Portfolio analysis

This is a presentation, i made for the M.com 4th sem seminar.

1. PORTFOLIO ANALYSIS by , VIVEK G KRISHNAN

2. SECURITY ANALYSIS Deals with the analysis of securities within the framework of return and risk. It is the analysis of tradable financial instruments called securities i.e. Debt securities, equities, or some hybrid of the two. More broadly, future contracts and the credit derivatives are sometimes included. It is divided into: 1. Fundamental analysis: which relies upon the examination of fundamental business factors such as financial statements, current interest rates as well as competitor’s products and financial market.

3. SECURITY ANALYSIS 2. Technical Analysis:  analysis of securities and helps the finance professionals to forecast the price trends through past price trends and market data.

4. PORTFOLIO ANALYSIS Portfolio analysis begins where security analysis ends. Portfolio refers to invest in a group of securities rather to invest in a single security. “Don’t put all your eggs in one basket”. Portfolio analysis is the determination of the future risk and return in holding various combinations of individual securities. Portfolio analysis helps to make the investment activity more rewarding and less risky.

5. PORTFOLIO ANALYSIS Portfolio analysis is broadly carried out for each asset at two levels: * Risk aversion : This method analyzes the portfolio composition while considering the risk appetite of an investor. Some investors may prefer to play safe and accept low profits rather than invest in risky assets that can generate high returns. * Analyzing returns : While performing portfolio analysis, prospective returns are calculated through the average and compound return methods. An average return is simply the arithmetic average of returns from individual assets. However, compound return is the arithmetic mean that considers the cumulative effect on overall returns.

6. PORTFOLIO ANALYSIS The concept of diversification goes side by side with the portfolio analysis. Diversification aims at reduction and even elimination of non systematic risk and achieving the specific objective of the investors. An investor can even estimate his expected return and expected risk level of a given portfolio of assets from proper diversification .

7. TRADITIONAL VS MODERN PORTFOLIO ANALYSIS TRADITIONAL PORTFOLIO ANALYSIS T raditional theory analysis the individual securities under the constraint of risk and return. This theory assumes that the selection of securities should be on the basis of lowest risk as measured by its standard deviation from the mean of expected returns. There exists a direct relationship between the variability of returns and risk under this approach. The greater is the variability of returns, the greater is the risk and the vice versa.

8. TRADITIONAL VS MODERN PORTFOLIO ANALYSIS Thus, the investor chooses assets with lowest variability of returns. The method of finding the return on an individual security is by finding out * the amounts of dividend that have been given by the company. * the price earnings ratio. * the common holding period, and * the estimation of market value of shares.

9. TRADITIONAL VS MODERN PORTFOLIO ANALYSIS MODERN PORTFOLIO ANALYSIS Modern Portfolio theory (MPT) a hypothesis put forth by Harry Markowitz in his paper "Portfolio Selection," (published in 1952 by the Journal of Finance). It is an investment theory based on the idea that risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. The modern portfolio theory emphasis the need for maximization of returns through a combination of securities whose total variability is lower. It is not necessary that the success could be achieved by trying to get all securities of minimum risk.

10. TRADITIONAL VS MODERN PORTFOLIO ANALYSIS 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. 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 the 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.

11. RETURN ON PORTFOLIO The return on portfolio measures the rate of return on a portfolio measured over a period of time. Each security in a portfolio contributes returns in the proportion of its investment in security. The rate of return on a portfolio can be calculated by Weighted Average Rate of return on the various assets within the portfolio. This method is particularly useful for projecting into the future the rate of return on a portfolio, given projections of the rates of return on the constituents of the portfolio.

12. RETURN ON PORTFOLIO The calculation of the rate of return on a portfolio can be expressed by the formula: where, r = rate of return on portfolio. A i = the weight of asset i in the portfolio. r i = the rate of return on asset i in the portfolio.

13. RETURN ON PORTFOLIO Assuming that the investor puts his funds in 5 securities, the holding period return of the portfolio is described in table below: Security Proportion of funds invested in each security Expected return of holding period Contribution of each security to return A 20% 10% 2.00 B 25% 20% 5.00 C 20% 10% 2.00 D 15% 15% 2.25 E 20% 15% 3.00 Weights 100% Weighted return of the portfolio 14.25%

14. RISK ON A PORTFOLIO The risk on a portfolio is not the same as risk on individual securities. The risk on a portfolio is reflected in the variability of returns from zero to infinity. The expected return from probability depends on the probability and their weighted contribution to the risk of the portfolio. The two measure of risk used in this context are: * The average or mean absolute deviation. * The Standard deviation

15. THE AVERAGE ABSOLUTE DEVIATION Event (1) Probability (2) Return (%) (3) Probability of return (4) = (2)x(3) Deviation (5) Probability of deviation (6) = (2)x(5) Probability of absolute Deviation (7) = I 6 I A .10 10 1.0 -5 -0.5 0.5 B .20 -10 -2.0 -25 -5.0 5.0 C .30 20 +6.0 5 1.5 1.5 D .40 25 +10.0 10 4.0 4.0 Expected Return 15.00 Average absolute deviation 11.0

16. THE AVERAGE ABSOLUTE DEVIATION In the table, The expected return is determined. In this case it is 15%. Next, all possible outcomes are analysed to determine the amount by which the value deviates from the expected amount. Column 5 – shows both positive and negative values. Column 6 – weighted average using probabilities as weights equal to 0. Column 7 – to assess the risk, the signs of deviations can be ignored which shows the weighted average of absolute deviations using the probabilities as weights, equal to 11%.

17. THE STANDARD DEVIATION Event (1) Probability (2) Deviation (3) Deviation square (4) = (3) 2 Probability of squared deviation (5) = (2)x(4) A .10 -5 25 2.5 B .20 -25 625 125.0 C .30 5 25 7.5 D .40 10 100 40.0 E Variation 175.0 Standard deviation 13.2287

18. THE STANDARD DEVIATION It is slightly more complex but preferable. In this the deviations are squared, making all values positive. Then the weighted average of these amounts is taken, using the probabilities as weights. The result is termed as variance. It is converted into original units by taking the square root. This result is termed as standard deviation.

19. NON-DIVERSIFIABLE RISK If an investor holds only one stock, there is no question of diversification and his risk is therefore the standard deviation of the stock. For a diversified investor, the risk of the stock is only that portion of the total risk that cannot be diversified away or its non diversifiable risk. The non diversifiable risk is generally measured by Beta ( β ) coefficient. β measure the relative risk associated with any individual portfolio as measured in relation to the risk of the market portfolio

20. NON-DIVERSIFIABLE RISK β = Non diversifiable risk of asset or portfolio A β of 1.0 indicates an asset of average risk, a β greater than 1.0 indicates above average risk and the β less than 1.0 indicates below average risk. In the case of a market portfolio, all the diversification has been done. Thus the risk of portfolio is all non diversifiable risk which cannot be avoided. The beta of the security portfolio is nothing but the weighted average of the betas of the securities that constitute the portfolio, the weights being the proportion of investments in the respective securities as shown in the following table:

21. NON-DIVERSIFIABLE RISK Securities Proportion in the portfolio (weights) Beta Weighted average of betas A 60% 1.5 0.9 B 40% 0.9 0.36 Beta of the portfolio 1.26

22. DIVERSIFICATION OF INVESTMENTS “ Don’t put all eggs in one basket” Diversification is the most basic yet important tool in an intelligent investors hand. If used correctly along with asset allocation, it can be a powerful tool to flaunt and one of the best ways to achieve safe returns on your investment portfolio. Diversification can be defined as “ A risk management technique that mixes a wide variety of investments within a portfolio”. Diversification helps in the reduction of unsystematic risks and promotes the optimisation or maximisation of returns. Diversification may take any of the following forms: (a) Different Assets: Eg - Gold, Bullion, real estate, Government securities etc. (b) Different instruments such as shares, debentures, Bonds etc.

23. DIVERSIFICATION OF INVESTMENTS (c) Different Industries such as Textiles, IT, Pharmaceuticals etc. (d) Different Companies such as New companies, New product Companies etc. (e) Different currencies such as Canadian funds, US dollars and the Euro. (f) Level of liquidity such as term deposits, could be easily cashable. Real estate requires a longer investment horizon. It is because the randomness increases the probability of reducing risk. Some Accepted methods of effecting diversification are as follows:

24. DIVERSIFICATION OF INVESTMENTS 1. Random Diversification Randomness is a statistical technique which involves placing of companies in any order and picking them up in random manner. reduces the probability of choosing wrong companies. Probability of reducing risk will be more. Some experts suggested that random diversification does not bring the expected return results.

25. DIVERSIFICATION OF INVESTMENTS 2. Optimum Number of companies. Investor to find out the optimum number of companies in which to invest the money. If the number of companies is too small , risk cannot be reduced adequately. If the number of companies is too large, there will be diseconomies of scale.

26. DIVERSIFICATION OF INVESTMENTS 3. Adequate Diversification. An intelligent investor has to choose not only the optimum number of securities but the right kind of securities also. Otherwise, the risk cannot be reduced adequately if the companies are positively correlated with each other and the market. In such a case, all of them will move in the same direction and many risks will increase instead if being reduced.

27. DIVERSIFICATION OF INVESTMENTS 4. Markowitz Diversification. A strategy that seeks to combine assets a portfolio with returns that are less than perfectly positively correlated, in an effort to lower portfolio risk (variance) without sacrificing return. An approach taken in order to reduce portfolio risk that involves the use of assets that have returns that are not positively correlated. According to this theory, the effects of one security purchase over the effects of the other security purchase is taken into consideration and then the results are evaluated.