INSITITUTE OF BUSINESS AND

TECHNOLOGY (BIZTEK)
The Portfolio Management Process

A four step process:

1. Construct a policy statement
2. Study current financial conditions and
forecast future trends
3. Construct a portfolio
4. Monitor needs and conditions
The Portfolio Management Process

1. Policy statement
 Specifies investment goals and acceptable risk
levels
 The “road map” that guides all investment
decisions
The Portfolio Management Process

2. Study current financial and economic

conditions and forecast future trends
 Determine strategies that should meet goals
within the expected environment
 Requires monitoring and updates since financial
markets are ever-changing
The Portfolio Management Process

3. Construct the portfolio

 Given the policy statement and the expected
conditions, go about investing
 Allocate available funds to meet goals while
managing risk
The Portfolio Management Process

4. Monitor and update

 Revise policy statement as needed
 Monitor changing financial and economic
conditions
 Evaluate portfolio performance

 Modify portfolio investments accordingly

The Policy Statement
 Understand and articulate realistic goals
 Know yourself
 Know the risks and potential rewards from
investments
 Learn about standards for evaluating
portfolio performance
 Know how to judge average performance
 Adjust for risk
The Policy Statement
 Don’t try to navigate
without a map!
 Important Inputs:
 Investment Objectives
 Investment Constraints
Investment Objectives
Need to specify return
and risk objectives
 Need to consider the
risk tolerance of the
investor
 Return goals need to
be consistent with risk
tolerance
 These will change over
time
Investment Objectives

Possible broad goals:

 Capital preservation
 Maintainpurchasing power
 Minimize the risk of loss

 Capital appreciation
 Achieve portfolio growth through capital gains
 Accept greater risk
Investment Objectives
 Current income
 Look to generate income rather than capital
gains
 May be preferred in “spending phase”

 Relatively low risk

 Total return
 Combining income returns and reinvestment
with capital gains
 Moderate risk
Investment Constraints
These factors may limit or at least impact the
investment choices:
 Liquidity needs
 How soon will the money be needed?
 Time horizon
 How able is the investor to ride out several bad years?
 Legal and Regulatory Factors
 Legal restrictions often constrain decisions
 Retirement regulations
Investment Constraints
 Tax Concerns
 Realized capital gains vs. Ordinary income?
 Taxable vs. Tax-exempt bonds?

 Regular IRA vs. Roth IRA?

 401(k) and 403(b) plans

 Unique needs and preferences

 Perhapsthe investor wishes to avoid types of
investments for ethical reasons
Investment Education
 The type of information necessary to construct a
good policy statement is neither “common
sense” or “common knowledge.”
 Many investors fail to diversify.
 Many fail to plan completely.
 Data indicates that many Americans have
greatly under-invested for the future.
 The bottom line: If you do not plan for the future,
you will likely not be prepared for it.
Asset Allocation Decisions

Four decisions in an investment strategy:

 What asset classes should be
considered?
 What should be the normal weight for
each asset class?
 What are the allowable ranges for the
weights?
 What specific securities should be
purchased?
The Importance of Asset Allocation
 Theasset allocation decision (which classes and
at what weights) is very important. Using fund
data:
 About 90% of return variability over time can be
explained by asset allocation.
 About 40% of the differences between returns can be
explained by differences in asset allocation.
 Assetallocation is thus the major factor that
drives portfolio risk and return.
Risk/Return History and Asset
Allocation
Looking at return data on various asset classes
indicate some important factors for investors:
 Over long time horizons, stocks have always
outperformed low-risk investments.
 So the additional risk of stock investing (higher return
standard deviations) over shorter time horizons seems
to all but disappear over time.
 Need to consider real investment returns over taxes and
costs
Asset Allocation and Cultural
Differences
 Differences in social, political, and tax
environments influence asset allocation.
 For instance, 58% of pension fund assets are
invested in equities in the U.S.
 78% in equities in United Kingdom, where high average
inflation impacts this choice
 8% in equities in Germany, where generous
government pensions and greater risk aversion seem to
play a strong role
 Probability Concept
•Random variable
⇒Something whose value in the future is
subject to uncertainty.
•Probability
⇒The relative likelihood of each possible
outcome (or value) of a random variable
⇒Probabilities of individual outcomes cannot
be negative nor greater than 1.0
⇒Sum of the probabilities of all possible
outcomes must equal 1.0
•Moments
⇒Mean, Variance (or Standard deviation),
covariance
 Computing the Basic Statistics

A security analyst has prepared the

following probability distribution of the
possible returns on the common stock
shares of two companies:
Compu-Graphics Inc. (CGI) and Data
Switch Corp. (DSC).
Probability Return on Return on
CGI DSC
0.30 10% 40%
0.50 14% 16%
0.20 20% 20%
 The Mean

For CGI, the mean (or expected) return is:

3
µ =∑pn x n
CGI
n =1

=0.30 (10 %) +0.50 (14 %) +0.20 ( 20 %)

=14 .00 %

Similarly, the mean return for DSC is 24.00%

 The Variance and Standard Deviation

The variance of CGI’s returns is:

N
2
σ 2x = ∑ pn   x n − μ x 
n  =1
2
= 0 .3 01 0− 1 4  0 .5 0  1 4− 1 4  0 .2 02 0− 1 42
2

¿ 1 2. 0 0

The Standard Deviation of CGI’s return is:

σ x = σ = 12.00 =3.46%
2
x
 The Covariance

The covariance of the returns on CGI and

DSC is:

σ =∑pn ( x n −µx )( y n −µy )

N

CD
n=1

=0.30(10−14 )( 40−24 )+0.50(14 −14 )(16 −24 )

+0.20( 20 −14 )( 20−24 )
=− 24 .00
 The Correlation Coefficient

The correlation coefficient between CGI

and DSC is:

σxy
ρxy =
σ x σy
− 24 .00
=
(3.46 )(10 .58 )
=−0.655
 Summary of Results for CGI and DSC

CGI DSC
Mean 14.00% 24.00%
Standard Deviation 3.46% 10.58%

Correlation Coefficient -0.655

 Portfolio Securities

• A portfolio is a combination of two or

more securities.
• Combining securities into a portfolio
reduces risk.
• An efficient portfolio is one that has the
highest expected return for a given level
of risk.
• We will look at two-asset portfolios in
fair detail.
 Portfolio Expected Return and Risk

Expected Return Risk

The Expected
The The Risk The The
Returns
Portfolio of the Portfolio Correlation
of the
Weights Securities Weights Coefficients
Securities
 Portfolio Expected Return and Risk

Portfolio Variance

The square root of variance is standard deviation of the

portfolio.
In equation WA = weight of security A, WB = weight of Security
B
others notation are the standard notations of Standard
Deviation and Coefficients of Correlation
Portfolio Weights and Expected
Return
Portfolio Weights Portfolio’s
CGI DSC Expected Standard
Return Deviation
1.00 0.00 14.00% 3.46%
0.75 0.25 16.50% 2.18%
0.67 0.33 17.33% 2.64%
0.50 0.50 19.00% 4.36%
0.25 0.75 21.50% 7.40%
0.00 1.00 24.00% 10.58%
Portfolio Expected Return and Risk
Home

25%
DSC
Expected Return

20%

15%
CGI

10%
0% 5% 10%
Standard Deviation
 Diversification of Risk

•Note that while the expected return of

the portfolio is between those of CGI and
DSC, its risk is less than either of the two
individual securities.
•Combining CGI and DSC results in a
substantial reduction of risk -
diversification!
•This benefit of diversification stems
primarily from the fact that CGI and DSC’s
returns are not perfectly correlated.
 Correlation Coefficient and Portfolio
Risk
• All else being the same, lower the
correlation coefficient, lower is the
risk of the portfolio.
– Recall that the expected return of the
portfolio is not affected by the
correlation coefficient.
• Thus, lower the correlation
coefficient, greater is the
diversification of risk.
Correlation Coefficient and Portfolio Risk
Consider stocks of two companies, X and
Y. The table below gives their expected
returns and standard deviations.
Stock X Stock Y
Expected Return 10% 25%
Standard Deviation 12% 30%

Plot the risk and expected return of

portfolios of these two stocks for the
following (assumed) correlation
coefficients:
-1.0 0.5 0.0 +0.5 +1.0
Correlation Coefficient and Portfolio Risk

25% Y
Expected Return

Correlation
Coefficient
15% -1.0
-0.5
0.0
X +0.5
+1.0
5%
0% 5% 10% 15% 20% 25% 30% 35%
Standard Deviation
 Portfolios with Many Assets

•The above framework can be expanded

to the case of portfolios with a large
number of stocks.
•In forming each portfolio, we can vary
⇒the number of stocks that make up the
portfolio,
⇒the identity of the stocks in the portfolio, and
⇒the weights assigned to each stock.

•Look at the plot of the expected returns

versus the risk of these portfolios
All Combinations of Risky Assets
 Efficient Frontier
•A portfolio is an efficient portfolio if
⇒no other portfolio with the same expected
return has lower risk, or
⇒no other portfolio with the same risk has a
higher expected return.

•Investors prefer efficient portfolios over

inefficient ones.
•The collection of efficient portfolio is
called an efficient frontier.
 Efficient Frontier

F
µ (expected
return)

σ (risk)
 Choosing the Best Risky Asset

•Investors prefer efficient portfolios over

inefficient ones.
•Which one of the efficient portfolios is best?
•We can answer this by introducing a riskless
asset.
⇒There is no uncertainty about the future value of
this asset (i.e. the standard deviation of returns is
zero). Let the return on this asset be rf.
⇒For practical purposes, 90-day U.S. Treasury
Bills are (almost) risk free.
Combinations of a Risk Free and a Risky Asset

F
µ (expected
return)

rf

σ (risk)
 Best Risky Asset

M
µ (expected
return)

rf

σ (risk)
 The Capital Market Line

•Assume investors can lend and borrow at

the risk free rate of interest.
⇒borrowing entails a negative investment in
the riskless asset.

•Since every investor hold a part of the

“best” risky asset M, M is the market
portfolio.
•The Market portfolio consists of all risky
assets.
⇒Each asset weight is proportional to its
market value.
The Capital Market Line

 µm − rf 
µp =rf + σ p
 σm 
 The Capital Market Line

F
µ (expected

M
return)

E
rf

σ (risk)
 Next Coverage

• Understand the determination of the expected rate of

return  Capital Asset Pricing Model

• Decomposition of Risk: Systematic Vs. Unsystematic.

• Explain the importance of asset pricing

models.
• Demonstrate choice of an investment
position on the Capital Market Line (CML).
• Understand the Capital Asset Pricing Model
(CAPM), Security Market Line (SML) and its
uses.
 Asset Pricing Models

•These models provide a relationship

between an asset’s required rate of return
and its risk.

•The required return can be used for:

⇒computing the NPV of your investment.
 The Capital Asset Pricing Model (CAPM)

•It allows us to determine the required

rate of return (=expected return) for an
individual security.
⇒Individual securities may not lie on the CML.
⇒Only efficient portfolios lie on the CML

•The Security Market Line (SML) can be

applied to any securities or portfolios
including inefficient ones.
 The Security Market Line (SML)

µ j =r f +β j µ −r ( m f
)
•where

C O V( r , r ) ρ σ σ ρ σ
j M j, m j m j, m j
β = = =
j
σ2 σ2 σ
m
m m
 What does the SML tell us

• The required rate of return on a security

depends on:
⇒ the risk free rate
⇒ the “beta” of the security, and
⇒ the market price of risk.

• The required return is a linear function of

the beta coefficient.
⇒ All else being the same, higher the beta
coefficient, higher is the required return on the
security.
 Graphical Representation of the SML

Expected
Returns

rf

Beta
 Computing Required Rates of Return

Common stock shares of Gator Sprinkler

Systems (GSS) have a correlation
coefficient of 0.80 with the market
portfolio, and a standard deviation of
28%. The expected return on the market
portfolio is 14%, and its standard
deviation is 20%. The risk free rate is 5%.
• What is the required rate of return on
GSS?
 Required Return on GSS

First compute the beta of GSS:

ρ GSS, mσ GSS
β GSS =
σm
=
( 0.80 )( 28 )
=1.12
20

Next, apply the SML:

μ GSS =rf +β GSS (μ m −rf )
=5% +1.12 (14% −5% )= 15.08%
 Required Rate of Return on GSS

•What would be the required rate of

return on GSS if it had a correlation of
0.50 with the market? (All else is the
same)
⇒Beta = 0.70 and µ GSS = 11.30%

•What would be the required rate of

return on GSS if it had a standard
deviation of 36%, and a correlation of
0.80? (All else is the same)
⇒Beta = 1.44 and µ GSS = 17.96%
 Estimating the Beta Coefficient

If we know the security’s correlation with

the
market, its standard deviation, and the
standard
deviation of the market, we can use the
definition of beta: ρ j, mσ j
β j=
σm

•Generally, these quantities are not

known.
 Interpreting the Beta Coefficient

The beta of the market portfolio is

always equal to 1.0.
ρm,m σm
βm = = 1 sin ce ρm,m = 10
.
σm

The beta of the risk free asset is always

equal to 0.0
ρ f ,m σ f
βf = =1 since σ f =0.0
σm
 Interpreting the Beta Coefficient

Beta indicates how sensitive a security’s

returns are to changes in the market
portfolio’s return.
⇒It is a measure of the asset’s risk.

Suppose the market portfolio’s risk premium

is +10% during a given period.
⇒if β = 1.50, the security’s risk premium will be
+15%.
⇒if β = 1.00, the security’s risk premium will be
+10%
⇒if β = 0.50, the security’s risk premium will be
Beta Coefficients for Selected Firms

Common Stock Beta

Alex Brown 1.90
Nike Inc. (Class B) 1.50
Microsoft 1.40
PepsiCo. Inc. 1.10
McDonald’s Corporation 1.05
Boeing Co. 1.00
AT&T Corp. 0.85
Exxon Corp. 0.60
 Beta of a Portfolio

•The beta of a portfolio is the weighted

average of the beta values of the
individual securities in the portfolio.

β p = w1 β 1 + w 2 β 2 + w 3 β 3 +  + w n β n

where wi is the proportion of value

invested in security i, and β i is the beta of
the security i.
 Applying the CAPM

• The CML prescribes that investors should

invest in the riskless asset and the market
portfolio.
• The true market portfolio, which consists
of all risky assets, cannot be constructed.
• How much diversification is necessary to
get substantially “all” of the benefits of
diversification?
⇒About 25 to 30 stocks!