Portfolio Theory PDF

+-----------------------------------------------------------------------+ | [Portfolio The Theory] | +=======================================================================+ | One of the most important and influential economic theories dealing | | with finance a...

+-----------------------------------------------------------------------+ | [Portfolio The Theory] | +=======================================================================+ | One of the most important and influential economic theories dealing | | with finance and investment. | +-----------------------------------------------------------------------+ | MPT was developed by Harry Markowitz and published under the title | | \"Portfolio Selection\" in the Journal of Finance in 1952. | +-----------------------------------------------------------------------+ | The theory is based on Markowitz\'s hypothesis that it is possible | | for investors to design an optimal portfolio to maximize returns by | | taking on a quantifiable amount of risk. | +-----------------------------------------------------------------------+ | Essentially, investors can reduce risk through diversification using | | a quantitative method. | +-----------------------------------------------------------------------+ | Modern portfolio theory says that it is not enough to look at the | | expected risk and return of one particular stock. | +-----------------------------------------------------------------------+ | By investing in more than one stock, an investor can reap the | | benefits of diversification---chief among them, a reduction in the | | riskiness of the portfolio. | +-----------------------------------------------------------------------+ | Markovitz postulated that investors are risk averse. | | | | As a result, they always try to achieve their required level of | | return by assuming the lowest possible risk. | +-----------------------------------------------------------------------+ | Portfolio risk is measured using the standard deviation of returns, | | which quantifies the volatility of the portfolio\'s returns over | | time. | +-----------------------------------------------------------------------+ | Constructing a portfolio of investments with varying levels of risk | | is the best approach for diversifying risk. | +-----------------------------------------------------------------------+ | MPT helps investors find the best portfolio and construct the optimal | | portfolio. | +-----------------------------------------------------------------------+ | That is a portfolio that gives the highest possible return for a | | given level of risk. Or vice versa, a portfolio that provides a given | | level of return for the lowest potential risk. | +-----------------------------------------------------------------------+ | The Modern Portfolio Theory focuses on the relationship between | | assets in a portfolio in addition to the individual risk that each | | asset carries. | +-----------------------------------------------------------------------+ | It exploits the fact that a negatively correlated asset offsets | | losses that are incurred on another asset. | +-----------------------------------------------------------------------+ | For example, crude oil prices and airline stock prices are negatively | | correlated. | +-----------------------------------------------------------------------+ | A portfolio with a 50% weight in crude oil and 50% weight in an | | airline stock is safe from the risk carried by each of the individual | | assets. | +-----------------------------------------------------------------------+ | When oil prices decline, airline stock prices are likely to increase, | | compensation the losses tolerate from the oil stock. | +-----------------------------------------------------------------------+ | [ Portfolio Management Process] | +-----------------------------------------------------------------------+ | The portfolio management process is an ongoing way of managing | | portfolio. | +-----------------------------------------------------------------------+ | Portfolio management refers to the art and science of making | | investment decisions for a collection of assets, known as a | | portfolio. | +-----------------------------------------------------------------------+ | It involves the process of selecting and managing a mix of | | investments to achieve specific financial goals while considering the | | investor\'s risk tolerance and time horizon. | +-----------------------------------------------------------------------+ | Portfolio management refers to building and supervising a group of | | investments, such as securities, bonds, exchange-traded funds, mutual | | funds, cryptocurrencies, etc., either personally or professionally. | +-----------------------------------------------------------------------+ | What Is Portfolio Management? | | | | Portfolio management is a well-planned investing strategy based on an | | investor's objectives and risk tolerance. | +-----------------------------------------------------------------------+ | Portfolio management entails selecting and monitoring investments | | such as stocks, bonds, and mutual funds. | +-----------------------------------------------------------------------+ | The primary goal of portfolio management is to invest in a way that | | allows maximizing returns while minimizing risks to achieve financial | | objectives. | +-----------------------------------------------------------------------+ | We define some of the basic terms which we will be using in the | | context of the Modern Portfolio Theory: | +-----------------------------------------------------------------------+ | Portfolio: A portfolio is a collection of assets such as stocks, | | property, bonds, currencies, etc. | +-----------------------------------------------------------------------+ | Risk: In the context of MPT, risk can be defined as the variance or | | deviation of the investment return from the level expected. | +-----------------------------------------------------------------------+ | Return: This is the reward an investor earns from | | investing/committing their capital to a given asset/security. | +-----------------------------------------------------------------------+ | Opportunity set: This is the set of available portfolios that an | | investor can choose based on their combinations of risk and return. | +-----------------------------------------------------------------------+ | \- Diversification: Diversification is the process of mixing | | different assets within a portfolio to ensure that unsystematic risk | | is smoothed out. | | | | -In this case, the negative performance of a given asset/security | | within the portfolio is balanced out by the positive performance of | | other assets within the portfolio. | +-----------------------------------------------------------------------+ | The principle theory behind the diversification concept is that | | investors should hold portfolios and focus on the relationship | | between the individual securities within the portfolio. | +-----------------------------------------------------------------------+ | Thus, when applying the MPT framework to the selection of investment | | portfolios, the investor should consider the properties (the risk and | | return) of the available investment portfolios, the opportunity set, | | and out of these, choose the most efficient portfolios, also called | | the efficient frontier from the set. | +-----------------------------------------------------------------------+ | Generally, the MPT tries to explain a method of constructing a | | portfolio that generates a maximum return for a given level of risk | | or a minimum risk for a stated return using the investor's utility, | | which is assumed to be known. | +-----------------------------------------------------------------------+ | The investor tries to find the optimal balance between the return and | | the risk involved in the investment. | +-----------------------------------------------------------------------+ | [Assumptions of Modern Portfolio (Mean-Variance Portfolio) | | Theory] | +-----------------------------------------------------------------------+ | [The Modern Portfolio theory relies on some assumptions, as listed | | below] | +-----------------------------------------------------------------------+ | Markets are efficient, and investors have access to all the | | available information regarding the expected return, variances, and | | covariances of securities or assets. | +-----------------------------------------------------------------------+ | Investors are risk-averse, i.e., they will tend to avoid | | unnecessary risks. For example, investors choose to invest in bank | | deposits that pay lower returns but guaranteed returns rather than | | investing in stocks that may promise high returns but carry a high | | risk of losses. | +-----------------------------------------------------------------------+ | Investors are non-satiated, i.e., given two securities with the | | same standard deviation, an investor would choose the highest | | expected return. | +-----------------------------------------------------------------------+ | There is a fixed single-time horizon. | +-----------------------------------------------------------------------+ | There are no taxes or transaction costs. | +-----------------------------------------------------------------------+ | Assets can be held at any amount. | +-----------------------------------------------------------------------+ | A risk-free rate of return exists in the market, and unlimited | | capital can be borrowed or invested at this rate. | +-----------------------------------------------------------------------+ | Investors make their decisions solely based on expected returns and | | variance. | +-----------------------------------------------------------------------+ | The only variable assumption made by the theory is that the | | investment decisions are solely made with regard to the mean and | | variance of the investment return. | +-----------------------------------------------------------------------+ | **[Definition of Portfolio Management Process]** | +-----------------------------------------------------------------------+ | The portfolio management process is an ongoing way of managing a | | client's portfolio of assets. | +-----------------------------------------------------------------------+ | There are various components and sub-components of the process that | | ensure a portfolio is tailored to meet the client's investment | | objectives well within his constraints. | +-----------------------------------------------------------------------+ | The portfolio management process is an integrated compilation of | | steps implemented consistently to create and manage a suitable | | portfolio of assets to achieve a client's specified goals. | +-----------------------------------------------------------------------+ | [ **Portfolio Perspective**] | +-----------------------------------------------------------------------+ | The portfolio perspective is the key fundamental principle of | | portfolio management. | +-----------------------------------------------------------------------+ | According to this perspective, portfolio managers, analysts, and | | investors need to analyze the risk-return trade-off of the whole | | portfolio and not of the individual assets in the portfolio. | +-----------------------------------------------------------------------+ | The [individual investments] carry an | | [unsystematic] risk, which is diversified away by | | bundling the investments into one single portfolio. | +-----------------------------------------------------------------------+ | The whole [portfolio] carries only the [systematic | | risk] caused by the influence of [economic | | fundamen]tals on the returns of a stock. GDP growth, | | consumer confidence, unexpected inflation, business cycles, etc., are | | examples of such economic fundamentals. | +-----------------------------------------------------------------------+ | The portfolio managers, analysts, and investors should only be | | concerned with the systematic risk of the whole portfolio. | +-----------------------------------------------------------------------+ | In fact, all the equity pricing models are based on the fact that | | only systematic risk is factored. | +-----------------------------------------------------------------------+ | **[Steps of the Portfolio Management Process]** | +-----------------------------------------------------------------------+ | The portfolio management process has the following steps and the | | sub-components: | +-----------------------------------------------------------------------+ | **[Planning]** | +-----------------------------------------------------------------------+ | This is the most crucial step as it lays down the foundation of the | | entire process. | +-----------------------------------------------------------------------+ | It contain of these tasks: | +-----------------------------------------------------------------------+ | **[1. Identification of Objectives and limitations:]** | +-----------------------------------------------------------------------+ | Identifying the client's investment objectives and any limitations | | are the foremost task in the planning stage. | +-----------------------------------------------------------------------+ | Any desired outcomes that the client has regarding return and risk | | are the investment objectives. | +-----------------------------------------------------------------------+ | Any limitations on the investment decisions or choices are the | | constraints. | +-----------------------------------------------------------------------+ | Both are specified at this stage. | +-----------------------------------------------------------------------+ | **[2. Investment Policy Statement:]** | +-----------------------------------------------------------------------+ | Once the objectives and limitations are identified, the next task is | | to draft an investment policy statement. | +-----------------------------------------------------------------------+ | **[3. Capital Market Expectations:]** | +-----------------------------------------------------------------------+ | The third step in the planning stage is to form expectations | | regarding capital markets. | +-----------------------------------------------------------------------+ | Risk and return of various asset classes are forecasted over the long | | term to choose portfolios that either maximize the expected return | | for certain levels of risk or minimize the portfolio risk for certain | | levels of expected return. | +-----------------------------------------------------------------------+ | **[4. Asset Allocation Strategy:]** | +-----------------------------------------------------------------------+ | This is the last task in the planning stage. | +-----------------------------------------------------------------------+ | **[a. Strategic Asset Allocation:]** | +-----------------------------------------------------------------------+ | The investment policy statement and the capital market expectations | | are combined to determine the long-term weights of the target asset | | classes, also known as strategic asset allocation. | +-----------------------------------------------------------------------+ | **[b. Tactical Asset Allocation:]** | +-----------------------------------------------------------------------+ | Any short-term change in the portfolio strategy due to the change in | | circumstances of the investor or the market expectations is tactical | | asset allocation. | +-----------------------------------------------------------------------+ | If the changes become permanent and the policy statement is updated | | to reflect the changes, there is a chance that the temporary tactical | | allocation becomes the new strategic portfolio allocation. | +-----------------------------------------------------------------------+ | **[Execution]** | +-----------------------------------------------------------------------+ | Once the planning stage is completed, execution of the planned | | portfolio is the next step. | +-----------------------------------------------------------------------+ | This consists of these decisions: | +-----------------------------------------------------------------------+ | **[1. Portfolio Selection:]** | +-----------------------------------------------------------------------+ | The capital markets' expectations are combined with a decided | | investment allocation strategy to choose specific assets for the | | investor's portfolio. | +-----------------------------------------------------------------------+ | Generally, portfolio managers use the portfolio optimization | | technique while determining portfolio composition. | +-----------------------------------------------------------------------+ | **[2. Portfolio Implementation:]** | +-----------------------------------------------------------------------+ | Once the portfolio composition is finalized, the portfolio is | | executed. | +-----------------------------------------------------------------------+ | Portfolio executions are equally important as high transaction costs | | can reduce the portfolio's performance. | +-----------------------------------------------------------------------+ | Transaction costs include both explicit costs like taxes, fees, | | commissions, etc., and implicit costs like opportunity costs, market | | price impacts, etc. | +-----------------------------------------------------------------------+ | Hence, the portfolio execution needs to be right timed and | | well-managed. | +-----------------------------------------------------------------------+ | **[Feedback]** | +-----------------------------------------------------------------------+ | Any changes required due to the feedback are analyzed carefully to | | ensure that they are as per the long-run considerations. | +-----------------------------------------------------------------------+ | The feedback stage has the following two sub-components: | +-----------------------------------------------------------------------+ | **[1. Monitoring and Rebalancing:]** | +-----------------------------------------------------------------------+ | The portfolio manager needs to monitor and evaluate the risk | | exposures of the portfolio and compares them with the strategic asset | | allocation. | +-----------------------------------------------------------------------+ | This is required to ensure that investment objectives and limitations | | are being achieved. | +-----------------------------------------------------------------------+ | The manager monitors the investor's circumstances, economic | | fundamentals, and market conditions. | +-----------------------------------------------------------------------+ | Portfolio rebalancing should also consider taxes and transaction | | costs. | +-----------------------------------------------------------------------+ | **[2. Performance Evaluation:]** | +-----------------------------------------------------------------------+ | The investment performance of the portfolio must be evaluated | | regularly to measure the achievement of objectives and the skill of | | the portfolio manager. | +-----------------------------------------------------------------------+ | Both absolute returns and relative returns can be used as a measure | | of performance while analyzing the performance of the portfolio. | +-----------------------------------------------------------------------+ | **[Investment Policy Statement]** | +-----------------------------------------------------------------------+ | A formal written document was created to govern investment | | decision-making after considering the client's objectives and | | constraints. | +-----------------------------------------------------------------------+ | This statement is formulated in the planning stage of the process, as | | mentioned above. | +-----------------------------------------------------------------------+ | **[Role:]** | +-----------------------------------------------------------------------+ | The investment policy statement has the following roles to play | +-----------------------------------------------------------------------+ | A complete client description providing enough background so that | | any investment advisor can understand the client's situation. | +-----------------------------------------------------------------------+ | Endorse long-term discipline in all portfolio decisions. | +-----------------------------------------------------------------------+ | This statement provides the general investment goals and objectives | | of a client and describes the strategies that the manager should | | employ to meet these objectives. | +-----------------------------------------------------------------------+ | Specific information on matters such as asset allocation, risk | | tolerance, and liquidity requirements are included in an investment | | policy statement. | +-----------------------------------------------------------------------+ | A schedule for reviewing the performance of the portfolio and the | | policy statement. | +-----------------------------------------------------------------------+ | Identification of responsibilities and duties of all the parties | | involved. | +-----------------------------------------------------------------------+ | | +-----------------------------------------------------------------------+ | | +-----------------------------------------------------------------------+ | [INVESTMENT OBJECTIVES AND CONSTRAINTS] | +-----------------------------------------------------------------------+ | In this section, we return to the tasks of identifying and specifying | | the investor's objectives and constraints that initiate the planning | | step. | +-----------------------------------------------------------------------+ | **[Objectives]** | +-----------------------------------------------------------------------+ | The two objectives in this framework, risk and return, are | | interdependent---one cannot be discussed without reference to the | | other. | +-----------------------------------------------------------------------+ | The risk objective limits how high the investor can set the return | | objective. | +-----------------------------------------------------------------------+ | **[Risk Objective]** | +-----------------------------------------------------------------------+ | The first element of the risk--return framework is the risk objective | | because it will largely determine the return objective. | +-----------------------------------------------------------------------+ | A 10 percent standard deviation risk objective,for example, implies a | | different asset allocation than a 15 percent standard deviationrisk | | objective, | +-----------------------------------------------------------------------+ | because expected asset risk is generally positively correlated | | withexpected asset return. | +-----------------------------------------------------------------------+ | In formulating a risk objective, the investor must address | | thefollowing questions: | +-----------------------------------------------------------------------+ | **[How do I measure risk?]** | +-----------------------------------------------------------------------+ | Risk measurement is a key issue in investments, and several | | approaches exist for measuring risk. | +-----------------------------------------------------------------------+ | In practice, risk may be measured in absolute terms or in relative | | terms with reference to various risk concepts. | +-----------------------------------------------------------------------+ | Examples of absolute risk objectives are a specified level of | | standard deviation or variance of total return. | +-----------------------------------------------------------------------+ | An example of a relative risk objective is a specified level of | | tracking risk. | +-----------------------------------------------------------------------+ | Tracking risk is the standard deviation of the differences between a | | portfolio's and the market total returns. | +-----------------------------------------------------------------------+ | **[What is the investor's willingness to take risk?]** | +-----------------------------------------------------------------------+ | The investor's stated willingness to take risk is often very | | different for institutional versus individual investors. | +-----------------------------------------------------------------------+ | Managers should try to understand the behavioral and, for | | individuals, the personality factors behind an investor's willingness | | to take risk. | +-----------------------------------------------------------------------+ | **[What is the investor's ability to take risk?]** | +-----------------------------------------------------------------------+ | Even if an investor is eager to bear risk, practical or financial | | limitations often limit the amount of risk that can be taken | +-----------------------------------------------------------------------+ | in the following discussion we talk about \" how much volatility | | would Causes trouble an investor who depends on investments \" | +-----------------------------------------------------------------------+ | What is the investor's financial strength---that is, the ability to | | increase the savings/contribution level if the portfolio cannot | | support the planned spending? | +-----------------------------------------------------------------------+ | More financial strength means more risk can be taken. | +-----------------------------------------------------------------------+ | Investors with high levels of wealth relative to probable worst-case | | short term loss scenarios can take more risk. | +-----------------------------------------------------------------------+ | **[How much risk is the investor both willing and able to | | bear?]** | +-----------------------------------------------------------------------+ | The answer to this question defines the investor's risk tolerance. | +-----------------------------------------------------------------------+ | Risk tolerance, the capacity to accept risk, is a function of both an | | investor's willingness and ability to do so. | +-----------------------------------------------------------------------+ | Risk tolerance can also be described in terms of risk aversion, the | | degree of an investor's inability and unwillingness to take risk. | +-----------------------------------------------------------------------+ | The investor's specific risk objectives are formulated with that | | investor's level of risk tolerance in mind. | +-----------------------------------------------------------------------+ | Importantly, any assessment of risk tolerance must consider both an | | investor's willingness and that investor's ability to take risk. | +-----------------------------------------------------------------------+ | Return Objective | +-----------------------------------------------------------------------+ | The second element of the investment policy framework is the return | | objective, | | | | which must be consistent with the risk objective. | +-----------------------------------------------------------------------+ | Just as tension may exist between willingness and ability in setting | | the risk objective, | +-----------------------------------------------------------------------+ | so the return objective requires a resolution of return desires | | versus the risk objective. | +-----------------------------------------------------------------------+ | In formulating a return objective,the investor must address the | | following questions: | +-----------------------------------------------------------------------+ | **[How is return measured?]** | +-----------------------------------------------------------------------+ | The usual measure is total return, the sum of the return from price | | appreciation and the return from investment income. | +-----------------------------------------------------------------------+ | Return may be stated as an absolute amount, such as 10 percent a | | year, or as a return relative to the market return, such as market | | return plus 2 percent a year. | +-----------------------------------------------------------------------+ | Nominal returns must be distinguished from real returns. | +-----------------------------------------------------------------------+ | Nominal returns are unadjusted for inflation. Real returns are | | adjusted for inflation and sometimes simply called inflation-adjusted | | returns. | +-----------------------------------------------------------------------+ | **[How much return does the investor says he wants?]** | +-----------------------------------------------------------------------+ | This amount is the stated return desire. | +-----------------------------------------------------------------------+ | These wants or desires may be realistic or unrealistic. | +-----------------------------------------------------------------------+ | The advisor or portfolio manager must continually evaluate the desire | | for high returns in light of the investor's ability to assume risk | | and the reasonableness of the stated return desire, especially | | relative to capital market expectations | +-----------------------------------------------------------------------+