Portfolio Management - Meaning and Important Concepts

Portfolio Management - Meaning and Important Concepts
What is a Portfolio ?
A portfolio refers to a collection of investment tools such as stocks, shares, mutual funds,
bonds, cash and so on depending on the investor’s income, budget and convenient time frame.
What is Portfolio Management ?
The art of selecting the right investment policy for the individuals in terms of minimum
risk and maximum return is called as portfolio management.
Portfolio management refers to managing an individual’s investments in the form of bonds,

shares, cash, mutual funds etc so that he earns the maximum profits within the stipulated time
frame.
Portfolio management refers to managing money of an individual under the expert guidance of
portfolio managers.
In a layman’s language, the art of managing an individual’s investment is called as portfolio

management.
Need for Portfolio Management
Portfolio management presents the best investment plan to the individuals as per their income,
budget, age and ability to undertake risks.
Portfolio management minimizes the risks involved in investing and also increases the chance
of making profits.
Portfolio managers understand the client’s financial needs and suggest the best and unique
investment policy for them with minimum risks involved.
Portfolio management enables the portfolio managers to provide customized investment

solutions to clients as per their needs and requirements.
Who is a Portfolio Manager ?
An individual who understands the client’s financial needs and designs a suitable investment
plan as per his income and risk taking abilities is called a portfolio manager. A portfolio
manager is one who invests on behalf of the client.
A portfolio manager counsels the clients and advises him the best possible investment plan
which would guarantee maximum returns to the individual.
A portfolio manager must understand the client’s financial goals and objectives and offer a
tailor made investment solution to him. No two clients can have the same financial needs.
List of Top 4 Portfolio Theories | Theories | Portfolio Management
Portfolio theories guide the investors to select securities that will maximize returns and
minimize risk. These theories can be classified into different categories as depicted in figure
6.1.
I. Traditional Approach:
1. Dow Theory:
Charles Dow, the editor of Wall Street Journal, USA, presented this theory through a series of
editorials. Dow formulated a hypothesis that the stock market does not move on a random basis
but is influenced by three distinct cyclical trends that guide its direction. These are the primary
movements, secondary reactions and minor movements.
a. Primary Movements:
These are the long term movements (from one to three years or more) of the prices of the
securities on the stock exchange. Such movements can sway the entire market up or down.
b. Secondary Reactions:
These act as a restraining force on the primary movement. These are in opposite direction of
primary movement and last only for a short while. These are also known as corrections.
c. Minor Movements:
These are the day to day fluctuations in the market. The minor movements are not significant
and have no analytical value as they are of very short duration.
These three movements have been compared with the tides, the waves and the ripples in the
ocean as depicted in figure 6.2a and 6.2b.
Harry Markowitz Model Portfolio Management Theory:
This model was developed by Harry Markowitz in 1952. It analyzes various portfolios of a
given number of securities and helps in selection of the best or the most efficient portfolio.
Markowitz used mathematical programming and statistical analysis in order to arrange for the
optimum allocation of assets within portfolio. Markowitz generated portfolios within a reward-
risk context.
In other words, he considered the variance in the expected returns from investments and their
relationship to each other in constructing portfolios. It is a theoretical framework for the
analysis of risk return choices. Decisions are based on the concept of ‘Efficient Portfolios’.
Efficient Portfolios are those portfolios that yield the highest return for the level of risk accepted
or alternatively, the smallest portfolio risk for a specified level of expected return. To build an
efficient portfolio an expected return level is chosen, and assets are substituted until the
portfolio combination with the smallest variance at the return level is found. As this process is
repeated for other expected returns, a set of efficient portfolios is generated.
The Modern Portfolio Theory is based on following assumptions:

i. Investors estimate risk on the basis of variability of expected returns.
ii. Investors base their decisions solely on expected returns and variance (standard deviation) of
returns only.
iii. For a given risk level, investors prefer high returns to lower returns. Similarly, for a given
level of expected return, investors prefer less risk to more risk.
iv. Asset returns are normally distributed random variables.
v. Markets are efficient.
Explanation of Modern Portfolio Theory:

Let us assume that there are 10 portfolios with the following expected returns and
standard deviation:
From the above, we can observe that in portfolio number 4 and 5, the standard deviation is same
but different returns. The investor would select portfolio 5 if given a choice between 4 and 5.
Similarly, in case of portfolio number 7 and 8, the returns are same with different standard
deviations. Given a choice, the investor would go for portfolio number 7.
Thus, the selection is guided by two criteria:

i. The investor would go for the portfolio with lower risk among two portfolios with same
returns
ii. The investor would go for the portfolio with higher returns among two portfolios with same
risk.
Shortcomings of Modern Portfolio Theory:

i. The Theory believes that it is possible to select stocks/assets which are not correlated to one
another. However, it has been proved that at times, seemingly uncorrelated assets do not
act/react independent of each other.
ii. The Efficient Market hypothesis is increasingly being challenged because of existence of
information asymmetry, insider trading, etc.
iii. The concept of rational investors is being challenged by behavioral economists, according to
whom; investors do not always behave rationally.
iv. There is no concept of risk-free asset in the real world since all assets carry some amount of
inherent risk
v. It is frequently observed that the returns in equity and other markets are not normally
distributed as assumed by the Theory.
vi. A large amount of input data is required for calculation. If there are N securities in the
portfolio, then the investor need to obtain N variance estimates and N(N-1)/2 covariance
estimates, resulting in a total of 2N + [N(N-1)/2] estimates. For example, analyzing a set of 100
securities would require 100 return estimates, 100 variance estimates and 4950 covariance
estimates, resulting in a total of 5150 estimates
Portfolio return and Portfolio risk can be calculated as per the following formula:
Where,
σ1 and σ2 = Standard deviation of security 1 and security 2

W1 and W2 = Proportion of funds invested in security 1 and security 2
r12 – Correlation coefficient between security 1 and 2
E (R1), E (R2), E (Rn) = Expected returns on security 1, 2 and so on.
Portfolio risk (portfolio with more than two securities):
Where,
Wi = Proportion of funds invested in security i

Wj= Proportion of funds invested in security j
σij = The covariance between the pairs of securities i and j
n = total number of securities in the portfolio

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What is portfolio management?

What is portfolio management?

What are the main portfolio theories discussed in the document?

What are the main portfolio theories discussed in the document?

Portfolio Management - Meaning and Important Concepts

What is Portfolio Management ?

Portfolio management refers to managing an individual’s investments in the form of bonds,

In a layman’s language, the art of managing an individual’s investment is called as portfolio

Need for Portfolio Management

Portfolio management enables the portfolio managers to provide customized investment

Who is a Portfolio Manager ?

Harry Markowitz Model Portfolio Management Theory:

The Modern Portfolio Theory is based on following assumptions:

iv. Asset returns are normally distributed random variables.

v. Markets are efficient.

Explanation of Modern Portfolio Theory:

Thus, the selection is guided by two criteria:

Shortcomings of Modern Portfolio Theory:

σ1 and σ2 = Standard deviation of security 1 and security 2

Wi = Proportion of funds invested in security i

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