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PORTFOLIO MANAGEMENT includes range of professional services to manage an

individual or companys securities.

Why Portfolio Management Matters?

Investing in securities and other assets can be complicated and risky. Relying in a portfolio

manager for professional services or relying on your knowledge regarding portfolio management

can be helpful to ensure that investment goals are within reach and levels of risk are within

tolerance levels.

Background Assumptions basic assumption & ground rules

Basic Assumption As an investor, you want to maximize returns for a given level of risk. To

deal with that, we have

Ground Rules

Your portfolio includes all of your assets and liabilities.

Relationship between returns for assets in the portfolio is important.

A good portfolio is not simply a collection of individually good investments.

Risk Aversion - Given a choice between two assets with equal rates of return, most investors will

select the asset with the lower level of risk.

Evidence That Investors are Risk Averse - Many investors purchase insurance for: Life,

Automobile, Health, and Disability Income. The purchaser trades known costs for unknown risk

of loss. But NOT ALL INVESTORS ARE RISK AVERSE. Risk preference may have to do with

amount of money involved - risking small amounts, but insuring large losses.

Definition of Risk

1. Uncertainty of future outcomes or

2. Probability of an adverse outcome

Markowitz Portfolio Theory

Quantifies risk

Derives the expected rate of return for a portfolio of assets and an expected risk measure

Shows that the variance of the rate of return is a meaningful measure of portfolio risk

Derives the formula for computing the variance of a portfolio, showing how to effectively

diversify a portfolio

1. Investors consider each investment alternative as being presented by a probability

distribution of expected returns over some holding period.

2. Investors minimize one-period expected utility, and their utility curves demonstrate

diminishing marginal utility of wealth.

3. Investors estimate the risk of the portfolio on the basis of the variability of expected

returns.

4. Investors base decisions solely on expected return and risk, so their utility curves are a

function of expected return and the expected variance (or standard deviation) of returns

only.

5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a

given level of expected returns, investors prefer less risk to more risk.

Under these five assumptions, a single asset or portfolio of assets is considered to be efficient

if no other asset or portfolio of assets offers higher expected return with the same (or lower)

risk, or lower risk with the same (or higher) expected return.

Alternative Measures of Risk

Variance or standard deviation of expected return

Range of returns

Returns below expectations

Semivariance a measure that only considers deviations below the mean

These measures of risk implicitly assume that investors want to minimize the damage

from returns less than some target rate

Expected Rates of Return

For an individual asset - sum of the potential returns multiplied with the corresponding

probability of the returns

For a portfolio of assets - weighted average of the expected rates of return for the individual

investments in the portfolio

Computation of Expected Return for an Individual Risky Investment

Standard deviation is the square root of the variance

Variance is a measure of the variation of possible rates of return R i, from the expected

rate of return [E(Ri)]

EXAMPLE:

Covariance of Returns

A measure of the degree to which two variables move together relative to their

individual mean values over time.

For two assets, i and j, the covariance of rates of return is defined as:

Covij = E{[Ri - E(Ri)][Rj - E(Rj)] n}

Correlation Coefficient

The correlation coefficient is obtained by standardizing (dividing) the covariance by the

product of the individual standard deviations.

A value of +1 would indicate perfect positive correlation. This means that returns for the two

assets move together in a completely linear manner.

A value of 1 would indicate perfect negative correlation. This means that the returns for two

assets have the same percentage movement, but in opposite directions

RELATIONSH

IP

DISPERSIO

N

COVARIAN

CE

VARIANCE

COEFFICIE

NT

STANDAR

D

DEVIATIO

random variable, you will use Variance which

is the measure of dispersion or scatter.

want to consider the relationship between

them, the strength of their relationship or

how do they move together, you have to

look at the Covariance.

The problem in variance and covariance is that, although they are mathematically convenient,

they are not intuitive for us to use these measures that is why we translate them into intuitive

measures which are standard deviation and correlation coefficient.

The variance is expressed in units squared so we translate it into standard deviation which is

expressed in units to be understandable to us.

We translate the covariance into correlation coefficient which is unit-less wherein it runs from

-1.0 to +1.0. Because it is unit-less, we automatically understand it, the closer it is to +1.0, the

greater the strength of relationship between two random variables.

PORTFOLIO RISK AND RETURN

Portfolio Risk is the variability of the portfolio as a whole

-our measure of portfolio risk is the standard deviation of returns for a portfolio of

assets

Portfolio Standard Deviation Formula

*The PSDF has to components: the assets own variance of returns and the covariance between

the returns of this asset and the returns of every other asset that is in the portfolio.

A. Assets with Equal Risk and Return Changing Correlations:

The lower the correlation/ covariance, the lower the standard deviation/ risk of the

portfolio

If correlation is perfectly positive, the portfolio standard deviation is equal to the

weighted average of the standard deviation of each asset.

If correlation is perfectly negative, portfolio standard deviation is reduced to zero.

B. Assets with Different Risk and Return Changing Correlations:

Just like in the first situation, the lower the correlation/ covariance, the lower the

standard deviation/ risk of the portfolio

Also, if correlation is perfectly positive, the portfolio standard deviation is equal to the

weighted average of the standard deviation of each asset.

But, a perfectly negative correlation does not reduce the risk to zero. This is because

the assets have different risks but with the same weight.

C. Constant Correlation with Changing Weights

Holding two assets with different risks and returns, having a constant correlation

coefficient, at any possible combinations will lead us to different portfolio risks and

portfolio returns. If we plot all these points in a graph, we would derive with a set of

combinations that trace an ellipse starting at Asset 2 and ending at Asset 1.

With two perfectly correlated assets, it is only possible to create a two asset portfolio

with risk-return along a line between either single asset.

With uncorrelated assets, it is possible to create a two asset portfolio with lower risk

than either single asset.

With correlated assets, it is possible to create a two asset portfolio between the first

two curves.

With negatively correlated assets, it is possible to create a two asset portfolio with

much lower risk than either single asset.

With perfectly negatively correlated assets, it is possible to create a two asset portfolio

with almost no risk.

EFFICIENT FRONTIER

- represents the set of portfolios that has the maximum rate of return for every given

level of risk, or the minimum risk for every level of return.

- the frontier will be portfolios of investments rather than individual securities

(exceptions being the asset with the highest return and the asset with the lowest risk)

the efficient frontier are

sub-optimal, because they

do not provide enough

return for the level of risk.

Portfolios that cluster to

the right of the efficient

frontier are also suboptimal, because they have

a higher level of risk for

the defined rate of return.

Investors Utility Curve specifies the trade-offs he is willing to make between expected return

and risk.

Optimal portfolio

- is one that provides the most satisfaction the greatest return for an

investor based on his tolerance for risk.

-it lies at the point of tangency between the efficient frontier and the utility

curve with the highest possible utility

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