Portfolio Construction - Meaning, Approaches in Portfolio Construction, SAPM Notes

Portfolio Construction
Unit 2 SAPM Notes 
Portfolio analysis and Management

Portfolio Construction

The process of combining together the broad asset classes so as to secure optimum return with minimum risk is called portfolio construction. In other words, it refers to the allocation of funds among a variety of financial assets available for investment. As investor has to make choice out of the following capital and money market instruments and financial assets:

1)      Capital Market Instruments: An investor may invest in any of the following capital instruments:

a)       Equity shares.

b)      Preference shares.

c)       Debentures or bonds.

d)      Zero coupon bonds.

e)      Discount bonds and deep discount bonds.

f)        Secured Premium notes.

2)      Money Market Instruments: The following money market instruments are available for investment:

a)       Commercial bills.

b)      Commercial paper (CP)

c)       Certificates of deposits.

d)      Participation certificates.

e)      Treasury bills.

f)        Inter-bank money etc.

3)      Financial Assets: An investor makes investment in the following assets to secure his future:

a)       Gold or silver.

b)      Real estate.

c)       Buildings.

d)      Insurance policies.

e)      Post office certificates.

f)        NSC or National Savings Certificate.

g)       NSS or National Saving Scheme.

h)      Bank deposits or fixed deposits with reputed companies.

i)        Investment in chit funds.

j)        Pension Funds/G.P.F.

k)       Public Provident Fund (P.P.F)

APPROACHES IN PORTFOLIO CONSTRUCTION

Basically, there are two approaches in the construction of the portfolio of securities.

a)       Traditional Approach.

b)      Modern Approach or Markowitz Approach.

(A) Traditional Approach to Portfolio Construction

Under this approach, investor’s needs in terms of income and capital appreciation are evaluated and appropriate securities are selected. After that risk and return analysis is carried out. Finally, weights are assigned to securities like bonds, stocks and debentures keeping in view the risk and return involved and then diversification is carried out. The following steps may be carried out:

1. Analysis of the constraints: It involves analysis of constraints of the investor within which the objectives will be formulated. The constraints may be decided on the basis of:

a) Income needs: Investors need for current income and constant income.

b) Liquidity needs: Investors preference for liquid assets.

c) Safety of principal: Safety of principal value at the time of liquidation.

d) Time horizon: Life cycle stage and investment planning period of the investor.

e) Tax consideration: Tax benefits of investment in a particular asset.

f) Temperament: Risk bearing capacity of the investor.

2. Determination of Objectives of Investors: It involves formulation of objectives within the framework of constraints. The basic objective of all investors is to achieve the maximum level of return and minimize the risk involved. Other objectives such as safety, liquidity hedge against inflation etc. are the subsidiary objectives. Some common objectives of the investors are:

a) Current income

b) Growth in income

c) Capital appreciation

d) Preservation of capital

3. Selection of the Securities: The selection of the securities depends upon the various objectives of the investor:

a)       If objective is to earn adequate amount of current income, then more of debt and less of equity would be a good combination.

b)      If the investor wishes a certain percentage of growth in the income from his investment, then he may have more of equity shares (say more than 60%) and less of debt (say 0-40%) in his portfolio. Inclusion of debt in portfolio helps the investor to avail of tax benefits.

c)       If the investor wants to multiply his investment over the years, he may invest in land or housing schemes. These investments offer faster rate of capital appreciation but lack liquidity. In stock market, the value of shares multiplies at much higher rates but involve risk.

d)      The investor’s portfolio may consist of more of debt instruments than equity shares with a view to ensure more safety of the principal amount.

4. Risk and Return Analysis: The objective of portfolio management is to maximize the return and minimize the risk. Risk is uncertainty of income/capital appreciation or loss of both. The two types of risks evolved are:

a)       Systematic or market related risks arises due to non-availability of raw material, interest rates fluctuations, inflation, import and export policy of the government., taxation policy, government policies, general business risk, financial risk etc.

b)      Unsystematic risk or company related risk due to mismanagement, defective sales policies, increasing inventory, faulty financial policies, labour problems, defective marketing of products resulting into decreased demand etc.

5. Diversification: The unsystematic risks or company related risks involved in investment and portfolio management can be reduced and returns can be optimized through diversification i.e. by carefully selecting variety of the assets, instruments, industry and scrip of companies’/government securities. When different assets are added to the portfolio, the total risk tends to decrease.