NEED FOR

PORTFOILO

WEALTH INDICES OF INVESTMENTS

IN THE US CAPITAL MARKETS
(YEAR-END 1925 =$ 1.00)

TREASURY BILLS
Stability of principal value is the great
virtue of T-bills. But the price paid for this
advantage is the rate of return that is only
marginally ahead of inflation
The compound annual return from T-bills
over the 80-year period was 3.7%
compared with compound annual inflation
of 3% over the same period
What if the returns are adjusted for tax
rate
Does it mean that T-bills are not worth
investing? Beware of money illusion while
investing in short term instruments

TREASURY BILLS
Inflation may erode the purchasing power of
your money invested in short term
instruments.
Example:
A widow aged 54 with 30-years of life
expectancy invests her money in 4% CD
interest rate. The amount available for
investment is Rs. 2500,000 With an average
inflation of 3% during the period how much
her wealth grow to at the end of the period if
she consumes the entire yearly interest
income?

CONSOLIDATED RESULTS (19262005)

EQUITY RISK PREMIUM

WHY PORTFOLIO

Let every man divide his money into

three parts, and invest a third in
land, a third in business, and a third
let him keep in reserve
- Talmud (c. 1200 BC-500 AD)

BEAR MARKET PERFORMANCE

(MARCH 24, 2000-OCTOBER 9, 2002)
ASSET CLASS

CUMULATIVE TOTAL
RETURN *

U.S. Bonds (taxable, high quality, Intermediate

term)

+29%

U.S. Stocks (large company)

-47%

Real Estate Securities (REITs)

+34%

ASSET ALLOCATION STRATEGY

/3 U.S. Bonds

-22% **

/3 U.S. Stocks

TALMUD STRATEGY
/3 U.S. Bonds

/3 U.S. Stocks

+5% **

/3 Real Estate Securities

*With full reinvestment of income. Rounded off to nearest percent.

** Buy and hold performance without periodic rebalancing. Rounded off to nearest

PORTFOLIO
One third allocated to fixed income
mitigates the volatility risk inherent in
two-thirds allocated to equity
investments.
Diversification across equity asset
classes with dissimilar patterns of
returns mitigate downside risk without
resorting to diversification into asset
classes with lower expected returns
Multiple-asset-class investing is a
smart strategy

SOME BASIC
ASSUMPTIONS

An investor wants to maximize the returns

from investments for a given level of risk
i.e. the investors are risk averse.
The full spectrum of investments must be
considered.
Your portfolio should include all of your
assets and liabilities, not only your stocks.
A good portfolio is not simply a collection of
individually good investments.

SOME BASIC
ASSUMPTIONS
Creation of an optimum investment
portfolio is not simply a matter of
combining a lot of unique individual
securities that have desirable riskreturn characteristics.
Relationship
among
the
investments is extremely important
in portfolio
construction.
n
E (R Port) = Wi E(R i)
i=1

EXPECTED RETURN FROM

INDIVIDUAL ASSETS VS.
PORTFOLIO

MEASURING RISK
The
variance,
or
standard
deviation, is a measure of the
variation of possible rates of
return, Ri , from the expected rate
of return [E(Ri)] as
Covariance is a measure of the
degree to which two variables
move together relative to their
individual mean values over time.
In portfolio analysis, we usually are
concerned with the covariance of
rates of return rather than prices
or some other variable.
Standardizing the covariance by
the individual standard deviations
yields the correlation coefficient
(rij), which can vary only in the
range 1 to +1.

VARIANCE AND STANDARD

DEVIATION OF INDIVIDUAL
ASSETS

COVARIANCE

COVARIANCE

COVARIANCE VS.
CORRELATION

COVARIANCE VS.
CORRELATION

HARRY MARKOITZS
PORTFOLIO SELECTION
MODEL
Assumptions:
1. Investors consider each investment alternative as being
represented by a probability distribution of expected returns
over some holding period.
2. Investors maximize 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 return, investors
prefer less risk to more risk.
Under these 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.

PORTFOLIO
RISK
The standard deviation for a portfolio

of assets is a function of the weighted

average of the individual variances
(where the weights are squared), plus
the weighted covariances between all
the assets in the portfolio.
The standard deviation for a portfolio
of assets encompasses not only the
variances of the individual assets but
also includes the covariances between
pairs of individual assets in the
portfolio. Further, it can be shown that,
in a portfolio with a large number of
securities, this formula reduces to the
sum of the weighted covariances.
The important factor to consider when
adding an investment to a portfolio that
contains a number of other investments
is not the investments own variance
but its average covariance with all the
other investments in the portfolio.

PORTFOLIO WITH
PERFECTLY NEGATIVE
CORRELATED SECURITIES

IMPACT OF CORRELATION ON
PORTFOLIO RISK-RETURN
Combining assets
that are not perfectly
correlated does not
affect the expected
return of the portfolio
But it does reduce
the risk
(standard
deviation)
of
the
portfolio.
Risk is eliminated
when we reach the
ultimately
combination
of
perfectly
negative
correlation.

PORTFOLIO RISK AND

RETURN PLOTS FOR
DIFFERENT WEIGHTS

THE EFFICIENT FRONTIER