What is a portfolio
A portfolio refers to a collection of investment tools as stocks, shares mutual funds, bonds, cash, and so on depending on the Investments’ income and convenient time frame.
What is a Portfolio Management?
The art of selecting the right investment policy for individuals in terms of minimum risk and maximum return is called portfolio management.
Portfolio management refers to managing an individual’s investments in 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 tricks.
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 Model
In the early 1960s, the investment community talked about risk, but there was no specific measure for the return. To build a portfolio model, however, investors had to quantify their risks 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 weeks measure.
Harry Markowitz model (HM model), also known as a 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 on Investment Projects
The expected rate of return of individual investment projects 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 risk over a period.While the expected return of a portfolio of assets is simply the weighted average of the individual securities held on the portfolio.
Alternative Measures of Risk
There are numerous potential measures of risk, but we will learn the variance or standard variation of return 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.
Deduction of Portfolio Risk Thought
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 and correlation on portfolio risk more quickly.
For example, the portfolio standard deviation of 17.50 is lower then 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
Why security Returns are Perfectly Positive
Why security returns are perfectly positively correlated, the coefficient correlation between the two security will be +1. The returns of the two securities then move up for move down together.
In the case of a perfectly positive correlation, diversification provides only risks averaging and no reduction because the portfolio risk cannot be reduced below the individual security risk.
When Security returns are perfectly negative
When Security returns are perfectly negatively correlated, the correction coefficient between -1. The returns always move in the actual 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 risks can be reduced significantly and events 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.