Portfolio Analysis - Tradintional and Modern
Unit 2 SAPM Notes
Portfolio analysis and Management
Portfolio Management and Security Analysis
Portfolio
management: Portfolio management is a dynamic concept and
requires continuous and systematic analysis, judgement and operations. It is a
process involving many activities of investment in assets and securities.
Firstly, it involves construction of a portfolio based upon the data base of
the client/investor, his objectives, constraint preferences for risk and return
etc. On the basis of above mentioned facts, selection of assets and securities
is made. Secondly, it involves monitoring/reviewing of the portfolio from time
to time in light of changing market conditions. Accordingly changes are
effected in the portfolio. Thirdly, it involves evaluation of the portfolio in
terms of targets set for risk and return and making adjustments accordingly.
Basically, portfolio management involves a
proper decision making as to what to purchase and what to sell. It requires
detailed risk and return analysis and proper money management in terms of
investments in a basket of assets, the basic objective being reduction of risk
and maximization or return.
Security Analysis: Security analysis involves an examination of expected return and accompanying risks. Securities that have return and risk characteristics of their own, in combination make up a portfolio. The entire process of estimating return and risk for individual securities is known as ‘securities analysis’. Portfolio analysis begins when security analysis ends. Investments are made based on security analysis and decisions involved are what securities to be bought or sold and the extent or proportion of funds to be invested in each. Understanding and measuring risk and return is, therefore, fundamental to the investment process.
PORTFOLIO ANALYSIS
Security analysis deals with the analysis of securities within the
framework of return and risk. Portfolio analysis begins where the security
analysis ends. The concept of portfolio analysis has very important relevance
for investors, because portfolios which are combinations of securities may or
may not take on the aggregate characteristics of their individual parts.
Portfolio analysis deals with the determination of future risk and
return in holding various combinations of individual securities. The portfolio
expected return is the weighted average of the expected returns, from each of the
individual securities, with weights representing the proportionate share of the
security in the total investment. The portfolio expected variance, in contrast,
can be something less than a weighted average of security variances. Therefore,
an investor can sometimes reduce risk by adding another security with greater
individual risk compared to any other individual security in the portfolio.
TRADITIONAL and MODERN PORTFOLIO ANALYSIS
Traditional
portfolio analysis: Traditional portfolio analysis has
been of a very subjective nature for each individual. The investors made the
analysis of individual securities through the evaluation of risk and return
conditions in each security. The normal method of finding the return on an
individual security was by finding out the amounts of dividends that have been
given by the company, the price earning ratios, the common holding period and
by an estimation of the market value of the shares. The traditional theory
assumes that selection of securities should be based on lowest risk as measured
by its standard deviation from the mean of expect returns. The greater the
variability of returns the greater is the risk. Thus, the investor chooses
assets with the lowest variability of returns.
Moreover, Traditional Theory believes that the market is
inefficient and the fundamental analyst can take advantage of the situation. By
analyzing internal financial statements of the company, he can make superior
profits through higher returns. The technical analysts believed in the market
behaviour and past trends to forecast the future of the securities. These
analysis were mainly under the risk and return criteria of single security
analysis.
Modern
Portfolio analysis and Markowitz Model: As
against the Traditional theory the modern Portfolio Theory emphasizes the need
for maximization of returns through a combination of securities whose total
variability is lower. It is not necessary that success can be achieved by
trying to get all securities of minimum risk.
The theory states that by combining a security of low risk with
another security of high risk, success can be achieved by an investor in making
a choice of investments. This theory, thus, takes into consideration the
variability of each security and covariance for their returns reflected through
their interrelationships. Thus, as per the Modern Theory expected returns, the
variance of these returns and covariance of the returns of the securities
within the portfolio are to be considered for the choice of a portfolio. A
portfolio is said to be efficient, if it is expected to yield the highest
return possible for the lower risk or a given level of risk. The modern
Portfolio Theory emphasizes the need for maximization of returns, through a
combination of securities, whose total variability is lower. The risk of each
security is different from that of others and by a proper combination of
securities, called diversification; one can arrive at a combination, where the
risk of one is off set partly or fully by that of the other. Combination of
securities can be made in many ways. Markowitz developed the theory of
diversification through scientific reasoning and method.
MARKOWITZ MODEL
Dr. Harry M. Markowitz was the person who developed the first
modern portfolio analysis model. Markowitz used mathematical programming and
statistical analysis in order to arrange for the optimum allocation of assets
within portfolio. He infused a high degree of sophistication into portfolio
construction by developing a mean-variance model for the selection of portfolio.
Markowitz approach determines for the investors the efficient set of portfolio
through three importance variables - Return, standard deviation and coefficient
of correlation.
Markowitz model is called the “Full Covariance Model”. Through
this method the investor can find out the efficient set of portfolio by finding
out the trade off between risk and return, between the limits of zero and
infinity. Markowitz theory is based on several assumptions these are:
ASSUMPTIONS OF MARKOWITZ’S MODEL
a)
The markets are efficient and absorb
all the information quickly and perfectly. So an investor can earn superior
returns either by technical analysis or fundamental analysis. All the investors
are in equal category in this regard.
b)
Investors
are risk averse. Before making any investments, all of them, have a common
goal-avoidance of risk. But practically this assumption does hold good. In a
country like India, majority of investors invests money on the basis of market
news without doing any technical and fundamental analysis.
c)
Investors are rational. They would
like to earn the maximum rate of return with a given level of income or money.
d)
Investors base their decisions solely
on expected return and variance (or standard deviation) of returns only.
e)
For a given risk level, investors
prefer high returns to lower returns. Similarly, for a given level of expected
return, they prefer less risk to more risk.
f)
The investor can reduce the risk if he
adds investments to his portfolio.
g)
Investors consider each investment alternative
as being represented by a probability distribution of expected returns over
some holding period.
h)
A portfolio of assets under the above
assumptions is considered to be efficient if no other portfolio of assets
offers higher expected return with the same (or lower) risk or lower risk with
the same (or higher) expected return.
PARAMETERS OF MARKOWITZ DIVERSIFICATION
Based on thorough and scientific research, Markowitz has set down
his own guidelines for diversification:
a)
The investments have different types
of risk characteristics. Some are systematic or market related risks and the
others are unsystematic or company related risks.
b)
His diversification involves a proper
number of securities not too less nor too many.
c)
The securities have no correlation or
negative correlation.
d)
Last is the proper choice of the
companies, securities or assets whose returns are not related and whose risks
are mutually off setting to reduce the overall risk.
Markowitz lays down three parameters for building up the efficient
set of portfolio:
a)
Expected returns.
b)
Standard deviation from mean to
measure variability of returns.
c)
Covariance or variance of one asset
return to other asset returns.
To generalize, higher the expected return, lower will be the
standard deviation or variance and lower is the correlation. In such a case,
better will be the security for investor choice. If the covariance of the
securities’ returns is negative or negligible, the total risk of the portfolio
of all securities may be lower as compared to the risk of the individual
securities in isolation.
By developing his model, Markowitz first did away with the
investment behaviour rule that the investor should maximize expected return.
This rule implied that the non-diversified single security portfolio with the
highest expected return is the most desirable portfolio. Only by buying that
single security can expected return be maximized. The single security portfolio
can be much preferred if the higher return turns out to be the actual return.
However, in real world, there are conditions of so much uncertainty that most
risk averse investors, joint with Markowitz in adopting diversification of
securities.
From the above discussion, the following difference between
Traditional Portfolio Theory and Modern Portfolio Theory has been obtained:
Traditional
Portfolio Theory |
Modern
Portfolio Theory |
1. It
deals with the evaluation of return and risk conditions in each security. 2. It
is based on measurement of standard deviation of particular scrip. 3. It
assumes that market is inefficient. 4. It
gives more importance to standard deviation. |
1.
It deals with the maximization of
returns through a combination of different types of financial assets. 2.
It is based on mainly
diversification process. 3.
It assumes that market is perfect
and all information is known to public. 4.
It gives more importance to Beta. |
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