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.

 

Need for portfolio management

(1) Best Investment Plan: Portfolio management presents the best investment plan to the individuals as per their income, budget, age and ability to undertake risks.

(2) Minimizes the Risks: Portfolio management minimizes the risks involved in investing and also increases the chance of making profits.

(3) Provide Customized Investment Solutions: Portfolio management enables the portfolio managers to provide customized investment solutions to clients as per their needs and requirements.

 

Markowitz portfolio theory or  basic portfolio ,odel

In the early 1960s, the investment community talked about risk, but there was no specific measure for the term. To build a portfolio model, however, investors had to quantify their risk variable.

The basic portfolio model was developed by Harry Markowitz (1952, 1959), who derived the expected rate of return for a portfolio of assets and an expected risk measure.

Harry Markowitz model (HM model), also known as Mean-Variance Model because it is based on the expected returns (mean) and the standard deviation (variance) of different portfolios, helps to make the most efficient selection by analyzing various portfolios of the given assets.

It shows investors how to reduce their risk in case they have chosen assets not “moving” together.

 

Expected rate of return of investment projects

The expected rate of return of individual investment project will be different from that of portfolio investment projects.

Return of an Individual Investment is the expected rate of return from an investment for a given level of risks over a period.

While, the expected return of a portfolio of assets is simply the weighted average of the return of the individual securities held n the portfolio.

 

Alternative measures of risk

There are numerous potential measures of risk, but we will learn the variance or standard deviation of returns because

(1)  These measures are somewhat   intuitive/insightful,

(2) They are correct and widely recognized   risk   measures, and

(3) They have been used in most of the   theoretical asset pricing models.

 

Reduction of portfolio risk through diversification

Diversification: The process of combining securities in a portfolio is known as diversification

The aim of diversification is to reduce total risk without sacrificing portfolio return.

 

Power of diversification

To understand the power of diversification, it is necessary to consider the impact of covariance or correlation on portfolio risk more quickly.

For example, the portfolio standard deviation of 17.50 is lower than the standard deviation of either of the two securities taken separately, which were 50 and 30 respectively.

Three situations we need to examine

(1)When security returns are perfectly positive

(2)When security returns are perfectly negative

(3)When security returns are not correlated

 

When security returns are perfectly positive

When security returns are perfectly positively correlated, the coefficient correlation between the two securities will be +1. The returns of the two securities then move up or move down together.

In the case of perfectly positive correlation, diversification provides only risks averaging and no risk reduction because the portfolio risk can not be reduced below the individual security risk.

 

When security returns are perfectly negative

When security returns are perfectly negatively correlated, the correlation coefficient between them becomes -1. The returns always move in exactly opposite direction.

The portfolio may become entirely risk free when security returns are perfectly negatively correlated. Hence, diversification becomes a highly productive activity when they are perfectly correlated. Because, portfolio risk can be reduced significantly and even sometimes eliminated.

 

When security returns are not correlated

When the returns of two securities are entirely uncorrelated, the correlation coefficient would be zero.

In this case, the portfolio standard deviation is less than the standard deviations of individual securities in the portfolio.

Thus, when security returns are uncorrelated, diversification reduces risk and is a productive activity.

 

Conclusion on diversification

It may be concluded  that the diversification reduces risk in all cases except when the security returns are perfectly positively correlated.

As correlation coefficient declines from +1 to -1, the portfolio standard deviation also declines. But, the risk reduction is greater when the security returns are negatively correlated.