Unit 5 - Portfolio Management TECHNICAL ANALYSIS Course Materials by K.Rajeswari Asst Professor SNS college of technology Unit 5 - Portfolio Management Portfolio Construction

6 Steps to Construct a Portfolio Investors today are confronted with a vast number of investment options and funds to choose from, when constructing an investment portfolio. Coupled with the wide choice of available funds, investors’ emotions can also get in the way of making an appropriate investment selection. By following a structured approach, investors can simplify the fund selection process and avoid emotional decision-making: 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

1. Determine your risk profile Investors generally fall into one of five risk profiles – conservative, cautious, moderate, moderately aggressive or aggressive – according to how much equity exposure they’re willing to take on. An investor’s level of satisfaction with his investment is closely linked to whether it’s in line with his risk profile. Higher risk generally means higher returns, so an aggressive investor probably won’t be satisfied with the returns from a conservative investment portfolio.  It’s important to consider not only how much risk you’re willing to take, but also how much risk you can afford to take. Investors typically fear losses more than they anticipate gains.  It’s therefore necessary to be comfortable with your portfolio’s level of equity exposure. Investors can, however, generally take on more risk if they’re investing over the long term as the impact of the volatility will be smoothed out over the term of the investment. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

2. Strategic Asset Allocation This step involves allocating a percentage of the investment amount to each of the main asset classes:  cash, bonds, equity, property and offshore assets.  The allocation depends on one’s risk profile.  Therefore a conservative investor will have less exposure to growth assets such as equities than a more aggressive investor.  All investors, regardless of their risk profile, should have at least some exposure to all of the asset classes.  Investors who stick to a diversified portfolio tend to do better over the long term. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

3. Tactical Asset Allocation Once the strategic asset allocation process is done, investors can then increase or decrease their exposure within the different ranges of each asset class, once again according to their risk profile. Investors can also select asset allocation funds – in this case the asset managers will make the decision on whether to increase or decrease exposure within a particular asset class.  Investors would do well to select a few managers with different investment styles, as at any given time some will outperform the market and others will underperform. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

4. Fund Selection Only now is the investor ready to make a fund selection.  International research shows that strategic asset allocation accounts for around 90% of the portfolio’s long-term return.  Based on this research it’s often found that the investor’s decision-making process is skewed towards asset allocation rather than  fund selection.  However, fund selection remains an important determinant of the overall success of the portfolio and a qualified financial intermediary will be able to assist investors to identify appropriate funds, suited to their risk profile. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

5. Constructing the Portfolio Once the actual portfolio has been constructed, it can be tested against the investor’s risk profile and investment objectives.  At this stage it’s also important to ensure that exposure isn’t confined to a single sector of the equity market.  This ensures a balanced approach and cushions against market events that could adversely affect a particular sector of the equity market. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

6. Monitoring the Portfolio A risk profile is not cast in stone;  it changes over time due to changes in the investor’s personal financial circumstances.  When it changes, the strategic asset allocation should change as well. Monitoring the portfolio also means re-balancing the asset class exposure when required.  This is because market movements can cause exposure within the asset classes to move outside the strategic asset allocation bands due to one class performing better or worse than another at a particular point in time. Also important when reviewing the portfolio is to pay attention to the performance attribution generated by the various funds.  For example, are your chosen funds performing as you expected them to, and in accordance with their mandate and objective? 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Approaches in Portfolio Construction Commonly, there are two approaches in the construction of the portfolio of securities viz. traditional approach and Markowitz efficient frontier approach. In the traditional approach, investor’s needs in terms of income and capital appreciation are evaluated and appropriate securities are selected to meet the needs of the investor. The common practice in the traditional approach is to evaluate the entire financial plan of the individual. In the modern approach, portfolios are constructed to maximize the expected return for a given level of risk. It views portfolio construction in terms of the expected return and the risk associated with obtaining the expected return 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Traditional approach The traditional approach basically deals with two major decisions. They are: Determining the objectives of the portfolio. Selection of securities to be included in the portfolio. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Steps in Traditional Approach 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Cont… Analysis of constraints: Income needs (current income and constant income) / Liquidity Safety of principal / Time horizon / Tax considerations / Temperaments of the investors. Determination of objectives: Current income / Growth in income / Capital appreciation / Preservation of capital Selection of portfolio: Selection of portfolio depends upon various objectives of investors. A Objective and asset mix / Growth of income and asset mix / Capital appreciation and asset mix / Safety of principal and asset mix. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Cont… Risk and return analysis: The traditional approach to portfolio building has some basic assumptions. First, the individuals prefers larger to smaller returns from securities. To achieve these goal investors has to take more risk. The ability to achieve higher returns is dependent upon his ability to judge risk and his ability to take specific risk. These risks may be interest rate risk, purchasing power risk, financial risk and market risk. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Cont… Diversification: Once the asset mix is determined and risk and return are analyzed, the final step is the diversification of portfolio. Financial risk can be minimized by commitments to top quality bonds, but these securities offer poor resistance to inflation. Stocks provide better inflation protection than bond but are more vulnerable to financial risks. Investors have to select industries appropriate to his investment objectives. Each industry corresponds to specific goals of the investors. Likewise investors has to select two or more companies in each industries as a part of diversification In the stock portfolio, he has to adopt the following steps which are shown in the following figure. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Cont… 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Modern Approach: Modern portfolio theory (MPT)—or portfolio theory —was introduced by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection. Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual securities in constructing their portfolios. Standard investment advice was to identify those securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these. Following this advice, an investor might conclude that railroad stocks all offered good risk-reward characteristics and compile a portfolio entirely from these. Intuitively, this would be foolish. Markowitz formalized this intuition. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Cont… Detailing mathematics of diversification, he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that each individually has attractive risk-reward characteristics. In a nutshell, inventors should select portfolios not individual securities. If we treat single-period returns for various securities as random variables, we can assign them expected values , standard deviations and correlations. Based on these, we can calculate the expected return and volatility of any portfolio constructed with those securities. We may treat volatility and expected return as proxies for risk and reward. Out of the entire universe of possible portfolios, certain ones will optimally balance risk and reward. These comprise what Markowitz called an efficient frontier of portfolios. An investor should select a portfolio that lies on the efficient frontier. 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management

Thanks… 5/28/2018 V.Prabakaran, AP/MBA - IM - Unit-5 Portfolio Management