Portfolio Analysis and Management

Portfolio Analysis

• Portfolio analysis is a process used to analyze and measure risk and return in a portfolio of investments.
• The goal is to maximize returns while minimizing risk.
• The approach involves selecting securities, allocating funds, and managing risks and returns.

Introduction to the Portfolio Approach

• Portfolio approach minimizes overall portfolio risk without necessarily reducing expected return.
• Diversification is a strategy to combine a variety of investments to reduce investor risk of any single security.
• Investors and advisors use techniques to forecast and measure risk and predict return.
• Portfolio construction is tailored to investor needs and circumstances.
• Understanding the relation between risk and return is crucial to constructing a portfolio.
• Different portfolio management approaches exist, such as active vs. passive.

Learning Objectives

• Calculate the rate of return of a single security.
• Differentiate among types and measures of risk, and understand the role of risk in asset selection.
• Calculate and interpret the expected return of a portfolio of securities.
• Summarize the benefits and challenges of combining securities in a portfolio.
• Compare and contrast the portfolio management styles of equity and fixed-income managers.

Key Terms

• Active investment strategy: a strategy that aims to outperform market benchmarks
• Alpha: Excess return earned by a portfolio that outperforms the market, calculated by removing the expected market return.
• Beta: Measures the degree to which the return of a security moves with the overall market return.
• Bottom-up analysis: Starts with a focus on individual stocks when forming a portfolio.
• Business risk: Risk that a company's earnings will decrease due to factors like worker strikes, competition or new products
• Buy and hold: An investment strategy that involves buying and holding an asset for a long period.
• Capital gain: Selling a security for a higher price than the purchase price.
• Capital loss: Selling a security for a lower price than the purchase price.
• Cash flow: Income generated from an investment (dividends, interest).
• Correlation: A measure of how securities' returns move together.
• Default risk: Risk that a company will not make interest payments or repay loan principal.
• Diversification: Reduces overall risk by investing in a variety of assets.
• Ex-ante: Expected returns
• Ex-post: Actual historical returns
• Foreign exchange rate risk: Risk of loss due to exchange rate fluctuations.
• Holding period return: Return generated over a specific period.
• Indexing: Involves buying and holding a portfolio of securities that match the composition of a benchmark index.
• Inflation rate risk: Risk that inflation will reduce future purchasing power.
• Interest rate risk: Risk that changing interest rates will adversely affect investment return.
• Liquidity risk: Risk that an investor cannot buy or sell a security at a fair price quickly enough.
• Non-systematic risk: Risk unique to a specific security or industry; it can be mitigated through diversification.
• Passive investment strategy: Aims to replicate the performance of a benchmark portfolio, such as an index.
• Political risk: Risk that political changes disrupt investments.
• Rate of return: Percentage representing an investment's profitability over a certain period.
• Real rate of return: Return adjusted for the effects of inflation.
• Risk-free rate of return: Return on a risk-free investment (e.g. U.S. Treasury bills).
• Sector rotation: strategy of shifting investments between industry sectors based on their expected performance.
• Specific risk: Risk related to a particular company, industry, or security. This kind of risk can be mitigated to some extent through diversification.
• Standard deviation: Measures the variability or dispersion of returns around the average return.
• Systematic risk: Risk associated with the overall market, also known as market risk.
• Top-down analysis: Starts by analyzing broad macroeconomic and industry conditions
• Volatility: Rate of fluctuation of an asset's price
• Yield: percentage of a bond's return over a period, often annually.
• Nominal rate of return: Total return without accounting for inflation.
• Real rate of return: Total return considered in context with inflation.
• T-bills: Treasury bills, considered a risk-free borrowing instrument.

Portfolio Manager Styles

• Active management: Focuses on outperforming a benchmark index.

• Passive management: Aims to replicate a benchmark index.

• Growth managers: Focus on companies with high growth potential.

• Value managers: Look for stocks trading below their intrinsic value.

• Sector rotation managers: Focus on identifying industry sectors with strong growth potential.

Relationship Between Risk and Return

• Higher expected return generally requires higher risk.
• Investors must balance their risk tolerance with their return expectations when selecting investments in a portfolio.
• Diversification helps mitigate the risk that comes with investing in a single security.

Portfolio Beta

• Beta measures the volatility of a single security or portfolio against the entire market.
• Beta of 1.0 indicates the security moves in line with the market.
• Beta greater than 1.0 implies greater volatility than the overall market.

Portfolio Alpha

• Alpha measures the excess return a portfolio earns compared to its expected return based on its beta.
• Positive alphas indicate that the portfolio has performed better than predicted.

Calculating Portfolio Return

• Portfolio return is calculated as a weighted average of the returns of individual securities.
• Weights are based on the proportion of each security's value within the portfolio.

Explore the principles of portfolio analysis and management in this quiz. Learn how to balance risk and return by diversifying investments and employing various management strategies. Understand the importance of tailoring portfolio construction to meet investor needs while maximizing returns.