modern communication facilities, infrastructure. The main objective of the company is to help the investors inmanaging their investment portfolio. The other objective is to providebest service and guideline to the clients for their suitable investmentavenue, so they get maximum gain with safety for their future. Generally,people is not aware about different safe and gainful investment avenue, ifthey invest their money in any investment avenue there are chances toincur a loss and could not get the proper return from it. Shri Satish joshi is a Director of the company. He has more thantwenty five years wide experience in Capital Market, Financial ServiceSector, and Equity Research. During his college life in 1976-77 he started applying in equityissues. A small beginning of Rs. 500/- of the year 1976-77 has reached tolacks of Rs. investment. He has done M.Sc. (1st class) in 1982 from S. P.University, Post graduate in computer science (1st class) in 1982-83. Hejoined PRL (Physical Research Laboratory) as computer scientist. Thehabit of doing research and analysis has given advantage in equityresearch. He spend two year in C.F.A and recently passed exam ofAssociation of Mutual Fund Industries (AMFI) for validity of his mutualfund activities. He has spent several years in fundamental analysis. Then 1PProjectsformba.blogspot.com
  2. 2. Projectsformba.blogspot.comhe started writing regular articles in various news papers and magazines.He is appearing on T.V. channels for his investment advice. He has beenrespected by thousand of investors and has earned reputation as one ofmost successful equity research analyst. He is a regular student of Yoga classes and meditation. His natureof helping everybody has proved beneficial to the society. He believes in and respects GOD. He loves challenge and strugglefor excellence. His primary objective of advice is "no investors of himshould lose". He is equally efficient in technical analysis. He has attendedseveral seminars on technical analysis. He is a professional advisor tomany Charted Accountants, engineers, advocates and managers. 2PProjectsformba.blogspot.com
  3. 3. Projectsformba.blogspot.com Saving: Saving are excess of income over expenditure for any economicunit. Thus, S=Y–E Where, S is saving, Y is income and E is expenditure. Secondly, excess funds or surplus in profits or capital gains arealso available for investment. Thus, S = W1 – W2 Where, W1 is wealth in period 2, W2 is wealth in period 1, So, the difference between them is capital gains or losses. Thirdly, investment is also made by many companies andindividuals by borrowing, from others. Thus the Corporate Sector andGovernment Sector are always net borrows, as they invest more than theirsavings. Thus, S=B–L Where, B is borrowings L is landingsSavings can be negative or positive Why Saving: Saving is abstaining from present consumption for a future use.Saving are sometimes autonomous coming from households as a matterof habit. But bulk of the savings come for specific objectives, like interestincome, future needs, contingencies, precautionary purposes, or growth infuture wealth, leading to rise in the standard of living etc. 3PProjectsformba.blogspot.com
  4. 4. Projectsformba.blogspot.com Saving and Investment: Investors are savers but all savers cannot be good investors, asinvestment is a science and an art. Savings are sometimes autonomousand sometimes induced by the incentives like fiscal concessions orincome or capital appreciation. The number of investors is about 50million out of population of more than one billion in India. Savers comefrom all classes except in the case of the population who are below thepoverty line. The growths of urbanization and literacy have activated thecult of investment. More recently, since the eighties the investmentactivity has become more popular with the change in the GovernmentPolices towards liberalization and financial deregulation. The process ofliberalization and privatization was accelerated by the Government policychanges towards a market oriented economy, through economic andfinancial reforms stated in July 1991. What is investment? “Investment may be defined as the purchase by an individual orinstitutional investor of a financial or real asset that produces a returnproportional to the risk assumed over some future investment period.” - F. Amling “Investment defined as commitment of funds made in theexpectation of some positive rate of return. If the investment is properlyundertaken, the return will commensurate with the risk the investorassumes.” - Fisher & Jordan Investment refers to acquisition of some assets. It also means theconversion of money into claims on money and use of funds forproductive income earnings assets. In essence, it means the use of funds 4PProjectsformba.blogspot.com
  5. 5. Projectsformba.blogspot.comfor productive purpose, for securing some objectives like, income,appreciation of capital or capital gains, or for further production of goodsand services with the objective of securing yield Financial and Economic Meaning of Investment: Financial investment involves of funds in various assets, such asstock, Bond, Real Estate, Mortgages etc. Investment is the employmentof funds with the aim of achieving additional income or growth in value.It involves the commitment of resources which have been saved or putaway from current consumption in the hope some benefits will accrue infuture. Investment involves long term commitment of funds and waitingfor a reward in the future. From the point of view people who invest their finds, they are thesupplier of ‘Capital’ and in their view investment is a commitment of aperson’s funds to derive future income in the form of interest, dividend,rent, premiums, pension benefits or the appreciation of the value of theirprinciple capital. To the financial investor it is not important whethermoney is invested for a productive use or for the purchase of secondhandinstruments such as existing shares and stocks listed on the stockexchange. Most investments are considered to be transfers of financialassets from one person to another. Economic investment means the net additions to the capital stockof the society which consists of goods and services that are used in theproduction of other goods and services. Addition to the capital stockmeans an increase in building, plants, equipment and inventories over theamount of goods and services that existed. 5PProjectsformba.blogspot.com
  6. 6. Projectsformba.blogspot.com The financial and economic meanings are related to each otherbecause investment is a part of the savings of individuals which flow intothe capital market either directly or through institutions, divided in ‘new’and secondhand capital financing. Investors as ‘suppliers’ and investorsas ‘users’ of long-term funds find a meeting place in the market. So from above we know the term investment. The savers becomethe investors in the following term and invest in unique assets: FINANICAL ASSETS: cash Bank Deposits P.F.; L.I.C scheme Pension scheme Post office certificates Becomes PHYSICAL ASSETS: House, Land, Building, Flats Saver Investor Gold, Silver and Other Metals Consumer Durables MARKETABLE ASSETS: Shares, Bonds Government securities Mutual Fund UTI units etc. Stock & Capital Markets New Issues Stock Market 6PProjectsformba.blogspot.com
  7. 7. Projectsformba.blogspot.comSource: Investment Management By.V.A. Avadhani, Himalaya Publishing, Page 45. Need of investment: Investments are both important and useful in the context of presentday conditions. The following points have made investment decisionincreasingly important. 1. Planning for retirement 2. Interest rate 3. High rate of inflation 4. Increase rate of taxation 5. Income 6. Investment channels1. Planning for retirement: A tremendous increase in working population, proper plans for lifespan and longevity have ensured the need for investment decisions.Investment decision have becomes significant as working people retirebetween the age 55 and 60. The life expectancy has increased due toimproved living conditions, medical facilities etc. The earnings fromemployment should, therefore, be calculated in such a manner that aportion should be put away as savings. Saving from the from the currentearning must be invested in a proper way so that principal and incomethereon will be adequate to meet expenditure on them after theirretirement.2. Interest rate: The level of interest rates is another factor for a sound investmentplan. Interest rates may vary between one investments to other risky andnon- risky investments. They may also differ due to different benefitschemes offered by the investments. These aspects must be consideredbefore actually allocating any amount. A high rate of interest may not be 7PProjectsformba.blogspot.com
  8. 8. Projectsformba.blogspot.comthe only factor favouring the outlet for investment. The investor has toinclude in his portfolio several kinds on investments. Stability of interestis as important as receiving a high rate of interest.3. High rate of inflation: In the conditions of inflation, the prices will rise and purchasingpower of rupee will decline. On account of this, capital is eroded everyyear to the extent of rise in the inflation. The return on any investmentshould be regarded as positive, when such return compensates the effectof inflation. For maintaining purchasing power stability, investors shouldcarefully plan and invest their funds by making analysis. a. The rate of expected return and inflation rate. b. The possibilities of expected gain or loss on their investment. c. The limitation imposed by personal and family considerations.4. Increase rate of taxation: Taxation is one of the crucial factors in a person’s savings. Taxplanning is an essential part of over all investment planning. If theinvestment or disinvestment in securities in made without considering thevarious provisions of the tax laws, the investor may find that most of hisprofits have been eroded by the payment of taxes. Proper planning couldlead to a substantial increase in the amount of tax to be paid. On the otherhand, good tax planning and investing in tax savings schemes not onlyreduces the tax payable by the investor but also helps him to save taxeson other incomes. Various tax incentives offered by the government andrelevant provisions of the Income Tax Act, the Wealth Tax Act, areimportant to an investor in planning investments. 8PProjectsformba.blogspot.com
  9. 9. Projectsformba.blogspot.com5. Income: Income is also a factor in making a sound investment decision. Thegeneral increase in employment opportunities which gave rise to incomelevel and avenues for investment, have lead to the ability and willingnessof working population to save and invest such savings.6. Investment Channels: The growth and development of the country leading to greatereconomic activity has led to the introduction of a vast array ofinvestments. Apart from putting aside savings in savings banks whereinterest is low, investors have the choice of a variety of instruments. Thequestion to reason out is which is the most suitable channel? Whichmedia will give a balanced growth and stability of return? The investor inhis choice of investment will have to try and achieve a proper mixbetween high rate of return and stability of return to reap the benefits ofboth. Some of the instruments available are corporate stock, providentfund, life insurance, fixed deposits in corporate sector, Unit TrustSchemes and so on. 9PProjectsformba.blogspot.com
  10. 10. Projectsformba.blogspot.com What Is Portfolio: A portfolio is a collection of securities. Since it is rarely desirable toinvest the entire funds of an individual or an institution in a singlesecurity, it is essential that every security be viewed in a portfoliocontext. A set or combination of securities held by investor. A portfoliocomprising of different types of securities and assets. As the investors acquire different sets of assets of financial nature,such as gold, silver, real estate, buildings, insurance policies, post officecertificates, NSC etc., they are making a provision for future. The risk ofeach of such investments is to be understood before hand. Normally theaverage householder keeps most of his income in cash or bank depositsand assumes that they are safe and least risky. Little does he realize thatthey also carry a risk with them – the fear of loss or actual loss or theftand loss of real value of these assets through the rise price or inflation inthe economy? Cash carries no interest or income and bank deposits carrya nominal rate of 4% on savings deposits, no interest on current accountand a maximum of 9% on term deposits of one year. The liquidity onfixed deposits is poor as one has to wait for the period to maturity or takeloan on such amount but at a loss of income due to penal rate. Generallyrisk averters invest only in banks, Post office and UTI and Mutual funds.Gold, silver real estate and chit funds are the other avenues of investmentfor average Householder, of middle and lower income groups. If theinvestor desired to have a real rate of return which is substantially higherthan the inflation rate he has to invest in relatively more risky areas ofinvestment like shares and debenture of companies or bonds of 10PProjectsformba.blogspot.com
  11. 11. Projectsformba.blogspot.comGovernment and semi-Government agencies or deposits with companiesand firms. Investment in Chit funds, Company deposits, and in privatelimited companies has a highest risk. But the basic principle is that thehigher the risk, the higher is the return and the investor should have aclear perception of the elements of risk and return when he makesinvestments. Risk Return analysis is thus essential for the investment andportfolio management. Why Portfolio: You will recall that expected return from individual securitiescarries some degree of risk. Risk was defined as the standard deviationaround the expected return. In effect we equated a security’s risk with thevariability of its return. More dispersion or variability about a security’sexpected return meant the security was riskier than one with lessdispersion. The simple fact that securities carry differing degrees of expectedrisk leads most investors to the notion of holding more than one securityat a time, in an attempt to spread risks by not putting all their eggs intoone basket. Diversification of one’s holdings is intended to reduce risk inan economy in which every asset’s returns are subject to some degree ofuncertainty. Even the value of cash suffers from the inroads of inflation.Most investors hope that if they hold several assets, even if one goes bad,the others will provide some protection from an extreme loss. Portfolio Management: The portfolio management is growing rapidly serving broad arrayof investors – both individual and institutional – with investmentportfolio ranging in asset size from few thousands to crores of rupees.Despite growing importance, the subject of portfolio and investment 11PProjectsformba.blogspot.com
  12. 12. Projectsformba.blogspot.commanagement is new in the country and is largely misunderstood. In mostcases, portfolio management has been practiced as a investmentmanagement counseling in which the investor has been advised to seekassets that would grow in value and / or provide income. Portfolio management is concerned with efficient management ofinvestment in the securities. An investment is defined as the currentcommitment of funds for a period of time in order to derive a future flowof funds that will compensate the investing unit: - For the time the funds are committed. - For the expected rate of inflation, and - For the uncertainty involved in the future flow of funds. The portfolio management deals with the process of selection ofsecurities from the number of opportunities available with differentexpected returns and carrying different levels of risk and the selection ofsecurities is made with a view to provide the investors the maximumyield for a given level of risk or ensure minimize risk for a given level ofreturn. Investors invest his funds in a portfolio expecting to get a goodreturn consistent with the risk that he has to bear. The return realizedfrom the portfolio has to be measured and the performance of theportfolio has to be evaluated. It is evident that rational investment activity involves creation of aninvestment portfolio. Portfolio management comprises all the processesinvolved in the creation and maintenance of an investment portfolio. Itdeals specially with security analysis, portfolio analysis, portfolioselection, portfolio revision and portfolio evaluation. Portfoliomanagement makes use of analytical techniques of analysis andconceptual theories regarding rational allocation of funds. Portfolio 12PProjectsformba.blogspot.com
  13. 13. Projectsformba.blogspot.commanagement is a complex process, which tries to make investmentactivity more rewarding and less risky. Definition of Portfolio Management: It is a process of encompassing many activities of investment inassets and securities. The portfolio management includes the planning,supervision, timing, rationalism and conservatism in the selection ofsecurities to meet investor’s objectives. It is the process of selecting a listof securities that will provide the investor with a maximum yield constantwith the risk he wishes to assume. Application to portfolio Management: Portfolio Management involves time element and time horizon.The present value of future return/cash flows by discounting is useful forshare valuation and bond valuation. The investment strategy in portfolioconstruction should have a time horizon, say 3 to 5 year; to produce thedesired results of say 20-30% return per annum. Besides portfolio management should also take into account taxbenefits and investment incentives. As the returns are taken by investorsnet of tax payments, and there is always an element of inflation, returnsnet of taxation and inflation are more relevant to tax paying investors.These are called net real rates of returns, which should be more than otherreturns. They should encompass risk free return plus a reasonable riskpremium, depending upon the risk taken, on the instruments/assetsinvested. 13PProjectsformba.blogspot.com
  14. 14. Projectsformba.blogspot.com Objective of Portfolio Management:- The objective of portfolio management is to invest in securities issecurities in such a way that one maximizes one’s returns and minimizesrisks in order to achieve one’s investment objective.A good portfolio should have multiple objectives and achieve a soundbalance among them. Any one objective should not be given undueimportance at the cost of others. Presented below are some importantobjectives of portfolio management.1. Stable Current Return: - Once investment safety is guaranteed, the portfolio should yield asteady current income. The current returns should at least match theopportunity cost of the funds of the investor. What we are referring tohere current income by way of interest of dividends, not capital gains.2. Marketability: - A good portfolio consists of investment, which can be marketedwithout difficulty. If there are too many unlisted or inactive shares inyour portfolio, you will face problems in encasing them, and switchingfrom one investment to another. It is desirable to invest in companieslisted on major stock exchanges, which are actively traded.3. Tax Planning: - Since taxation is an important variable in total planning, a goodportfolio should enable its owner to enjoy a favorable tax shelter. Theportfolio should be developed considering not only income tax, butcapital gains tax, and gift tax, as well. What a good portfolio aims at istax planning, not tax evasion or tax avoidance. 14PProjectsformba.blogspot.com
  15. 15. Projectsformba.blogspot.com4. Appreciation in the value of capital: A good portfolio should appreciate in value in order to protect theinvestor from any erosion in purchasing power due to inflation. In otherwords, a balanced portfolio must consist of certain investments, whichtend to appreciate in real value after adjusting for inflation.5. Liquidity: The portfolio should ensure that there are enough funds available atshort notice to take care of the investor’s liquidity requirements. It isdesirable to keep a line of credit from a bank for use in case it becomesnecessary to participate in right issues, or for any other personal needs.6. Safety of the investment: The first important objective of a portfolio, no matter whoowns it, is to ensure that the investment is absolutely safe. Otherconsiderations like income, growth, etc., only come into the picture afterthe safety of your investment is ensured. Investment safety or minimization of risks is one of theimportant objectives of portfolio management. There are many types ofrisks, which are associated with investment in equity stocks, includingsuper stocks. Bear in mind that there is no such thing as a zero riskinvestment. More over, relatively low risk investment givecorrespondingly lower returns. You can try and minimize the overall riskor bring it to an acceptable level by developing a balanced and efficientportfolio. A good portfolio of growth stocks satisfies the entire objectivesoutline above. 15PProjectsformba.blogspot.com
  16. 16. Projectsformba.blogspot.com Scope of Portfolio Management:- Portfolio management is a continuous process. It is a dynamicactivity. The following are the basic operations of a portfoliomanagement. a) Monitoring the performance of portfolio by incorporating the latest market conditions. b) Identification of the investor’s objective, constraints and preferences. c) Making an evaluation of portfolio income (comparison with targets and achievement). d) Making revision in the portfolio. e) Implementation of the strategies in tune with investment objectives. Approaches of Portfolio Management:- Different investors follow different approaches when they dealwith investments. Four basic approaches are illustrated below, but therecould be numerous variations.i) The Holy-Cow Approach: These investors typically buy but never sell. He treats his scripslike holy cows, which are never to be sold for slaughter. If you canconsistently find and then confine yourself to buying only prized bulls,this holy cow approaches may pay well in the long run.ii) The Pig-Farmer Approach: The pig-farmer on the other hand, knows that pigs are meant forslaughter. Similarly, an investor adopting this approach buys and sells 16PProjectsformba.blogspot.com
  17. 17. Projectsformba.blogspot.comshares as fast as pigs are growth and slaughtered. Pigs become pork andequity hard cash.iii) The Rice-Miller Approach: The rice miller buys paddy feverishly in the market during theseason, then mills, hoards and sells the rice slowly over an extendedperiod depending on price movements. His success lies in his shills inbuying and selling, and his financial capacity to hold stocks. Similarly, aninvestor following this approach grabs the share at the right price, takes aposition, holds on to it, and liquidates slowly.iv) The Woolen-Trader Approach: The woolen-trader buys woolen ever a period of time but sellsthem quickly during the season. Hid success also lies in his skill inbuying and selling, and his ability to hold stocks. An investor followingthis strategy over a period of time but sells quickly, and quits. SEBI Guidelines to Portfolio Management:- SEBI has issued detailed guidelines for portfolio managementservices. The guidelines have been made to protect the interest ofinvestors. The salient features of these guidelines are given here under; 1) The nature of portfolio management services shall be investment consultant. 2) The portfolio manager shall not guarantee any return ti his clients. 3) Client’s funds will be kept in separate bank account. 4) The portfolio manager shall acts as trustee of client’s funds. 5) The portfolio manager can invest in money or capital market. 6) Purchase and sale of securities will be at prevailing market price. 17PProjectsformba.blogspot.com
  18. 18. Projectsformba.blogspot.com Different Phases of Portfolio Management: Portfolio management is a process encompassing many activitiesaimed at optimizing the investment of one’s funds. Main five phases canbe identified in this management process: a. Security Analysis b. Portfolio Analysis c. Portfolio Selection d. Portfolio Revision e. Portfolio Evaluation f. Portfolio Construction(A) SECURITY ANALYSIS:- The different types of securities are available to an investor forinvestment. In stock exchange of the country the shares of 7000companies are listed. Traditionally, the securities were classified intoownership such as equity shares, preference share, and debt as adebenture bonds etc. Recently companies to raise funds for their projectsare issuing a number of new securities with innovative feature.Convertible debenture, discount bonds, Zero coupon bonds, Flexi bond,floating rate bond, etc. are some of these new securities. From these hugegroup of securities the investors has to choose those securities, which heconsiders worthwhile to be included in his investment portfolio. So forthis detailed security analysis is most important. The aim of the security analysis is to find out intrinsic value of asecurity. The basic value is also called as the real value of a security isthe true economic worth of a financial asset. The real value of the security 18PProjectsformba.blogspot.com
  19. 19. Projectsformba.blogspot.comindicates whether the present market price is over priced or under pricedin order to make a right investment decision. The actual price of thesecurity is considered to be a function of a set of anticipatedcapitalization rate. Price changes, as anticipation risk and return change,which in turn change as a result of latest information. Security analysis refers to analyzing the securities from the point ofview of the scrip prices, return and risks. The analysis will help inunderstanding the behaviour of security prices in the market forinvestment decision making. If it is an analysis of securities and referredto as a macro analysis of the behaviour of the market. Security analysisentails in arriving at investment decisions after collection and analysis ofthe requisite relevant information. To find out basic value of a security“the potential price of that security and the future stream of cash flowsare to be forecast and then discounted back to the present value.” Thebasic value of the security is to be compared with the current market priceand a decision may be taken for buying or selling the security. If the basicvalue is lower than the market price, then the security is in the overbought position, hence it is to be sold. On the other hand, if the basicvalue is higher than the market price the security’s worth is not fullyrecognized by the market and it is in under bought position, hence it is tobe purchased to gain profit in the future. There are mainly three alternative approaches to security analysis,namely fundamental analysis, technical analysis and efficient markettheory. The fundamental analysis allows for selection of securities ofdifferent sectors of the economy that appear to offer profitableopportunities. The security analysis will help to establish what type ofinvestment should be undertaken among various alternatives i.e. realestate, bonds, debentures, equity shares, fixed deposit, gold, jewellery etc. 19PProjectsformba.blogspot.com
  20. 20. Projectsformba.blogspot.comNeither all industries grow at same rate nor do all companies. The growthrates of a company depend basically on its ability to satisfy humandesires through production of goods or performance is important toanalyze nation economy. It is very important to predict the course ofnational economy because economic activity substantially affectscorporate profits, investors’ attitudes, expectations and ultimately securityprice. According to this approach, the share price of a company isdetermined by these fundamental factors. The fundamental works out thecompares this intrinsic value of a security based on its fundamental; themcompares this intrinsic value, the share is said to be overpriced and viceversa. The mispricing security provides an opportunity to the investor tothose securities, which are under priced and sell those securities, whichare overpriced. It is believed that the market will correct notable cases ofmispricing in future. The prices of undervalued shares will increase andthose of overvalued will decline. Fundamental analysis helps to identify fundamentally strongcompanies whose shares are worthy to be included in the investor’sportfolio. The second alternative of security analysis is technical analysis.The technical analysis is the study of market action for the purpose offorecasting future price trends. The term market action includes the threeprincipal sources of information available to the technician – price, value,and interest. Technical Analysis can be frequently used to supplement thefundamental analysis. It discards the fundamental approach to intrinsicvalue. Changes in price movements represent shifts in supply and demandposition. Technical Analysis is useful in timing a buy or sells order. Thetechnical analysis does not claim 100% of success in predictions. It helpsto improve the knowledge of the probability of price behaviour and 20PProjectsformba.blogspot.com
  21. 21. Projectsformba.blogspot.comprovides for investment. The current market price is compared with thefuture predicted price to determine the extent of mispricing. Technicalanalysis is an approach, which concentrates on price movements andignores the fundamentals of the shares. A more recent approach to security analysis is the efficientmarket hypothesis/theory. According to this school of thought, thefinancial market is efficient in pricing securities. The efficient markethypothesis holds that market prices instantaneously and fully reflect allrelevant available information. It means that the market prices ofsecurities will always equal its intrinsic value. As a result, fundamentalanalysis, which tries to identify undervalued or overvalued securities, issaid to be a useless exercise. Efficient market hypothesis is direct repudiation of bothfundamental analysis and technical analysis. An investor can’tconsistently earn abnormal return by undertaking fundamental analysis ortechnical analysis. According to efficient market hypothesis it is possiblefor an investor to earn normal return by randomly choosing securities of agiven risk level.(B) PORTFOLIO ANALYSIS:- The main aim of portfolio analysis is to give a caution direction tothe risk and return of an investor on portfolio. Individual securities haverisk return characteristics of their own. Therefore, portfolio analysisindicates the future risk and return in holding of different individualinstruments. The portfolio analysis has been highly successful in tracingthe efficient portfolio. Portfolio analysis considers the determination offuture risk and return in holding various blends of individual securities.An investor can sometime reduce portfolio risk by adding anothersecurity with greater individual risk than any other security in the 21PProjectsformba.blogspot.com
  22. 22. Projectsformba.blogspot.comportfolio. Portfolio analysis is mainly depending on Risk and Return ofthe portfolio. The expected return of a portfolio should depend on theexpected return of each of the security contained in the portfolio. Theamount invested in each security is most important. The portfolio’sexpected holding period value relative is simply a weighted average ofthe expected value relative of its component securities. Using currentmarket value as weights, the expected return of a portfolio is simply aweighted average of the expected return of the securities comprising thatportfolio. The weights are equal to the proportion of total funds investedin each security. Tradition security analyses recognize the key importance of riskand return to the investor. However, direct recognition of risk and returnin portfolio analysis seems very much a “seat-of-the-pants” process in thetraditional approaches, which rely heavily upon intuition and insight. Theresult of these rather subjective approaches to portfolio analysis has, nodoubt, been highly successfully in many instances. The problem is thatthe methods employed do not readily lend themselves to analysis byothers. Most traditional method recognizes return as some dividend receiptand price appreciations aver a forward period. But the return forindividual securities is not always over the same common holding periodnor are he rates of return necessarily time adjusted. An analyst may wellestimate future earnings and P/E to derive future price. He will surelyestimate the dividend. But he may not discount the value to determine theacceptability of the return in relation to the investor’s requirements. A portfolio is a group of securities held together as investment.Investments invest their funds in a portfolio of securities rather than in asingle security because they are risk averse. By constructing a portfolio,investors attempt to spread risk by not putting all their eggs into one 22PProjectsformba.blogspot.com
  23. 23. Projectsformba.blogspot.combasket. Thus diversification of one’s holding is intended to reduce risk ininvestment. Most investor thus tends to invest in a group of securities ratherthan a single security. Such a group of securities held together as aninvestment is what is known as a portfolio. The process of creating such aportfolio is called diversification. It is an attempt to spread and minimizethe risk in investment. This is sought to be achieved by holding differenttypes of securities across different industry groups.(C) PORTFOLIO SELECTION: - Portfolio analysis provides the input for the next phase in portfoliomanagement, which is portfolio selection. The proper goal of portfolioconstruction is to generate a portfolio that provides the highest returns ata given level of risk. A portfolio having this characteristic is known as anefficient portfolio. The inputs from portfolio analysis can be used toidentify the set of efficient portfolios. From this set of efficient portfoliosthe optimum portfolio has to be selected for investment. Harry Markowitzportfolio theory provides both the conceptual framework and analyticaltools for determining the optimal portfolio in a disciplined and objectiveway.(D) PORTFOLIO REVISION: - Once the portfolio is constructed, it undergoes changes due tochanges in market prices and reassessment of companies. Portfoliorevision means alteration of the composition of debt/equity instruments,shifting from the one industry to another industry, changing from onecompany to another company. Any portfolio requires monitoring andrevision. Portfolios activities will depend on daily basis keeping in viewthe market opportunities. Portfolio revision uses some theoretical tools 23PProjectsformba.blogspot.com
  24. 24. Projectsformba.blogspot.comlike security analysis that already discuss before this, Markowitz model,Risk-Return evaluation. Portfolio revision involves changing the existing mix of securities.This may be effected either by changing the securities currently includedin the portfolio or by altering the proportion of fund invested in thesecurities. New securities may be added to the portfolio or some of theexisting securities may be removed from the portfolio. Portfolio revisionthus, leads to purchasing and sales of securities. The objective ofportfolio revision is the same as the objective of portfolio selection, i.emaximizing the return for a given level of risk or minimizing the risk foagiven level of return. The ultimate aim of portfolio revision ismaximization of returns and minimizing of risk. Having constructed the optimal portfolio, the investor has toconstantly monitor the portfolio to ensure that it continues to be optimal.As the economy and financial markets are dynamic, changes take placealmost daily. As time passes, securities, which were once attractive, maycease to be so. New securities with promises of high returns and low riskmay emerge. The investor now has to revise his portfolio in the light ofthe development in the market. This revision leads to purchase of somenew securities and sale of some of the existing securities from theportfolio. The mixture of security and its proportion in the portfoliochanges as a result of the revision. Portfolio revision may also be necessitated some investor relatedchanges such as availability of additional funds, changes in risk attitudeneed of cash for other alternative use etc. Whatever be the reason for portfolio revision, it has to be donescientifically and objectively so as to ensure the optimality of the revisedportfolio. Portfolio revision is not a casual process to be carried outwithout much care. In fact, in the entire process of portfolio management 24PProjectsformba.blogspot.com
  25. 25. Projectsformba.blogspot.comportfolio revision is as important as portfolio analysis and selection. Inportfolio management, the maximum emphasis is placed on portfolioanalysis and selection which leads to the construction of the optimalportfolio. Very little discussion is seen on portfolio revision which is asimportant as portfolio analysis and selection. Portfolio revision involving purchase and sale of securities givesrise to certain problem which acts as constraints in portfolio revision,from those constraints some may be as following:1. Statutory Stipulations: Investment companies and mutual funds manage the largest portfolios in every country. These institutional investors are normally governed by certain statutory stipulations regarding their investment activity. These stipulations often act as constraints in timely portfolio revision.2. Transaction cost: Buying and selling of securities involve transaction costs such as commission and brokerage. Frequent buying and selling of securities for portfolio revision may push up transaction cost thereby reducing the gains from portfolio revision. Hence, the transaction costs involved in portfolio revision may act as a constraint to timely revision of portfolio.3. Intrinsic difficulty: Portfolio revision is a difficult and time-consuming exercise. The methodology to be followed for portfolio revision is also not clearly established. Different approaches may be adopted for the purpose. The difficulty of carrying out portfolio revision it self may act as a restriction to portfolio revision. 25PProjectsformba.blogspot.com
  26. 26. Projectsformba.blogspot.com4. Taxes: Tax is payable on the capital gains arising from sale of securities. Usually, long term capital gains are taxed at a lower than short- term capital gains. To qualify as long-term capital gain, a security must be held by an investor for a period not less than 12 months before sale. Frequent sales of securities in the course of periodic portfolio revision of adjustment will result in short-term capital gains which would be taxed at a higher rate compared to long-term capital gains. The higher tax on short-term capital gains may act as a constraint to frequent portfolios.(F) PORTFOLIO PERFORMANCE EVALUATION:- Portfolio evaluating refers to the evaluation of the performance ofthe portfolio. It is essentially the process of comparing the return earnedon a portfolio with the return earned on one or more other portfolio or ona benchmark portfolio. Portfolio evaluation essentially comprises of twofunctions, performance measurement and performance evaluation.Performance measurement is an accounting function which measures thereturn earned on a portfolio during the holding period or investmentperiod. Performance evaluation , on the other hand, address such issues aswhether the performance was superior or inferior, whether theperformance was due to skill or luck etc. The ability of the investor depends upon the absorption of latestdevelopments which occurred in the market. The ability of expectations ifany, we must able to cope up with the wind immediately. Investmentanalysts continuously monitor and evaluate the result of the portfolioperformance. The expert portfolio constructer shall show superiorperformance over the market and other factors. The performance also 26PProjectsformba.blogspot.com
  27. 27. Projectsformba.blogspot.comdepends upon the timing of investments and superior investment analystscapabilities for selection. The evolution of portfolio always followed byrevision and reconstruction. The investor will have to assess the extent towhich the objectives are achieved. For evaluation of portfolio, theinvestor shall keep in mind the secured average returns, average or belowaverage as compared to the market situation. Selection of propersecurities is the first requirement. The evaluation of a portfolioperformance can be made based on the following methods: a) Sharpe’s Measure b) Treynor’s Measure c) Jensen’s Measure(a) Sharpe’ Measure: The objective of modern portfolio theory is maximization ofreturn or minimization of risk. In this context the research studies havetried to evolve a composite index to measure risk based return. The creditfor evaluating the systematic, unsystematic and residual risk goes tosharpe, Treynor and Jensen. Sharpe measure total risk by calculatingstandard deviation. The method adopted by Sharpe is to rank allportfolios on the basis of evaluation measure. Reward is in the numeratoras risk premium. Total risk is in the denominator as standard deviation ofits return. We will get a measure of portfolio’s total risk and variability ofreturn in relation to the risk premium. The measure of a portfolio can bedone by the following formula: Rt – Rf SI = σfWhere, SI = Sharpe’s Index Rt = Average return on portfolio 27PProjectsformba.blogspot.com
  28. 28. Projectsformba.blogspot.com Rf = Risk free return σf = Standard deviation of the portfolio return.For instance: Which portfolio perform better performance from following twoportfolio, by using Sharpe’s modelPortfolio Average return Standard deviation Risk free rate A 50% 10% 24% B 60% 18% 24%Performance can be finding out by the following formula:For Portfolio A: Rt – Rf SI = σfRt = 50Rf = 24σf = 0.10 0.50 – 0.24 SI = = 0.26 / 0.10 0.10 = 2.6 Portfolio AFor Portfolio B: Rt – Rf SI = σf 0.60 – 0.24 SI = = 0.36 / 0.18 0.18 = 2, Portfolio B Conclusion: According to the calculated “portfolio A” has betterperformance than portfolio B(b) Treynor’s Measure: The Treynor’s measure related a portfolio’s excess return to non-diversifiable or systematic risk. The Treynor’s measure employs beta. 28PProjectsformba.blogspot.com
  29. 29. Projectsformba.blogspot.comThe Treynor based his formula on the concept of characteristic line. It isthe risk measure of standard deviation, namely the total risk of theportfolio is replaced by beta. The equation can be presented as follow: Rn - Rf Tn = βmWhere, Tn = Treynor’s measure of performance Rn = Return on the portfolio Rf = Risk free rate of return βm = Beta of the portfolio ( A measure of systematic risk)For instance: Which securities perform better performance fromfollowing two portfolios, by using Treynor’s methodPortfolio Return βm Risk free rate X 44% 0.12% 22% Z 52% 2.40% 22%For portfolio X: Rn - Rf Tn = βmRn = 0.44 Rf = 0.22 βm = 0.12 0.44 – 0.22 0.22 Tn = = = 0.092 2.40 2.40For portfolio Y: 0.52 - 0.22 0.30 Tn = = = 0.125 2.4 2.40Conclusion: Portfolio Y is better than X because Tnx < Tny(c) Jensen’s Measure: Jensen attempts to construct a measure of absolute performance ona risk adjusted basis. This measure is based on CAPM model. It measuresthe portfolio manager’s predictive ability to achieve higher return than 29PProjectsformba.blogspot.com
  30. 30. Projectsformba.blogspot.comexpected for the accepted riskiness. The ability to earn returns throughsuccessful prediction of security prices on a standard measurement. TheJensen measure of the performance of portfolio can be calculated byapplying the following formula: Rp = Rf + (RMI – Rf) x βWhere, Rp = Return on portfolio RMI = Return on market index Rf = Risk free rate of returnFor instance: From the following data, the portfolio performance can bemeasure according to Jensens model as follow: Portfolio Estimated Return on portfolio Portfolio Beta I 40% 1.5 II 34% 1.1 III 46% 1.8 Market Index: 36% 1.03Risk free rate of return: 20%Market Beta =1.00For portfolio –I: RMI = 40%, Rf = 20%, β=3 Rp = 20 + (40 – 20) x 1.5 = 50%For portfolio – II: RMI = 34%, Rf = 20%, β = 1.1 Rp = 20 + (34 – 20) x 1.1 = 35.4%For portfolio – III: RMI = 46%, Rf = 20%, β = 1.8 Rp = 20 + (46 – 20) x 1.8 =66.8%The measure of performance = Actual – estimated I = 50% - 40% = 10% 30PProjectsformba.blogspot.com
  31. 31. Projectsformba.blogspot.com II = 35.4% - 34% = 1.4% III = 66.8% - 46% = 20.8% Here, the portfolio III is better perform then other two(G) PORTFOLIO CONSTRUCTION:- Portfolio construction refers to the allocation of funds among avariety of financial assets open for investment. Portfolio theory concernsitself with the principles governing such allocation. The objective of thetheory is to elaborate the principles in which the risk can be minimizedsubject to desired level of return on the portfolio or maximize the return,subject to the constraint of a tolerate level of risk. Thus, the basic objective of portfolio management is to maximizeyield and minimize risk. The other ancillary objectives are as per theneeds of investors, namely:6  Safety of the investment  Stable current Returns  Appreciation in the value of capital  Marketability and Liquidity  Minimizing of tax liability. In pursuit of these objectives, the portfolio manager has to set outall the various alternative investment along with their projected returnand risk and choose investment with safety the requirement of theindividual investor and cater to his preferences. The manager has to keepa list of such investment avenues along with return-risk profile, taximplications, yield and other return such as convertible options, bonus,rights etc. A ready reckoned giving out the analysis of the risk involvedin each investment and the corresponding return should be kept. The portfolio construction, as referred to earlier, be made on thebasis of the investment strategy, set out for each investor. Through choice 31PProjectsformba.blogspot.com
  32. 32. Projectsformba.blogspot.comof asset classis, instrument of investment and the specific scripts, save ofbond or equity of different risk and return characteristics, the choice oftax characteristics, risk level and other feature of investment, are decidedupon. Portfolio Investment Process:- The ultimate aim of the portfolio manager is to reduce the risk andincrease the return to the investor in order to reach the investmentobjectives of an investor. The manager must be aware of the investmentprocess. The process of portfolio management involves many logicalsteps like portfolio planning, portfolio implementation and monitoring.The portfolio investment process applies to different situation. Portfoliois owned by different individuals and organizations with differentrequirements. Investors should buy when prices are very low and sellwhen prices rise to levels higher that their normal fluctuation. The process used to manage a security portfolio is conceptually thesame as that used in any managerial decision. One should (1) Panning,(2) Implement the plan; and (3) Monitor the result. This portfolioinvestment process is displayed schematically as follow: Planning: Investor’s situation Market Condition Speculative policies Strategic asset allocation The Portfolio Investment Process Implementation: Rebalance Strategic Asset Allocation Tactical Asset Allocation Security Selection Monitoring: 32P Evaluate Statement of Investment PolicyProjectsformba.blogspot.com Evaluate Investment Performance
  33. 33. Projectsformba.blogspot.com Applying the different steps for portfolio investment process can becomplex and opinions are divided for maximization of wealth to theinvestor. Many differences exist between present investment theory andempirical result and which have often contradictory result the followingsome basic principles should be applied to all portfolio decisions. 1. The quantum of risk to be acceptable. 2. The profits will vary along with variability of risk. 3. Individual securities affect the aggregate portfolio. 4. Portfolio should provide a sound liquidity position. 5. Diversification of a portfolio may decrease the risk level. 6. Portfolio should be tailored to the needs of investors. 7. Follow the passive investment strategy or an activity speculative strategy. Portfolio investment process is an important step to meet the needsand convenience of investors. The portfolio investment process involvesthe following steps: 1. Planning of portfolio 2. Implementation of portfolio plan. 33PProjectsformba.blogspot.com
  34. 34. Projectsformba.blogspot.com 3. Monitoring the performance of portfolio.1) PLANNING OF PORTFOLIO: Planning is the most important element in a proper portfoliomanagement. The success of the portfolio management will depend uponthe careful planning. While making the plan, due consideration will begiven to the investor’s financial capability and current capital marketsituation. After taking into consideration a set of investment andspeculative policies will be prepared in the written form. It is called asstatement of investment policy. The document must contain (1) Theportfolio objective (2) Applicable strategies (3) Investment andspeculative constraints. The planning document must clearly define theasset allocation. It means an optimal combination of various assets in anefficient market. The portfolio manager must keep in mind about thedifference between basic pure investment portfolio and actual portfolioreturns. The statement of investment policy may contain these elements.The portfolio planning comprises the following situation for its betterperformance:(A) Investor Conditions: - The first question which must be answered is this – “What is thepurpose of the security portfolio?” While this question might seemobvious, it is too often overlooked, giving way instead to the excitementof selecting the securities which are to be held. Understanding thepurpose for trading in financial securities will help to: (1) define theexpected portfolio liquidation, (2) aid in determining an acceptable levelor risk, and (3) indicate whether future consumption (liability needs) are 34PProjectsformba.blogspot.com
  35. 35. Projectsformba.blogspot.comto be paid in nominal or real money, etc. For example: a 60 year oldwoman with small to moderate saving probably (1) has a short investmenthorizon, (2) can accept little investment risk, and (3) needs protectionagainst short term inflation. In contrast, a young couple investing coupleinvesting for retirement in 30 years has (1) a very long investmenthorizon, (2) an ability to accept moderate to large investment risk becausethey can diversify over time, and (3) a need for protection against long-term inflation. This suggests that the 60 year old woman should investsolely in low-default risk money market securities. The young couplecould invest in many other asset classes for diversification and acceptgreater investment risks. In short, knowing the eventual purpose of theportfolio investment makes it possible to begin sketching out appropriateinvestment / speculative policies.(B) Market Condition: - The portfolio owner must known the latest developments in themarket. He may be in a position to assess the potential of future return onvarious capital market instruments. The investors’ expectation may betwo types, long term expectations and short term expectations. The mostimportant investment decision in portfolio construction is asset allocation.Asset allocation means the investment in different financial instrumentsat a percentage in portfolio. Some investment strategies are static. Theportfolio requires changes according to investor’s needs and knowledge.A continues changes in portfolio leads to higher operating cost. Generallythe potential volatility of equity and debt market is 2 to 3 years. Theanother type of rebalancing strategy focuses on the level of prices of agiven financial asset.(C) Speculative Policies: 35PProjectsformba.blogspot.com
  36. 36. Projectsformba.blogspot.com The portfolio owner may accept the speculative strategies in orderto reach his goals of earning to maximum extant. If no speculativestrategies are used the management of the portfolio is relatively easy.Speculative strategies may be categorized as asset allocation timingdecision or security selection decision. Small investors can do bypurchasing mutual funds which are indexed to a stock. Organization withlarge capital can employ investment management firms to make theirspeculative trading decisions.(D) Strategic Asset Allocation:- The most important investment decision which the owner of aportfolio must make is the portfolio’s asset allocation. Asset allocationrefers to the percentage invested in various security classes. Securityclasses are simply the type of securities: (1) Money Market Investment,(2) Fixed Income obligations; (3) Equity Shares, (4) Real EstateInvestment, (5) International securities. Strategic asset allocation represents the asset allocation whichwould be optimal for the investor if all security prices trade at their long-term equilibrium values that is, if the markets are efficiency priced.2) IMPLEMENTATION:- In the implementation stage, three decisions to be made, if thepercentage holdings of various assets classes are currently different fromthe desired holdings as in the SIP, the portfolio should be rebalances tothe desired SAA (Strategic Asset Allocation). If the statement ofinvestment policy requires a pure investment strategy, this is the onlything, which is done in the implementation stage. However, manyportfolio owners engage in speculative transaction in the belief that suchtransactions will generate excess risk-adjusted returns. Such speculative 36PProjectsformba.blogspot.com
  37. 37. Projectsformba.blogspot.comtransactions are usually classified as “timing” or “selection” decisions.Timing decisions over or under weight various assets classes, industries,or economic sectors from the strategic asset allocation. Such timingdecision deal with securities within a given asset class, industry group, oreconomic sector and attempt to determine which securities should beover or under-weighted.(A) Tactical Asset Allocation:- If one believes that the price levels of certain asset classes,industry, or economic sectors are temporarily too high or too low, actualportfolio holdings should depart from the asset mix called for in thestrategic asset allocation. Such timing decision is preferred to as tacticalasset allocation. As noted, TAA decisions could be made acrossaggregate asset classes, industry classifications (steel, food), or variousbroad economic sectors (basic manufacturing, interest-sensitive,consumer durables). Traditionally, most tactical assets allocation has involved timingacross aggregate asset classes. For example, if equity prices are believesto be too high, one would reduce the portfolio’s equity allocation andincrease allocation to, say, risk-free securities. If one is indeed successfulat tactical asset allocation, the abnormal returns, which would be earned,are certainly entering.(B) Security Selection:- The second type of active speculation involves the selection ofsecurities within a given assets class, industry, or economic sector. Thestrategic asset allocation policy would call for broad diversificationthrough an indexed holding of virtually all securities in the asset in theclass. For example, if the total market value of HPS Corporation share 37PProjectsformba.blogspot.com
  38. 38. Projectsformba.blogspot.comcurrently represents 1% of all issued equity capital, than 1% of theinvestor’s portfolio allocated to equity would be held in HPS corporationshares. The only reason to overweight or underweight particular securitiesin the strategic asset allocation would be to off set risks the investors’faces in other assets and liabilities outside the marketable securityportfolio. Security selection, however, actively overweight andunderweight holding of particular securities in the belief that they aretemporarily mispriced.(3) PORTFOLIO MONITORING: - Portfolio monitoring is a continuous and on going assessment ofpresent portfolio and the portfolio manger shall incorporate the latestdevelopment which occurred in capital market. The portfolio managershould take into consideration of investor’s preferences, capital marketcondition and expectations. Monitoring the portfolio is up-gradingactivity in asset composition to take the advantage of economic, industryand market conditions. The market conditions are depending upon theGovernment policy. Any change in Government policy would reflect thestock market, which in turn affects the portfolio. The continues revisionof a portfolio depends upon the following factors: i. Change in Government policy. ii. Shifting from one industry to other iii. Shifting from one company scrip to another company scrip. iv. Shifting from one financial instrument to another. v. The half yearly / yearly results of the corporate sector 38PProjectsformba.blogspot.com
  39. 39. Projectsformba.blogspot.com Risk reduction is an important factor in portfolio. It will beachieved by a diversification of the portfolio, changes in market pricesmay have necessitated in asset composition. The composition has to bechanged to maximize the returns to reach the goals of investor. 39PProjectsformba.blogspot.com
  40. 40. Projectsformba.blogspot.com RISK & RETURN IN PORTFOLIO Return:-` The typical objective of investment is to make current income fromthe investment in the form of dividends and interest income. Suitablesecurities are those whose prices are relatively stable but still payreasonable dividends or interest, such as blue chip companies. Theinvestment should earn reasonable and expected return on theinvestments. Before the selection of investment the investor should keepin mind that certain investment like, Bank deposits, Public deposits,Debenture, Bonds, etc. will carry fixed rate of return payable periodically. 40PProjectsformba.blogspot.com
  41. 41. Projectsformba.blogspot.comOn investments made in shares of companies, the periodical payments arenot assured but it may ensure higher returns from fixed income securities.But these instruments carry higher risk than fixed income instruments. Risk:- The Webster’s New Collegiate Dictionary definition of riskincludes the following meanings: “……. Possibility of loss or injury …..the degree or probability of such loss”. This conforms to the connotationsput on the term by most investors. Professional often speaks of“downside risk” and “upside potential”. The idea is straightforwardenough: Risk has to do with bad outcomes, potential with good ones. In considering economic and political factors, investors commonlyidentify five kinds of hazards to which their investments are exposed. Thefollowing tables show components of risk: (A) SYSTEMATIC RISK: 1. Market Risk 2. Interest Rate Risk 3. Purchasing power Risk (B) UNSYSTEMATIC RISK: 1. Business Risk 2. Financial Risk(A) SYSTEMATIC RISK: Systematic risk refers to the portion of total variability in returncaused by factors affecting the prices of all securities. Economic, Politicaland Sociological charges are sources of systematic risk. Their effect is tocause prices of nearly all individual common stocks or security to move 41PProjectsformba.blogspot.com
  42. 42. Projectsformba.blogspot.comtogether in the same manner. For example; if the Economy is movingtoward a recession & corporate profits shift downward, stock prices maydecline across a broad front. Nearly all stocks listed on the BSE / NSEmove in the same direction as the BSE / NSE index. Systematic risk is also called non-diversified risk. If isunavoidable. In short, the variability in a securities total return in directlyassociated with the overall movements in the general market or Economyis called systematic risk. Systematic risk covers market risk, Interest raterisk & Purchasing power risk1. Market Risk: Market risk is referred to as stock / security variability due tochanges in investor’s reaction towards tangible & intangible events is thechief cause affecting market risk. The first set that is the tangible events,has a ‘real basis but the intangible events are based on psychologicalbasis. Here, Real Events, comprising of political, social or Economicreason. Intangible Events are related to psychology of investors or sayemotional intangibility of investors. The initial decline or rise in marketprice will create an emotional instability of investors and cause a fear ofloss or create an undue confidence, relating possibility of profit. Thereaction to loss will reduce selling & purchasing prices down & thereaction to gain will bring in the activity of active buying of securities.2. Interest Rate Risk: The price of all securities rise or fall depending on the change ininterest rate, Interest rate risk is the difference between the Expectedinterest rates & the current market interest rate. The markets will havedifferent interest rate fluctuations, according to market situation, supply 42PProjectsformba.blogspot.com
  43. 43. Projectsformba.blogspot.comand demand position of cash or credit. The degree of interest rate risk isrelated to the length of time to maturity of the security. If the maturityperiod is long, the market value of the security may fluctuate widely.Further, the market activity & investor perceptions change with thechange in the interest rates & interest rates also depend upon the nature ofinstruments such as bonds, debentures, loans and maturity period, creditworthiness of the security issues.3. Purchasing Power Risk: Purchasing power risk is also known as inflation risk. This risksarises out of change in the prices of goods & services & technically itcovers both inflation & deflation period. Purchasing power risk is morerelevant in case of fixed income securities; shares are regarded as hedgeagainst inflation. There is always a chance that the purchasing power ofinvested money will decline or the real return will decline due toinflation. The behaviour of purchasing power risk can in some way becompared to interest rate risk. They have a systematic influence on theprices of both stocks & bonds. If the consumer price index in a countryshows a constant increase of 4% & suddenly jump to 5% in the next.Year, the required rate of return will have to be adjusted with upwardrevision. Such a change in process will affect government securities,corporate bonds & common stocks.(B) UNSYSTEMATIC RISK:- The risk arises out of the uncertainty surrounding a particular firmor industry due to factors like labour Strike, Consumer preference &management policies are called Unsystematic risk. These uncertaintiesdirectly affect the financing & operating environment of the firm. 43PProjectsformba.blogspot.com
  44. 44. Projectsformba.blogspot.comUnsystematic risk is also called “Diversifiable risk”. It is avoidable.Unsystematic risk can be minimized or Eliminated throughdiversification of security holding. Unsystematic risk covers Businessrisk and Financial risk1. Business Risk: Business risk arises due to the uncertainty of return which dependupon the nature of business. It relates to the variability of the business,sales, income, expenses & profits. It depends upon the market conditionsfor the product mix, input supplies, strength of the competitor etc. Thebusiness risk may be classified into two kind viz. internal risk andExternal risk. Internal risk is related to the operating efficiency of the firm. Thisis manageable by the firm. Interest Business risk loads to fall in revenue& profit of the companies. External risk refers to the policies of government or strategic ofcompetitors or unforeseen situation in market. This risk may not becontrolled & corrected by the firm.2. Financial Risk: Financial risk is associated with the way in which a companyfinances its activities. Generally, financial risk is related to capitalstructure of a firm. The presence of borrowed money or debt in capitalstructure creates fixed payments in the form of interest that must besustained by the firm. The presence of these interest commitments – fixedinterest payments due to debt or fixed dividend payments on preferenceshare – causes the amount of retained earning availability for equity sharedividends to be more variable than if no interest payments were required.Financial risk is avoidable risk to the extent that management has the 44PProjectsformba.blogspot.com
  45. 45. Projectsformba.blogspot.comfreedom to decline to borrow or not to borrow funds. A firm with no debtfinancing has no financial risk. One positive point for using debtinstruments is that it provides a low cost source of funds to a company atthe same time providing financial leverage for the equity shareholders &as long as the earning of company are higher than cost of borrowed funds,the earning per share of equity share are increased. Risk - Return Relationship:- The entire scenario of security analysis is built on two concepts ofsecurity: Return and risk. The risk and return constitute the framework fortaking investment decision. Return from equity comprises dividend andcapital appreciation. To earn return on investment, that is, to earndividend and to get capital appreciation, investment has to be made forsome period which in turn implies passage of time. Dealing with thereturn to be achieved requires estimated of the return on investment overthe time period. Risk denotes deviation of actual return from theestimated return. This deviation of actual return from expected returnmay be on either side – both above and below the expected return.However, investors are more concerned with the downside risk. The risk in holding security deviation of return deviation ofdividend and capital appreciation from the expected return may arise dueto internal and external forces. That part of the risk which is internal thatin unique and related to the firm and industry is called ‘unsystematicrisk’. That part of the risk which is external and which affects allsecurities and is broad in its effect is called ‘systematic risk’. The fact that investors do not hold a single security which theyconsider most profitable is enough to say that they are not only interestedin the maximization of return, but also minimization of risks. The 45PProjectsformba.blogspot.com
  46. 46. Projectsformba.blogspot.comunsystematic risk is eliminated through holding more diversifiedsecurities. Systematic risk is also known as non-diversifiable risk as thiscan not be eliminated through more securities and is also called ‘marketrisk’. Therefore, diversification leads to risk reduction but only to theminimum level of market risk. The investors increase their required return as perceiveduncertainty increases. The rate of return differs substantially amongalternative investments, and because the required return on specificinvestments change over time, the factors that influence the required rateof return must be considered. Following chart-A represent the relationship between risk andreturn. The slop of the market line indicates the return per unit of riskrequired by all investors highly risk-averse investors would have asteeper line, and Yields on apparently similar may differ. Difference inprice, and therefore yield, reflect the market’s assessment of the issuingcompany’s standing and of the risk elements in the particular stocks. Ahigh yield in relation to the market in general shows an above averagerisk element. This is shown in the Char-BChart-A: RELATIONSHIP BETWEEN RISK AND RETURNRate ofReturn Low Average High Risk Risk Risk Market Line Slop indicates required return per unit of risk Risk free return 46PProjectsformba.blogspot.com
  47. 47. Projectsformba.blogspot.com RiskChart-B: RISK RETURN RELATIONSHIP: DIFFERENT STOCKS Rate of Market Line Return Risk Premium Ordinary shares Preference shares Subordinate loan stock Unsecured loan Debenture with floating charge Mortgage loan Government (i.e. risk free) stock Degree of riskSource: Financial Management, By Ravi M. Kishore, Page No: 1145-46 Given the composite market line prevailing at a point of time,investors would select investments that are consistent with their riskpreference. Some will consider low risk investments, while others preferhigh risk investments. The construction of a best portfolio will depend upon a carefulsecurity analysis. The portfolio management always thinks about thereturn and rewards of different financial assets which are fully involvedwith systematic and unsystematic risk. The portfolio management ismainly concentrated on the stock behaviour in the market. Selection of aparticular scrip or financial asset is the responsibility of a securityanalyst. But the portfolio manager’s obligation is to know best returns tothe portfolio owner with a combination of different kinds of financialassets. Portfolio analysis indicates the determination of future risk andreturn in holding a different set of individual securities. The portfolioanalysis contains the important elements as presented below; 1. Return on portfolio 47PProjectsformba.blogspot.com
  48. 48. Projectsformba.blogspot.com 2. Risk of a portfolio Return on Portfolio:- The portfolio value is highly influenced by return of individualsecurities. Each security in a portfolio contributes return in the proportionof its investment is security. Thus, the portfolio value may increase andthe targeted goals can be achieved. The return on portfolio is theweighted average of the expected returns, from each security with aproportionate weight of the different securities in the total investment.The return on portfolio depends upon the selection of financial assetwhich was made according to the investor’s perception. The efficiency ofa portfolio is highly influenced by a number of factors, i.e. investor’sobjective, investor’s risk presumption, safety of investment, capitalappreciation, liquidity of financial asset, hedging, time horizon set out byinvestor, constraints regarding diversification by the investor etc. The data of the following table reveals the calculation of 4portfolio’s return and risk Proportion of funds Expected Contribution ofSecurity invested in each return on each security to security (Weights) each security return A 35% 13% 4.55 B 30% 185 5.40 C 20% 23% 4.60 D 15% 15% 2.25 100% 16.8% The above portfolio yield 16.8% return on an average of 4 kinds ofsecurities. 48PProjectsformba.blogspot.com
  49. 49. Projectsformba.blogspot.com The portfolio risk can be calculated by using the measure such asstandard deviation and variance. These can be calculated by applying thefollowing formula;Standard deviation = √ ∑(x-x1)Variance = ∑(x-x1) 2 = ∑x2x = is the expected return on security ‘A’x1= is the mean or the weighted average return on the security ‘A’so, the co-efficient of variance = σ x 100 x1 The following table will explain the calculation of standarddeviation for a given portfolio. Security Return Probability 1 7% 0.30 2 11% 0.55 3 15% 0.15Solution: Weighted Return Weighted Return Probability(1) Return deviation deviations (2) (3) (2 x 3) from mean squared1 7% 0.30 0.021 - 0.033 0.0012 11% 0.55 0.060 0.007 0.0013 15% 0.15 0.022 0.047 0.002- - 1.00 0.103 - 0.004Average expected return 0.103 or 10.3 (mean)The return deviation can be obtained as follows:For security 1 = (0.07 – 0.103) = -0.033For security 2 = (0.11 – 0.103) = 0.007For security 3 = (0.15 – 0.103) = 0.047σ2 = 0.004 49PProjectsformba.blogspot.com
  50. 50. Projectsformba.blogspot.comσ = √ σ2 =√ 0.004σ = 0.063 0r 6.3%The co-efficient of variance = σ x 100 x1 = 6.3 / 10.3 = 61% Risk on Portfolio:- Risk is the most important element in portfolio management. Riskis reflected in the variability of the returns from Zero to infinity. The riskon a portfolio is different from the risk on individual securities. Theexpected return of a portfolio depends on the probability of the returnsand their weighted contribution to the risk. This is the essence of risk.Risk means, the probability of various possible bad outcomes from aconstructed portfolio. The measurement of risk in portfolio involves (a) Finding of average absolute deviation. (b) Standard deviation.These elements can be explained with following illustrations: The probability of each of the return of a portfolio is given below.Calculate the absolute deviations for the given portfolio. Event Return Probability 1 0.20 -10 2 0.25 22 3 0.30 27 4 0.25 12Estimation of absolute deviation:-Event Return Probability Absolute Probability (X)Absolute return deviation deviation (1) (2) (3) (2x3)=(4) (5) (5x2)=(6) 1 0.20 -10 -2.0 -24.6 4.92 50PProjectsformba.blogspot.com
  51. 51. Projectsformba.blogspot.com 2 0.25 22 +5.5 7.4 1.85 3 0.30 27 +8.1 12.4 3.72 4 40.25 12 +3.0 -2.6 0.65 Total +14.6 11.14%Probability deviation can be calculated as follows ;-10 - 14.6 = -24.622 - 14.6 = +7.427 - 14.6 = +12.412 - 14.6 = -2.6 The measure of absolute deviation is 11.14 % 51PProjectsformba.blogspot.com
  52. 52. Projectsformba.blogspot.com Different Type of Investment in India and Risk – Return Associated With It:-1) Life Insurance Policy:- In India the life insurance corporation offers different types ofpolicies tailor made to suit the varied age group in society. The WholeLife Policies, Limited – Payment Life Policy, Convertible Whole LifeAssurance Policy, Endowment Assurance Policy, Jeevan Mitra, TheSpecial Endowment Plan with Profits, Jeevan Saathi, The New MoneyBack Plan, Marriage Endowment, Children’s Differed EndowmentAssurance Policy, Jeevan Dhara have gained immense popularity amongall classes of people. In LIC there is some scheme have eligible forexemption from tax under section 80C of the Income Tax Act, 1961. Riskassociated with Insurance Corporation is as follow: HighRIS ModerateK Low Low Moderate High RETURN 52PProjectsformba.blogspot.com
  53. 53. Projectsformba.blogspot.com2) Bank Deposits:- Commercial Bank has been extending deposits facilities to thepublic and has been the Indian investor’s greatest investment opportunity.The various schemes offered by commercial Banks are in the categoriesof saving accounts. Fixed Deposits, recurring deposits, monthly re-payment plan, cash certificates, children’s deposits schemes andretirement plans. The saving account offers an interest rate of 4% perannum. One fixed deposits the banks give a rate of 6.5% per annum. HighRIS ModerateK Low Low Moderate High RETURN 53PProjectsformba.blogspot.com
  54. 54. Projectsformba.blogspot.com3) Provident Funds:- Many employers offer recognized provident Fund schemes for thebenefit of their employees. In general employees are obliged to contributea minimum of 8.33% of their salary every month to the PPF, however,they may in certain cases contribute up to a maximum of 30% of theirsalary, Whatever, may be the employee’s contribution, the employer’scontribution is generally restricted to 8.33% only. Employees owncontribution can be claimed as a deduction form his total income undersection 80C of income Tax Act. The interest on Provident Funds is now10 % per annum. The prime benefit of the provident fund is the facility ofloan up to 755 of the sum contributed. HighRIS ModerateK Low Low Moderate High RETURN The SBI and its subsidiaries operate the public provident fundsschemes. It is a 15 year scheme. A minimum sum of Rs. 100/- has to bedeposited every year in this fund; the maximum amount which can be 54PProjectsformba.blogspot.com
  55. 55. Projectsformba.blogspot.comdeposited in this fund, is Rs.20,000/- in one year. The rate of interest onthe PPF is 12% per annum. The PPF scheme offers both income Tax andWealth Tax benefits. The deposits made every year qualify for deductionunder section 80C and the interest is completely tax free, in addition,loans can also be taken after one year from the close of the year in whichthe account was opened.4) Equity Shares: - The investment in equity share has a number of positive aspectassociated with it. These are Capital Appreciation as a hedge againstinflation, bonus shares, Right shares, voting rights, marketability, annualdividends and fringe benefits etc. Income tax and wealth tax benefits arealso available to investment in equity share, 50% of the contributionmade by investors in shares of new companies qualifies for deductionunder section 80CC. No deduction is available in under section 80CCAwith effect from 1993-94 except rebate of Section 88. HighRIS ModerateK Low Low Moderate High RETURN 55PProjectsformba.blogspot.com
  56. 56. Projectsformba.blogspot.com5) Government Bonds:- The government bond, there is two categories of these bonds,namely, tax-free and taxable. The tax-free bonds are 9 to 10% bondsissued for Rs.1000; interest compounded half-yearly and payable half-yearly. They have a maturity period of 7 to 10 years with the facility forbuy-back sometimes provided to small investors up to certain limits. Thetaxable bonds yield 13% or above, compounded half-yearly and payablehalf-yearly. They have normally a face value of Rs.1000/- and have buy-back facilities similar to taxable bonds. Income from these bonds is taxexempt up to Rs.12, 000/- under section 80L. HighRIS ModerateK Low Low Moderate High RETURN 56PProjectsformba.blogspot.com
  57. 57. Projectsformba.blogspot.com6) Fixed Deposits with Companies:- Fixed Deposits are invited from the public by different privatesector companies. Their major selling point is the high rates of interest,which they offer. Some of these companies offer even up to 16% returnper annum on deposits; the risk element is high in fixed deposits sincethey are absolutely unsecured. In addition, there are no tax benefits, Anexample, may be cited of a well known company. Orkay Silk Mills, TheCompany delayed the payment of quarterly interest by two months andthe matured amount has not been returned to the depositors. HighRIS ModerateK Low Low Moderate High RETURN 57PProjectsformba.blogspot.com
  58. 58. Projectsformba.blogspot.com7) Debentures:- A debenture is just a loan bond. Debenture holders are lenders butnot owners of the company. They don’t enjoy any voting rights. UsuallyDebentures are of the face value of Rs.100/- each. They carry a fixed rateof interest. The ruling rate in the market for debentures is 10% to 14%.There are no income tax or wealth tax benefits for an investment inDebenture. HighRIS ModerateK Low Low Moderate High RETURN 58PProjectsformba.blogspot.com
  59. 59. Projectsformba.blogspot.com 59PProjectsformba.blogspot.com
  60. 60. Projectsformba.blogspot.com DIVERSIFICATION Risk Reduce through Diversification:- The process of combining securities in a portfolio is known asdiversification. The aim of diversification is to reduce total risk withoutsacrificing portfolio return. To understand the mechanism and power ofdiversification, it is necessary to consider the impact of covariance orcorrelation on portfolio risk more closely. We shall examine three cases:(1) when security returns are perfectly positively correlated, (2) whensecurity returns are perfectly negatively correlated and (3) when securityreturns are not correlated. Diversification means, investment of funds in more than one riskyasset with the basic objective of risk reduction. The lay man can makegood returns on his investment by making use of technique ofdiversification. Main three forms of diversification:- 1. Simple Diversification, 2. Over Diversification, 3. Efficient Diversification.(1) Simple Diversification: It involves a random selection of portfolio construction. Thecommon man could make better returns by making a randomdiversification of investments. It is the process of altering the mix ratio ofdifferent components of a portfolio. The simple diversification can reduceunsystematic risk. The research studies on portfolio found that 10 to 15 60PProjectsformba.blogspot.com
  61. 61. Projectsformba.blogspot.comsecurities in a portfolio will bring sufficient amount of returns. Further,this concept reveals that the prediction should be based on a scientificmethod.(2) Over Diversification: - Investors have the freedom to choose many investment alternativesto achieve the desired profit on his portfolio. However, the investor shallhave a great knowledge regarding a large number of financial assetsspreading different sectors, industries, companies. The investors alsomore careful about the liquidity of each investment, return, tax liability,the performance of the company etc. Investors find problems to handlethe large number of investments. It involves more transaction cost andmore money will be spent in managing over diversification. If anyinvestor involves in over diversification, there may be a chance either toget higher return or exposure to more risk. All the problems involved inthis process may result in inadequate return on the portfolio.(3) Efficient Diversification:- Efficient diversification means a combination of low risk involvedsecurities and high risk instruments. The combination will only befinalized after considering the expected return from an individual securityand it does inter relationship with other components in a portfolio. Thesecurities shall have to be evaluated and thus diversification to berestricted to some extent. Efficient diversification assures the better returnat an accepted level of risk. 61PProjectsformba.blogspot.com
  62. 62. Projectsformba.blogspot.com Importance of Diversification:- If you invest in a single security, your return will depend solely onthat security; if that security flops, your entire return will be severelyaffected. Clearly, held by itself, the single security is highly risky. If you add nine other unrelated securities to that single securityportfolio, the possible outcome changes—if that security flops, yourentire return wont be as badly hurt. By diversifying your investments,you have substantially reduced the risk of the single security. However,that securitys return will be the same whether held in isolation or in aportfolio. Diversification substantially reduces your risk with little impact onpotential returns. The key involves investing in categories or securitiesthat are dissimilar: Their returns are affected by different factors and theyface different kinds of risks. Diversification should occur at all levels of investing.Diversification among the major asset categories—stocks, fixed-incomeand money market investments—can help reduce market risk, inflationrisk and liquidity risk, since these categories are affected by differentmarket and economic factors. Diversification within the major asset categories—for instance,among the various kinds of stocks (international or domestic, forinstance) or fixed-income products—can help further reduce market andinflation risk. And as shown in the 10-security portfolio, diversification amongindividual securities helps reduce business risk. 62PProjectsformba.blogspot.com
  63. 63. Projectsformba.blogspot.com Diversification process:- The process of diversification has various phases involvinginvestment into various classes of assets like equity, preference shares,money market instruments like commercial paper, inter-corporateinvestments, deposits etc. Within each class of assets, there is furtherpossibility of diversification into various industries, different companiesetc. The proportion of funds invested into various classes of assets,instruments, industries and companies would depend upon the objectivesof investor, under portfolio management and his asset preferences,income and asset requirements. The subject is further elaborated inanother chapter. A portfolio with the objective of regular income would invest aproportion of funds in bonds, debentures and fixed deposits. For suchinvestment, duration of the life of the bond/debenture, quality of the assetas judged by the credit rating and the expected yield are the relevantvariables. Bond market is not well developed in India but debentures, partlyor fully convertible into equity are in good demand both from individualsand mutual funds. The portfolio manager has to use his analytical powerand discretion to choose the right debentures with the required duration,yield and quality. The duration and immunization of expected inflows offunds to the required quantum of funds have to be well planned by theportfolio manager. Research and high degree of analytical power ininvestment management and bond portfolio management are necessary. The bond investment are thus equally challenging as equitiesinvestment and more so in respect of money market instruments. Allthese facts bring out clearly the needed analytical powers and expertise ofportfolio manager. 63PProjectsformba.blogspot.com

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