Investment Analysis and

Portfolio Management
 The Life of every man is a diary in which he
means to write one story, and writes another;
and his humblest hour is when he compares
the volume as it is with what he vowed to
make it.

- J.M. Barrie

2
 The Portfolio Perspective

Evaluate in
isolation?

Evaluate as a
portfolio?
 Introduction
The portfolio perspective refers to evaluating
individual investments by their contribution to the
risk and return of an investor's portfolio. The
alternative to taking a portfolio perspective is to
examine the risk and return of individual
investments in isolation. An investor who holds all
his wealth in a single stock because he believes it
to be the best stock available is not taking the
portfolio perspective-his portfolio is very risky
compared to holding a diversified portfolio of stocks.
 Introduction
Modern portfolio theory concludes that the extra risk from
holding only a single security is not rewarded with higher
expected investment returns. Conversely, diversification
allows an investor to reduce portfolio risk without necessarily
reducing the portfolio's expected return.

In the early 1950s, the research of Professor Harry Markowitz

provided a framework for measuring the risk-reduction
benefits of diversification. Using the standard deviation of
returns as the measure of investment risk, he investigated
how combining risky securities into a portfolio affected the
portfolio's risk and expected return. One important conclusion
of his model is that unless the returns of the risky assets are
perfectly positively correlated, risk is reduced by diversifying
across assets.
 Introduction
In the early 1950s, the research of Professor
Harry Markowitz provided a framework for
measuring the risk-reduction benefits of
diversification. Using the standard deviation of
returns as the measure of investment risk, he
investigated how combining risky securities into
a portfolio affected the portfolio's risk and
expected return. One important conclusion of
his model is that unless the returns of the risky
assets are perfectly positively correlated, risk is
reduced by diversifying across assets.
 Introduction
In the 1960s, professors Treynor, Sharpe, Mossin, and Lintner
independently extended this work into what has become
known as modern portfolio theory (MPT). MPT results in
equilibrium expected returns for securities and portfolios that
are a linear function of each security's or portfolio's market risk
(the risk that cannot be reduced by diversification).

One measure of the benefits of diversification is the

diversification ratio. It is calculated as the ratio of the risk of an
equally weighted portfolio of n securities (measured by its
standard deviation of returns) to the risk of a single security
selected at random from the n securities. Note that the
expected return of an equal-weighted portfolio is also the
expected return from selecting one of the n portfolio securities
at random (the simple average of expected security returns in
both instances).
 EXHIBIT 4-4 The Importance of the Portfolio
Perspective
Yue Yuen Cathay Hutchinson Li & Fung COSCO Equally
Industrial Pacific Whampoa Pacific Weighted
Airways Portfolio

Mean annual 7.3% 8.7% 12.3% 32.8% 14.2% 15.1%

return

Annual
standard 20.2% 25.4% 18.1% 29.5% 31.3% 17.9%
deviation

Mean annual return, randomly selected security = 15.1%

Annual standard deviation, randomly selected security = 24.9%
Diversification ratio = 17.9% 24.9% 71%
Source: Datastream
EXHIBIT 4-5 Optimal Portfolios for a Sample of
HKSE Shares

Optimal
Portfolio
s

Source: Datastream
Key Tenets of Modern Portfolio
Theory
Representative Investment Motives for
Individual Investors
Banks, Insurance Companies, and Investment
Companies
 Introduction
Portfolio Management: The management of a group of
investment. Ideally the investment should have different
patterns of returns over time.

Phases of Portfolio Management:

1.Security Analysis
2.Portfolio Analysis
3.Portfolio Selection
4.Portfolio revision
5.Portfolio evaluation
Investors make two major steps or decisions in
constructing their own portfolios
Portfolio is simply collection of investment assets

The asset allocation decision is the choice among

broad asset classes such as stocks, bonds, real
estate, commodities, and so on.

The security selection decision is the choice of

which particular securities to hold within each
asset class.

14
 Stock Selection Philosophy
Fundamental analysis
Technical analysis

15
 Fundamental Analysis
A fundamental analyst tries to discern the
logical worth of a security based on its
anticipated earnings stream

The fundamental analyst considers:

Financial statements
Industry conditions
Prospects for the economy
16
 Technical Analysis
A technical analyst attempts to predict the
supply and demand for a stock by observing
the past series of stock prices

Financial statements and market conditions

are of secondary importance to the technical
analyst

17
 Security Analysis
A three-step process
1) The analyst considers prospects for the
economy, given the state of the business
cycle
2) The analyst determines which industries are
likely to do well in the forecasted economic
conditions
3) The analyst chooses particular companies
within the favored industries
18
 An understanding of the risk/return trade-off
Assets with higher expected returns have greater
risk.
Higher risk assets offer higher expected returns
than lower-risk assets.
Risk tolerance: The investors willingness to accept
higher risk to attain higher expected returns.
Risk aversion: The investor is also reluctant to
accept risk
An investors objectives can be classified as return
requirement and risk tolerance

19
 Investors Constraints
Constraints are the kind of financial circumstances imposed on
an investors choice.
Five common types of constraints are:
1. Liquidity: refers to how easy an asset can be converted to
cash
2. Investment horizon: is the planned liquidation duration of
investment.
3. Regulations: Professional and institutional investors are
constrained by regulations- investors who manage other
peoples money have fiduciary responsibility to restrict
investment to assets that would have been approved by a
prudent investor.

20
 Investors Constraints
4.Tax considerations: special considerations
related to tax position of the investor. The
performance of any investment strategy are
always measured by its rate of return after tax.

5.Unique needs: often centre around the

investors stage in the life cycle such as
retirement, housing and childrens education.

21
 Portfolio Management (contd)
Market efficiency and portfolio
management
A properly constructed portfolio achieves a
given level of expected return with the least
possible risk
Portfolio managers have a duty to create the
best possible collection of investments for each
customers unique needs and circumstances

22
 Purpose of Portfolio Management
Portfolio management primarily involves
reducing risk rather than increasing return
Consider two $10,000 investments:
1) Earns 10% per year for each of ten years (low
risk)
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%,
-12%, and 10% in the ten years, respectively (high
risk)

23
Low Risk vs. High Risk Investments
(contd)
1) Earns 10% per year for each of ten years (low risk)
Terminal value is $25,937
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%,
-12%, and 10% in the ten years, respectively (high
risk)
Terminal value is $23,642

The lower the dispersion of returns, the greater the

terminal value of equal investments

24
 Portfolio Management
Passive management has the
following characteristics:
Follow a predetermined
investment strategy that is
invariant to market conditions or

Do nothing

25
Portfolio Management (contd)
Active management:
Requires the periodic changing of
the portfolio components as the
managers outlook for the market
changes

26
 Risk Versus Uncertainty
Uncertainty involves a doubtful outcome
What you will get for your birthday
If a particular horse will win at the track

Risk involves the chance of loss

If a particular horse will win at the track if
you made a bet

27
 Risk and Return
Risk and return are the two
most important attributes
of an investment.

Research has shown that the

two are linked in the Return
capital markets and that %
generally, higher returns
can only be achieved by Risk Premium
taking on greater risk.
RF
Risk isnt just the potential Real Return

loss of return, it is the Expected Inflation Rate

potential loss of the Risk

entire investment itself
(loss of both principal and
interest).

28
 Why Do Individuals Invest ?

By saving money (instead of spending it), individuals tradeoff

present consumption for a larger future consumption.

Characteristics of Investment: All investments are characterized by

certain features which include inter alia:
1. Return
2. Risk
3. Safety
4. Liquidity
 Objectives of Investment
1. Maximization of return
2. Minimization of risk
3. Hedge against inflation

Investment Vs. Speculation: Investment is distinguished from

speculation with respect to three factors, viz. (1) Risk; (2) Capital
Gain; (3) Time period.
An investor generally commits his/her funds to low risk investment, whereas a
speculator commits funds to a higher risk investment.
The speculators motive is to achieve profits through price changes, i.e., he/she
is interested in capital gains rather than income from investment.
Investment is long-term in nature, whereas speculation is short-term.
 Cont

Investment vs Gambling: Gambling consist in taking

high risks not only for high returns, but also for thrill
and excitement. It is unplanned and non scientific,
undertaken without the knowledge of the nature of the
risk involved.

Investment is an attempt to carefully plan, evaluate and

allocate funds to various investment outlets which offer
safety of principal and moderate and continuous return
over a long period of time. Gambling is quite opposite
of investment.
 Cont..
Investment Avenues:
1.Corporate securities
2.Deposits in banks and non-banking companies
3.Mutual funds schemes
4.Post office deposits and certificates
5.Life insurance policies
6.Provident fund schemes
7.Government securities
How Do We Measure The Rate Of
Return On An Investment ?
The pure rate of interest is the
exchange rate between future
consumption and present
consumption. Market forces
determine this rate.

$ 1 . 00 4 % $ 1 . 04
How Do We Measure The Rate Of
Return On An Investment ?
Peoples willingness to pay the
difference for borrowing today and
their desire to receive a surplus on
their savings give rise to an interest
rate referred to as the pure time
value of money.
How Do We Measure The Rate Of
Return On An Investment ?
If the future payment will be
diminished in value because of
inflation, then the investor will
demand an interest rate higher than
the pure time value of money to also
cover the expected inflation expense.
How Do We Measure The Rate Of
Return On An Investment ?
If the future payment from the
investment is not certain, the
investor will demand an interest
rate that exceeds the pure time
value of money plus the inflation
rate to provide a risk premium to
cover the investment risk.
Defining an Investment
A current commitment of $ for a
period of time in order to derive
future payments that will
compensate for:
the time the funds are committed
the expected rate of inflation
uncertainty of future flow of funds.
 Measures of
Historical Rates of Return
Holding Period Return 1.1

Ending Value of Investment

HPR
Beginning Value of Investment
$220
1.10
$200
 Measures of
Historical Rates of Return
1.2

Holding Period Yield

HPY = HPR - 1
1.10 - 1 = 0.10 = 10%
 Measures of
Historical Rates of Return
Annual Holding Period Return
Annual HPR = HPR 1/n
where n = number of years investment is held

Annual Holding Period Yield

Annual HPY = Annual HPR - 1
 Measures of
Historical Rates of Return
1.4
Arithmetic Mean

AM HPY/ n
where :

HPY the sum of annual

holding period yields
 Measures of
Historical Rates of Return
1.5
Geometric Mean
GM HPR
1
n 1
where :
the product of the annual
holding period returns as follows :
HPR 1 HPR 2 HPR n
A Portfolio of Investments
The mean historical rate of return for
a portfolio of investments is
measured as the weighted average of
the HPYs for the individual
investments in the portfolio.
 Computation of Holding
Period Yield for a Portfolio Exhibit 1.1

# Begin Beginning Ending Ending Market Wtd.

Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
A 100,000 $ 10 $ 1,000,000 $ 12 $ 1,200,000 1.20 20% 0.05 0.010
B 200,000 $ 20 $ 4,000,000 $ 21 $ 4,200,000 1.05 5% 0.20 0.010
C 500,000 $ 30 $ 15,000,000 $ 33 $ 16,500,000 1.10 10% 0.75 0.075
Total $ 20,000,000 $ 21,900,000 0.095

$ 21,900,000
HPR = = 1.095
$ 20,000,000

HPY = 1.095 -1 = 0.095

= 9.5%
 Expected Rates of Return
Risk is uncertainty that an
investment will earn its expected
rate of return
Probability is the likelihood of an
outcome
 Expected Rates of Return
1.6
Expected Return E(R i )
n

( Probabilit y of Return) (Possible

i 1
Return)

[(P1 )(R 1 ) (P 2 )(R 2 ) .... (P n R n )

n

i i
(P
i 1
)(R )
 Risk Aversion
The assumption that most investors
will choose the least risky
alternative, all else being equal and
that they will not accept additional
risk unless they are compensated in
the form of higher return
 Measuring the Risk of
Expected Rates of Return 1.7

Variance ( )
n

(Probabilit
i 1
y) (Possible Return - Expected Return) 2

i i
(P
i 1
)[R E(R i )] 2
 Measuring the Risk of
Expected Rates of Return 1.8

Standard Deviation is the square

root of the variance

i i
P [R
i 1
- E(R i )] 2
 Measuring the Risk of
Expected Rates of Return 1.9

Coefficient of variation (CV) a measure of

relative variability that indicates risk per unit
of return
Standard Deviation of Returns
Expected Rate of Returns
i

E(R)
 Measuring the Risk of
Historical Rates of Return 1.10

n
[ HPYi E ( HPY)
2 2/n

i 1

2
variance of the series
HPYi holding period yield during period I
E(HPY) expected value of the HPY that is equal
to the arithmetic mean of the series
n the number of observations
 Determinants of
Required Rates of Return
Time value of money
Expected rate of inflation
Risk involved
The Real Risk Free Rate (RRFR)

Assumes no inflation.
Assumes no uncertainty about
future cash flows.
Influenced by time preference for
consumption of income and
investment opportunities in the
economy
 Adjusting For Inflation 1.12

Real RFR =

(1 Nominal RFR)
(1 Rate of Inflation) 1

 Nominal Risk-Free Rate
Dependent upon
Conditions in the Capital Markets
Expected Rate of Inflation
 Adjusting For Inflation 1.11

Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1
 Facets of Fundamental Risk
Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk
 Business Risk

Uncertainty of income flows caused by

the nature of a firms business
Sales volatility and operating leverage
determine the level of business risk.
 Financial Risk
Uncertainty caused by the use of debt
financing.
Borrowing requires fixed payments which
must be paid ahead of payments to
stockholders.
The use of debt increases uncertainty of
stockholder income and causes an increase
in the stocks risk premium.
 Liquidity Risk
Uncertainty is introduced by the secondary
market for an investment.
How long will it take to convert an investment
into cash?
How certain is the price that will be received?
 Exchange Rate Risk
Uncertainty of return is introduced by
acquiring securities denominated in a
currency different from that of the investor.

Changes in exchange rates affect the

investors return when converting an
investment back into the home currency.
 Country Risk
Political risk is the uncertainty of returns
caused by the possibility of a major change
in the political or economic environment in
a country.
Individuals who invest in countries that
have unstable political-economic systems
must include a country risk-premium when
determining their required rate of return
 Risk Premium
f (Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk,
Country Risk)
or
f (Systematic Market Risk)
 Risk Premium
and Portfolio Theory
The relevant risk measure for an
individual asset is its co-movement
with the market portfolio
Systematic risk relates the variance of
the investment to the variance of the
market
Beta measures this systematic risk of
an asset
 Fundamental Risk
versus Systematic Risk
Fundamental risk comprises business
risk, financial risk, liquidity risk, exchange
rate risk, and country risk
Systematic risk refers to the portion of an
individual assets total variance attributable
to the variability of the total market
portfolio
 Relationship Between
Risk and Return Exhibit 1.7

Rateof Return (Expected)

Security
Low Average High
Risk Risk Risk Market Line

The slope indicates the

RFR required return per unit of risk

Risk
(business risk, etc., or systematic risk-beta)
Changes in the Required Rate of Return
Due to Movements Along the SML
Expected Exhibit 1.8
Rate
Security
Market Line

Movements along the curve

that reflect changes in the
RFR risk of the asset
Risk
(business risk, etc., or systematic risk-beta)
 Changes in the Slope of the SML
1.13

RPi = E(Ri) - NRFR

where:
RPi = risk premium for asset i
E(Ri) = the expected return for asset i
NRFR = the nominal return on a risk-free asset
 Market Portfolio Risk 1.14

The market risk premium for the market

portfolio (contains all the risky assets in the
market) can be computed:
RPm = E(Rm)- NRFR where:
RPm = risk premium on the market portfolio
E(Rm) = expected return on the market portfolio
NRFR = expected return on a risk-free asset