Portfolio management - PowerPoint Presentation

Slide1

Portfolio management

Slide2

How Finance is organized

Corporate finance

Investments

International Finance

Financial DerivativesSlide3

Risk and Return

The investment process consists of two broad tasks:

security and market analysis

portfolio managementSlide4

Risk and Return

Investors are concerned with both expected return

risk

As an investor you want to maximize the returns for a given level of risk.

The relationship between the returns for assets in the portfolio is important.Slide5

Risk Aversion

Portfolio theory assumes that investors are averse to risk

Given a choice between two assets with equal expected rates of return, risk averse investors will select the asset with the lower level of risk

It also means that a riskier investment has to offer a higher expected return or else nobody will buy itSlide6

Top Down Asset Allocation

1. Capital Allocation decision: the choice of the proportion of the overall portfolio to place in risk-free

assets versus risky assets.

2. Asset Allocation decision: the distribution of risky

investments across broad asset classes such as bonds,

small stocks, large stocks, real estate etc.

3. Security Selection decision: the choice of which

particular securities to hold within each asset class.Slide7

Expected Rates of Return

Weighted average of expected returns (R

i

) for the individual investments in the portfolio

Percentages invested in each asset (w

i

) serve as the weights

E(R

port

) =

S

w

i

R

iSlide8

Portfolio Risk (two assets only)

When two risky assets with variances

s

1

2

and

s

2

2

, respectively, are combined into a portfolio with portfolio weights w

1

and w

2

, respectively, the portfolio variance is given by:



p

2

= w

1

2



1

2

+ w

2

2



2

2

+ 2W

1

W

2

Cov(r

1

r

2

)

Cov(r

1

r

2

) = Covariance of returns for

Security 1 and Security 2Slide9

Correlation between the returns of two securities

Correlation,



: a measure of the strength of the linear

relationship between two variables

-1.0

<

r

<

+1.0

If

r

= +1.0, securities 1 and 2 are perfectly positively correlated

If

r

= -1.0, 1 and 2 are perfectly negatively correlated

If

r

= 0, 1 and 2 are not correlatedSlide10

Efficient Diversification

Let’s consider a portfolio invested 50% in an equity mutual fund and 50% in a bond fund. Equity fund Bond fundE(Return) 11% 7% Standard dev. 14.31% 8.16%Correlation -1Slide11

100% bonds

100% stocks

Note that some portfolios are “better” than others. They have higher returns for the same level of risk or less. We call this portfolios EFFICIENT.Slide12

The Minimum-Variance Frontier

of Risky Assets

E(r)

Efficient

frontier

Global

minimum

variance

portfolio

Minimum

variance

frontier

Individual

assets

St. Dev.Slide13

Two-Security Portfolios with Various Correlations

100% bonds

return



100% stocks

 = 0.2

 = 1.0

 = -1.0Slide14

The benefits of diversification

Come from the correlation between asset returns

The

smaller the correlation

, the greater the risk reduction potential



greater the benefit of diversification

If

r

= +1.0, no risk reduction is possible

Adding extra securities with lower corr/cov with the existing ones decreases the total risk of the portfolioSlide15

Estimation Issues

Results of portfolio analysis depend on accurate statistical inputs

Estimates of

Expected returns

Standard deviations

Correlation coefficientsSlide16

Portfolio Risk as a Function of the Number of Stocks in the Portfolio

Nondiversifiable risk; Systematic Risk; Market Risk

Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk

n



Portfolio risk

Thus diversification can eliminate some, but not all of the risk of individual securities.