1

PROJECT REPORT

ON

Portfolio construction

SUBMITTED TO SUBMITTED BY

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Preface

The reforms, since 1991, have brought substantial deregulation to Indian

capital market; today the markets are moving towards computerized, scrip

less trading. In this process the market would become more efficient and the

lessons of portfolio theory would assume increased relevance.

About ten years ago, we often wondered whether many of the concepts that

we are dealing with had any relevance to India. Terms like Mutual Funds,

Portfolio Management, and Interest Rate Risk seemed alien to this land. The

last few years have, however, changed everything. Today, when we talk of

portfolio management in our classrooms or in seminars and conferences, we

sense a tremendous excitement and interest among the audience.

There is a little doubt that stock markets can be treacherous. But we have

learnt that investing in shares need not be such a nerve-racking experience,

provided the decisions are made on the basis of analysis and reasoning, and

are not guided by whims, fancies and rumors.

I have kept the use of mathematics to a minimum in the text as I believe that

the principles and techniques of portfolio management can be understood

and used without a rigorous knowledge of the mathematical foundations

upon which they are based.

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Contents

Preface 2

Executive Summary 4-5

1. Introduction to Portfolio Management 6-8

2. Portfolio Construction 9-11

3. Steps to Stock Selection Process 12

4. Types of Assets 12-17

5. Phases of Portfolio Management 18

6. Security Analysis 19-26

7. Portfolio Analysis 27-28

8. Portfolio Selection 29-30

9. Portfolio Revision 31-32

10. Portfolio Evaluation 33-35

11.Conclusion 36

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12.Bibliography 37

Executive Summary

Investing is both Arts and Science. Every Individual has their own specific

financial need and expectation based on their risk taking capabilities,

whereas some needs and expectation are universal. Therefore, we find that

the scenario of the Stock Market is changing day by day hours by hours and

minute by minute. The evaluation of financial planning has been increased

through decades, which can be best seen in customers. Now a day’s

investments have become very important part of income saving.

In order to keep the Investor safe from market fluctuation and make them

profitable, Portfolio Management Services (PMS) is fast gaining Investment

Option for the High Net worth Individual (HNI). There is growing

competition between brokerage firms in post reform India. For investor it is

always difficult to decide which brokerage firm to choose.

At the time of investing money everyone look for the Risk factor involve in

the Investment option.

The first of the two most consequential take-home messages that we want to

convey is that good portfolio management practice is not a matter of

establishing a discussion culture, but one of implementing sound, data

driven, and transparent decision processes. The second message is that, even

as seen in the light of the previous insight, portfolios and their constituent

projects are ultimately managed by people, not by functions. Objections to

portfolio management, or attempts to push it in a certain direction,

frequently arise from less rational elements in the personalities of the acting

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people, even if they are driven by the best intentions. A good portfolio

manager will be aware of this and make use of these human features instead

of attempting their suppression.

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Introduction to Portfolio Management

Investing in securities such as shares, debenture and bonds is profitable as

well as exciting. Investing in financial securities is now considered to be one

of the best avenues for investing one’s savings while it is acknowledged to

be one of the most risky avenues of investment.

It is rare to find investors investing their entire funds or savings in a single

security. Instead, they tend to invest in a group of securities. Such a group of

securities is called a portfolio. Creation of a portfolio helps to reduce risk

without sacrificing returns. Portfolio Management deals with the analysis of

individual securities as well as with the theory and practice of optimally

combining securities into portfolios. An investor who understands the

fundamental principles and analytical aspects of portfolio management has a

better chance of success.

WHAT IS PORTFOLIO MANAGEMENT

An investor considering investment in securities is faced with the problem

of choosing from among a large number of securities. His choice depends

upon the risk-return characteristics of individual securities. He would

attempt to choose the most desirable securities and like to allocate his funds

over this group of securities. Again he is faced with the problem of deciding

which securities to be held and how much to invest in each. The investor

faces an infinite number of possible portfolios or group of securities.

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As the economic and financial environment keeps changing, the risk-return

characteristics of individual securities as well as portfolios also change. This

calls for periodic review and revision of investment portfolios of investors.

An investor invests his funds in a portfolio expecting to get a good return

consistent with the risk that he has to bear. The return realized from the

portfolio has to be measured and the performance of the portfolio has to be

evaluated.

Portfolio Management comprises all the processes in the creation and

maintenance of an investment portfolio. It deals specifically with security

analysis, portfolio analysis, portfolio selection, portfolio revision, and

portfolio evaluation. Portfolio Management is a complex process which tries

to make investment activity more rewarding and less risky.

A person making an investment expects to get some return from the

investment in the future. But, as the future is uncertain, so is the future

expected return. It is this uncertainty associated with the returns from an

investment that reduces risk into an investment.

The total variability in returns of a security represents the total risk of that

security. Systematic and Unsystematic Risk are the two components of total

risk. Thus,

Total Risk = Systematic Risk + Unsystematic Risk

The impact of economic, political and social changes on the performance of

companies and thereby on their stock prices caused by such system wide

factors is referred to as systematic risk. Systematic Risk is further

subdivided into interest rate risk, market risk, and purchasing power risk.

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When variability of returns occurs because of company issuing factors such

as raw material scarcity, labour strike, management inefficiency, it is known

as Unsystematic Risk.

The systematic risk of a security is measured by a statistical measure called

Beta. The input data required for the calculation of beta are the historical

data of returns of the individual security as well as the returns of a

representive stock market index.

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PORTFOLIO CONSTRUCTION

The Portfolio Construction of Rational investors wish to maximize the

returns on their funds for a given level of risk. All investments possess

varying degrees of risk. Returns come in the form of income, such as interest

or dividends, or through growth in capital values (i.e. capital gains).

The portfolio construction process can be broadly characterized as

comprising the following steps:

1. Setting objectives:

The first step in building a portfolio is to determine the main objectives of

the fund given the constraints (i.e. tax and liquidity requirements) that may

apply. Each investor has different objectives, time horizons and attitude

towards risk. Pension funds have long-term obligations and, as a result,

invest for the long term. Their objective may be to maximize total returns in

excess of the inflation rate. A charity might wish to generate the highest

level of income whilst maintaining the value of its capital received from

bequests. An individual may have certain liabilities and wish to match them

at a future date. Assessing a client’s risk tolerance can be difficult. The

concepts of efficient portfolios and diversification must also be considered

when setting up the investment objectives.

2. Defining Policy:

Once the objectives have been set, a suitable investment policy must be

established. The standard procedure is for the money manager to ask clients

to select their preferred mix of assets, for example equities and bonds, to

provide an idea of the normal mix desired. Clients are then asked to specify

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limits or maximum and minimum amounts they will allow to be invested in

the different assets available. The main asset classes are cash, equities,

gilts/bonds and other debt instruments, derivatives, property and overseas

assets. Alternative investments, such as private equity, are also growing in

popularity, and will be discussed in a later chapter. Attaining the optimal

asset mix over time is one of the key factors of successful investing.

3. Applying portfolio strategy:

At either end of the portfolio management spectrum of strategies are active

and passive strategies. An active strategy involves predicting trends and

changing expectations about the likely future performance of the various

asset classes and actively dealing in and out of investments to seek a better

performance. For example, if the manager expects interest rates to rise, bond

prices are likely to fall and so bonds should be sold, unless this expectation

is already factored into bond prices. At this stage, the active fund manager

should also determine the style of the portfolio. For example, will the fund

invest primarily in companies with large market capitalizations, in shares of

companies expected to generate high growth rates, or in companies whose

valuations are low? A passive strategy usually involves buying securities to

match a preselected market index. Alternatively, a portfolio can be set up to

match the investor’s choice of tailor-made index. Passive strategies rely on

diversification to reduce risk. Outperformance versus the chosen index is not

expected. This strategy requires minimum input from the portfolio manager.

In practice, many active funds are managed somewhere between the active

and passive extremes, the core holdings of the fund being passively managed

and the balance being actively managed.

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4. Asset selections:

Once the strategy is decided, the fund manager must select individual assets

in which to invest. Usually a systematic procedure known as an investment

process is established, which sets guidelines or criteria for asset selection.

Active strategies require that the fund managers apply analytical skills and

judgment for asset selection in order to identify undervalued assets and to try

to generate superior performance.

5. Performance assessments:

In order to assess the success of the fund manager, the performance of the

fund is periodically measured against a pre-agreed benchmark – perhaps a

suitable stock exchange index or against a group of similar portfolios (peer

group comparison). The portfolio construction process is continuously

iterative, reflecting changes internally and externally. For example, expected

movements in exchange rates may make overseas investment more

attractive, leading to changes in asset allocation. Or, if many large-scale

investors simultaneously decide to switch from passive to more active

strategies, pressure will be put on the fund managers to offer more active

funds. Poor performance of a fund may lead to modifications in individual

asset holdings or, as an extreme measure; the manager of the fund may be

changed altogether.

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Steps to Stock Selection Process

Types of assets

The structure of a portfolio will depend ultimately on the investor’s

objectives and on the asset selection decision reached. The portfolio

structure takes into account a range of factors, including the investor’s time

horizon, attitude to risk, liquidity requirements, tax position and availability

of investments. The main asset classes are cash, bonds and other fixed

income securities, equities, derivatives, property and overseas assets.

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Cash and cash instruments

Cash can be invested over any desired period, to generate interest income, in

a range of highly liquid or easily redeemable instruments, from simple bank

deposits, negotiable certificates of deposits, commercial paper (short term

corporate debt) and Treasury bills (short term government debt) to money

market funds, which actively manage cash resources across a range of

domestic and foreign markets. Cash is normally held over the short term

pending use elsewhere (perhaps for paying claims by a non-life insurance

company or for paying pensions), but may be held over the longer term as

well. Returns on cash are driven by the general demand for funds in an

economy, interest rates, and the expected rate of inflation. A portfolio will

normally maintain at least a small proportion of its funds in cash in order to

take advantage of buying opportunities.

Bonds

Bonds are debt instruments on which the issuer (the borrower) agrees to

make interest payments at periodic intervals over the life of the bond – this

can be for two to thirty years or, sometimes, in perpetuity. Interest payments

can be fixed or variable, the latter being linked to prevailing levels of

interest rates. Bond markets are international and have grown rapidly over

recent years. The bond markets are highly liquid, with many issuers of

similar standing, including governments (sovereigns) and state-guaranteed

organizations. Corporate bonds are bonds that are issued by companies. To

assist investors and to help in the efficient pricing of bond issues, many bond

issues are given ratings by specialist agencies such as Standard & Poor’s and

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Moody’s. The highest investment grade is AAA, going all the way down to

D, which is graded as in default. Depending on expected movements in

future interest rates, the capital values of bonds fluctuate daily, providing

investors with the potential for capital gains or losses.

Future interest rates are driven by the likely demand/ supply of money in an

economy, future inflation rates, political events and interest rates elsewhere

in world markets. Investors with short-term horizons and liquidity

requirements may choose to invest in bonds because of their relatively

higher return than cash and their prospects for possible capital appreciation.

Long Term investors, such as pension funds, may acquire bonds for the

higher income and may hold them until redemption – for perhaps seven or

fifteen years. Because of the greater risk, long bonds (over ten years to

maturity) tend to be more volatile in price than medium- and short-term

bonds, and have a higher yield.

Equities

Equity consists of shares in a company representing the capital originally

provided by shareholders. An ordinary shareholder owns a proportional

share of the company and an ordinary share carries the residual risk and

rewards after all liabilities and costs have been paid.

Ordinary shares carry the right to receive income in the form of dividends

(once declared out of distributable profits) and any residual claim on the

company’s assets once its liabilities have been paid in full. Preference shares

are another type of share capital. They differ from ordinary shares in that the

dividend on a preference share is usually fixed at some amount and does not

change. Also, preference shares usually do not carry voting rights and, in the

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event of firm failure, preference shareholders are paid before ordinary

shareholders. Returns from investing in equities are generated in the form of

dividend income and capital gain arising from the ultimate sale of the shares.

The level of dividends may vary from year to year, reflecting the changing

profitability of a company. Similarly, the market price of a share will change

from day to day to reflect all relevant available information. Although not

guaranteed, equity prices generally rise over time, reflecting general

economic growth, and have been found over the long term to generate

growing levels of income in excess of the rate of inflation. Granted, there

may be periods of time, even years, when equity prices trend downwards –

usually during recessionary times. The overall long-term prospect, however,

for capital appreciation makes equities an attractive investment proposition

for major institutional investors.

Derivatives

Derivative instruments are financial assets that are derived from existing

primary assets as opposed to being issued by a company or government

entity.

The two most popular derivatives are futures and options. The extent to

which a fund may incorporate derivatives products in the fund will be

specified in the fund rules and, depending on the type of fund established for

the client and depending on the client, may not be allowable at all.

A futures contract is an agreement in the form of a standardized contract

between two counterparties to exchange an asset at a fixed price and date in

the future. The underlying asset of the futures contract can be a commodity

or a financial security. Each contract specifies the type and amount of the

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asset to be exchanged, and where it is to be delivered (usually one of a few

approved locations for that particular asset). Futures contracts can be set up

for the delivery of cocoa, steel, oil or coffee. Likewise, financial futures

contracts can specify the delivery of foreign currency or a range of

government bonds. The buyer of a futures contract takes a ‘long position’,

and will make a profit if the value of the contract rises after the purchase.

The seller of the futures contract takes a ‘short position’ and will, in turn,

make a profit if the price of the futures contract falls. When the futures

contract expires, the seller of the contract is required to deliver the

underlying asset to the buyer of the contract. Regarding financial futures

contracts, however, in the vast majority of cases no physical delivery of the

underlying asset takes place as many contracts are cash settled or closed out

with the offsetting position before the expiry date.

An option contract is an agreement that gives the owner the right, but not

obligation, to buy or sell (depending on the type of option) a certain asset for

a specified period of time. A call option gives the holder the right to buy the

asset. A put option gives the holder the right to sell the asset. European

options can be exercised only on the options’ expiry date. US options can be

exercised at any time before the contract’s maturity date. Option contracts

on stocks or stock indices are particularly popular. Buying an option

involves paying a premium; selling an option involves receiving the

premium. Options have the potential for large gains or losses, and are

considered to be high-risk instruments. Sometimes, however, option

contracts are used to reduce risk. For example, fund managers can use a call

option to reduce risk when they own an asset. Only very specific funds are

allowed to hold options.

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Property

Property investment can be made either directly by buying properties, or

indirectly by buying shares in listed property companies. Only major

institutional investors with long-term time horizons and no liquidity

pressures tend to make direct property investments. These institutions

purchase freehold and leasehold properties as part of a property portfolio

held for the long term, perhaps twenty or more years. Property sectors of

interest would include prime, quality, well-located commercial office and

shop properties, modern industrial warehouses and estates, hotels, farmland

and woodland. Returns are generated from annual rents and any capital gains

on realization. These investments are often highly illiquid.

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PHASES OF PORTFOLIO MANAGEMENT

Portfolio Management is a process encompassing many activities aimed at

optimizing the investment of one’s funds. Five phases can be identified in

this process:

1. Security Analysis

2. Portfolio Analysis

3. Portfolio Selection

4. Portfolio Revision

5. Portfolio Evaluation

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SECURITY ANALYSIS

Security analysis is the initial phase of the portfolio management process.

This step consists of examining the risk-return characteristics of individual

securities. A basic strategy in securities investment is to buy underpriced

securities and sell overpriced securities.

There are two approaches to security analysis, namely fundamental

analysis and technical analysis.

Fundamental analysis is really a logical and systematic approach to

estimating the future dividends and share price. It is based on the basic

premise that the share price is determined by a number of fundamental

factors relating to the economy, industry, and company.

Each share is assumed to have an economic worth based on its present and

future earning capacity. This is called its intrinsic value or fundamental

value. The investor can then compare the intrinsic value of the share with the

prevailing market price to arrive at an investment decision. If the market

price of the share is lower than its intrinsic value, the investor would decide

to buy the share as it is underpriced. The price of such a share is expected to

move up in the future to match with its intrinsic value.

On the contrary, when the market price of a share is higher than its intrinsic

value, it is perceived to be overpriced. The market price of such a share is

expected to come down in future and hence, the investor would decide to

sell such a share.

The fundamental approach calls upon the investor to make his buy or sell

decision on the basis of a detailed analysis of the information about the

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company, the industry to which the company belongs, and the economy in

which it is established. Thus, a fundamental makes use of EIC (Economy,

Industry, and Company) framework of analysis.

Fundamental analysis thus involves three steps:

1. Economy Analysis

2. Industry Analysis

3. Company Analysis

Economy analysis is the first stage of fundamental analysis and starts

with an analysis of historical performance of the economy. But as an

investment is a future oriented activity, the investor is more interested in the

expected future performance of the overall economy. Economic forecasting

thus becomes a key activity in economic analysis.

FORECASTING TECHNIQUES

Economic forecasting may be carried out for short term periods (up to three

years), intermediate term periods (three to five years) and long-term periods

(more than five years). Some of the techniques of short term economic

forecasting are discussed below:

Anticipatory Surveys

Much of the activities in government, business, trade and industry are

planned in advance and stated in the form of budgets. To the extent that

institutions and people plan and budget for expenditures in advance, surveys

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of their intentions can provide valuable input to short term economic

forecasting.

Barometric or Indicator Approach

To find out how the economy is likely to perform in the future various kinds

of indicators such as time series data of certain economic variables are

studied to economic forecasting.

Econometric Model Building

This technique makes use of Econometrics, which is a discipline that

applies mathematical and statistical techniques to economic theory. The

precise relationship between the dependent and independent variables are

specified in a formal mathematical manner in the form of equations. The

system of the equation is then solved to yield a forecast that is quite precise.

Opportunistic Model Building

It is also known as GNP model building or sectoral analysis. Initially, an

analyst estimates the total demand in the economy, and based on this he

estimates the total income or GNP for the forecast period. This initial

estimate takes into consideration the prevailing economic environment such

as existing tax rates, interest rates, and rate of inflation and economic and

fiscal policies of the government.

Industry analysis is to determine the stage of growth through which

the industry is passing. Industry analysis refers to an evaluation of the

relative strengths and weaknesses of particular industries.

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A number of key characteristics that should be considered by the analyst.

These features broadly relate to the operational and structural aspects of the

industry. They have a bearing on the prospects of the industry. Some of

these are discussed below:

Demand Supply Gap

An industry is likely to experience under supply and over-supply of capacity

at different times, usually the demand for the product tends to change at a

steady rate. Excess supply reduces the profitability of the industry through a

decline in the unit price realization. Therefore, the gap between demand and

supply in an industry is fairly good indicator of its short-term or medium-

term prospects.

Competitive Conditions in the Industry

The level of competition among various companies in an industry is

determined by certain competitive forces. These competitive forces are:

barriers to entry, the threat of substitution, bargaining power of the

buyers/suppliers, and the rivalry among competitors.

Labour conditions

If the labour in a particular industry is rebellious and is inclined to resort to

strikes frequently, the prospects of that industry cannot become bright.

Attitude of Government

The government may encourage the growth of certain industries and can

assist such industries through favourable legislation or vice-versa. In India,

this has been the experience of alcoholic drinks and cigarette industries.

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Company analysis is the final stage of fundamental analysis. In

company analysis, the analyst tries to forecast the future earnings of the

company because there is strong evidence that earnings have a direct and

powerful effect upon share prices. The level, trend and stability of earnings

of a company, however, depend upon a number of factors concerning the

operations of the company.

Financial Statements

The prosperity of a company would depend upon its profitability and

financial health. The financial statements published by a company

periodically help us to assess the profitability and financial health of the

company. The Balance Sheet and the Profit and Loss Account are two

basic financial statements provided by accompany.

Financial ratios are most extensively used to evaluate the financial

performance of the company. Four groups of ratios may be used for

analyzing the performance of a company.

Liquidity Ratios

These measure the company’s ability to fulfil its short term obligations and reflect its short term financial strength or liquidity.

1. Current ratio = Current Assets Current Liabilities

2. Quick Ratio = Current Assets – Prepaid expenses Current Liabilities

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3. Leverage Ratios (i) Debt-Equity Ratio = Long-term debt Shareholder’s equity

(ii) Total debt ratio = Total Debt Total Assets

(iii) Proprietary Ratio = Shareholders’ equity Total Assets

(iv) Interest Coverage Ratio = Earnings before interest and Taxes Interest

4. Profitability Ratios

(i) Gross Profit Ratio = Gross Profit Net Sales

(ii) Operating Profit Ratio = EBIT Net Sales

(iii) Net Profit Ratio = Earnings after tax Net Sales

(iv) Return on Capital Employed = EBIT Total Capital Employed

(v) EPS = Net profit available to equity shareholders Number of equity shares

(vi) Dividend Payout Ratio = DPS EPS

(vii) Price- Earnings Ratio = Market Price per share EPS

(viii) Return on Investment = Earnings after taxes Total Assets

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Technical analysis believes that share price are determined by the demand

and supply forces operating in the market. A technical analyst therefore

concentrates on the movement of share prices. He claims that by examining

past share price movement future share prices can be accurately predicted.

Thus, technical analysis is really a study of past or historical price and

volume movements so as to predict the future stock price behavior.

Bar Chart

It is perhaps the most popular chart used by technical analysts. In this chart,

the highest price, the lowest price and the closing price of each day are

plotted on a day-to-day basis.

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1 2 3 4 5 6 7320

325

330

335

340

345

350

355

360

365

Close Price (Rs.)

DAYS

PRICES

Date High Price (Rs.) Low Price (Rs.) Close Price (Rs.)

1 346.5 335 340.5

2 355 340 354.1

3 359.4 354 356.2

4 357.8 348 350.6

5 353.75 345.15 349.9

6 355.6 346 350.75

7 353.35 349.15 352.05

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PORTFOLIO ANALYSIS

From a given set of securities, any number of portfolios can be constructed.

A rational investor attempts to find the most efficient of these portfolios. The

efficiency of each portfolio can be evaluated only in terms of the expected

return and risk of the portfolio as such. Thus, determining the expected

return and risk of different portfolios is a primary step in portfolio

management. This step is designated as portfolio analysis.

EXPECTED RETURN OF A PORTFOLIO

As a first step in portfolio analysis, an investor needs to specify the list of

securities eligible for selection in the portfolio. Next he has to generate the

risk-return expectations for these securities. These are typically expressed as

the expected rate of return (mean) and the variance or standard deviation of

the return.

Let’s consider a portfolio of two equity shares P and Q with expected return

of 15% and 20% resp. if 40% of the available total funds is invested in share

P and the rest in Q, then the expected portfolio return will be:

(.4 x 15) + (.6 x 20) = 18 per cent

RISK OF A PORTFOLIO

The variance of return and standard deviation of return are alternative

statistical measures that are used for measuring risk in investment. The

variance or standard deviation of an individual security measures the

riskiness of a security in absolute sense. This depends on their interactive

risk, i.e. how the returns of a security move with the returns of other

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securities in the portfolio and contribute to the overall risk of the

portfolio.

Covariance is the statistical measure that indicates the interactive risk of

a security.

Year Rx Deviation

Rx – Rx

Ry Deviation

Ry – Ry

Product of

Deviations

(Rx – Rx ) (Ry – Ry )

1 10 -4 17 5 -20

2 12 -2 13 1 -2

3 16 2 10 -2 -4

4 18 4 8 -4 -16

Rx =

56/4 =

14

Ry =

48/4 =12

-42

Covariance = Product of deviation / 4 = -42/4 = -10.5

The covariance is a measure of how returns of two securities move

together. If the returns of the two securities move in the opposite

direction consistently the covariance would be negative.

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PORTFOLIO SELECTION

The objective of every rational investor is to maximize his returns and

minimize the risk. Diversification is the method adopted for reducing

risk. It essentially results in the construction of portfolios. The proper

goal of portfolio construction would be to generate a portfolio that

provides the highest return and the lowest risk. Such a portfolio would be

known as the optimal portfolio. The process of finding the optimal

portfolio is described as portfolio selection.

The feasible set of portfolios in which the investor can possibly invest, is

known as the portfolio opportunity set. In the opportunity set some

portfolios will obviously be dominated by others. A portfolio will

dominate another if it has either a lower standard deviation and the same

expected return as other, or a higher expected return and the same

standard deviation as the other.

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Efficient Set of Portfolios

Portfolio No. Expected Return

(%)

Standard deviation

(Risks)

1 5.6 4.5

2 7.8 5.8

3 9.2 7.6

4 10.5 8.1

5 11.7 8.1

6 12.4 9.3

7 13.5 9.5

8 13.5 11.3

9 15.7 12.7

10 16.8 12.9

If we compare portfolio no. 4 and 5, for the same standard deviation of

8.1 portfolio no. 5 gives a higher expected return of 11.7, making it more

efficient than portfolio no. 4.

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PORTFOLIO REVISION

The financial markets are continually changing. In this dynamic

environment, a portfolio that was optimal when constructed may not

continue to be optimal with the passage of time. It may have to be revised

periodically so as to ensure that it continues to be optimal.

NEED FOR REVISION

The need for portfolio revision may arise because of some investor

related factors also. These factors may be listed as:

1. Availability of additional funds for investment

2. Changes in risk tolerance

3. Changes in the investment goals

4. Need to liquidate a part of the portfolio to provide funds for some

alternative use

Constraints in Portfolio Revision

The practice of portfolio adjustment involving purchase and sale of

securities gives rise to certain problems which act as constraints in portfolio

revision.

1. Transaction Cost

Buying and selling of securities involve transaction costs such as

commission and brokerage. Frequent buying and selling may push up

transaction costs thereby reducing the gains from portfolio revision.

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2. Taxes

Frequent sales of securities of periodic portfolio revision will result in

short term capital gains which would be taxed at a higher rate

compared to long term capital gains.

3. Statutory Stipulations

The largest portfolios in every country are managed by investment

companies and mutual funds. These institutional investors are

governed by certain statutory stipulations regarding their investment

activity.

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PORTFOLIO EVALUATION

Portfolio Evaluation is the last step in the process of portfolio

management. It is the stage where we examine to what the extent the

objectives has been achieved. Through portfolio evaluation the

investor tries to find out how well the portfolio has performed.

Without portfolio evaluation, portfolio management would be

incomplete.

NEED FOR EVALUATION

Evaluation is an appraisal of performance. Whether the investment

activity is carried out by individual investors themselves or through

mutual funds and investment companies, different situations arise

where evaluation of performance becomes imperative.

Self Evaluation

An investor would like to evaluate the performance of his portfolio in

order to identify the mistakes committed by him. This self evaluation

will enable him to improve his skills and achieve better performance

in future.

Evaluation of Portfolio Managers

Evaluation of Mutual Funds

Two methods of measuring the reward per unit of risk have been proposed

by William Sharpe and Jack Treynor in their pioneering work on evaluation

of portfolio performance.

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Sharpe Ratio

It is the ratio of the reward or risk premium to the variability of return or risk

as measured by the standard deviation of return. The formula for

calculating Sharpe Ratio may be stated as:

Sharpe Ratio (SR) = (rp – rf) / p

Where rp = Realised return on the portfolio

rf = Rik free rate of Return

p = Standard deviation of portfolio return

Treynor Ratio

It is the ratio of the reward or risk premium to the variability of return or risk as measured by beta of portfolio.

Treynor Ratio (TR) = (rp – rf) / p

Fund Return (%) Standard Deviation (%) Beta

A 12 18 .7

Z 19 25 1.3

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M (Market Index) 15 20 1.0

the risk free rate of return is 7 per cent.

SR =

A = 12 – 7 /18 = .277

Z = 19 – 7 /25 = .48

M = 15 – 7 /20 = .40

as per Sharpe’s performance measure, fund Z has performed better than the

benchmark market index, while fund A has performed worse than the market index.

TR =

A = 12 – 7 /.7 = 7.14

Z = 19 – 7 / 1.3 = 9.23

M = 15 – 7 / 1.0 = 8.00

according to Treynor’s performance measure also, fund Z has performed better and

fund A has performed worse than the benchmark.

Conclusion

The composition of a share portfolio says a lot about its owner. An outsider should be able to look at the holdings in it and see

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whether the owner of the shares is aiming for growth or income whether the owner is risk-averse or willing to take risks whether the owner considers himself a beginner, an intermediate or

advanced investor whether the owner is a short term or long term investor

The point is that different types of investors, with different goals, resources and aptitudes require very different types of investments. If you've put together your portfolio rationally, it will reflect your circumstances.

The purpose of this workshop is to drive home the lesson that in creating and managing a portfolio, do so rationally. Think about your objectives and how different asset classes meet them, think about risk and how to reduce it, think about diversification and the level you are comfortable with, and think about your weaknesses and strengths and how to work within them.

Investing with a high degree of self-awareness will not only bring you the best results but also preserve your peace of mind in what can be a fraught theatre of nerves.

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Bibliography

1. Avadhani, V.A., Securities Analysis and Portfolio Management,

Himalaya Publishing House, Mumbai, 1997

2. David Blake, Financial Market Analysis, McGraw-Hill, London,

1992.

3. Edwin J. Elton and Martin J. Gruber, Modern Portfolio Theory and

Investment Analysis, 4th edition, John Wiley & Sons, New York,

1994.

4. James L. Farrell, Jr., Portfolio Management: Theory and

Application, 2nd ed., McGraw-Hill, Inc., New York, 1997.

5. Preeti Singh, Investment Management, Himalaya Publishing House,

Mumbai, 1993.

6. Samir K. Barua, J.R. Varma and V. Raghunathan, Portfolio

Management, 1st revised ed., Tata McGraw-Hill, New Delhi, 1996.