PORTFOLIO THEORIES IN THE CONTEXT OF PORTFOLIO MANAGEMENT

FINANCIAL INSTRUMENTS PORTFOLIOS THEORIES IN THE CONTEXT OF PORTFOLIO MANAGEMENT:

You already know about the meaning of

"financial instruments" & "portfolios".

Now let us know about the meaning of "Theory".

Here Theory means a set of principles or ideas on which an activity(Portfolio Creation & Management) is based.

Here Principles are the system of beliefs governing the behaviour of Persons (Portfolio Creators & Managers).

Here ideas are the thoughts or suggestions about a possible course of action (Portfolio Creation & Management) .

Now we can discuss about the Portfolio Theories

1.PORTFOLIO THEORIES:

Portfolio theory forms the basis for portfolio management.

Portfolio management deals with the selection of financial instruments and their continuous shifting in the portfolio to optimise returns to suit the objectives of an investor.

This, however, requires financial expertise in selecting the right mix of financial instruments in changing market conditions to get the best out of the Financial Instruments market.

In India as well as in a number of Western countries, portfolio management service has assumed the role of a specialised service and a number of professional investment bankers/fund managers compete aggressively to provide the best options to high net-worth clients, who have little time to manage their own investments.

The idea is catching on with the growth of the capital market and an increasing number of people want to earn profits by investing their desired money in a planned manner.

A portfolio theory guides investors about the method of selecting and combining Financial Instruments that will provide the highest expected rate of return for any given degree of risk or that will expose the investor to the lowest degree of risk for a given expected rate of return. Portfolio theory can be discussed under the following heads:

1.1 Traditional Approach :

The traditional approach to portfolio management concerns itself with the investor, definition of portfolio objectives, investment strategy, diversification and selection of individual investment as detailed below:

(i) Investor's study includes an insight into his –

(a) age, health, responsibilities, other assets,

portfolio needs;

(b) need for income, capital maintenance,

liquidity;

(c) attitude towards risk; and

(d) taxation status;

(ii) Portfolio objectives are defined with reference to maximising the investors' wealth which is subject to risk. The higher the level of risk borne, the more the expected returns.

(iii) Investment strategy covers examining a number of aspects including:

(a) Balancing fixed interest Financial Instruments

against equities ;

(b) Balancing high dividend payout companies

against high earning growth companies as

required by investor;

(c) Finding the income of the growth portfolio;

(d) Balancing income tax payable against capital

gains tax;

(e) Balancing transaction cost against capital gains

from rapid switching; and

(f) Retaining some liquidity to seize upon bargains.

(iv) Diversification reduces volatility of returns and risks and thus adequate equity diversification is sought. Balancing of equities against fixed interest bearing financial instruments is also sought.

(v) Selection of individual investments is made on the basis of the following principles:

(a)Methods for selecting sound investments by

calculating the true or intrinsic value of a share

and comparing that value with the current market

value (i.e. by following the fundamental analysis)

or trying to predict future share prices from past

price movements (i.e., following the technical

analysis);

(b) Expert advice is sought besides study of published accounts to predict intrinsic value;

(c) Inside information is sought and relied upon to move to diversified growth companies,

switch quickly to winners than loser companies;

(d) Newspaper tipsters about good track record of companies are followed closely;

(e) Companies with good asset backing, dividend growth, good earning record, high quality management with appropriate dividend paying policies and leverage policies are traced out constantly for making selection of portfolio holdings.

In India, most of the share and financial instruments brokers follow the above traditional approach for selecting a portfolio for their clients.

The Traditional Approach suggests that one should not put all money in one basket, instead an investor should diversify by investing in different financial instruments and assets.

As long as an investor invests in different assets and financial instruments, he shall get the advantage of diversification.

Markowitz questioned this wisdom of the Traditional Approach and proved that putting money in particular kinds of financial instruments or assets will give the investor advantage of diversification.

Therefore, one should not blindly pick up financial instruments and assets to make a portfolio.

Originally developed by Harry Markowitz in the early 1950's, Portfolio Theory - sometimes referred

to as Modern Portfolio Theory - provides a logical/mathematical framework in which investors can optimise their risk and return.

Harry Markowitz introduced portfolio theory in a 1952 Journal of Finance article. That article has been widely referenced, frequently reprinted, and it was cited when Markowitz was awarded the Nobel prize.

The central plank of the theory is that diversification through portfolio formation by adding securities whose returns are having low correlation or negative correlation into Portfolio can reduce risk, and second, one can get higher return by taking higher risk.

Harry Markowitz is regarded as the father of Modern Portfolio Theory. According to him, investors are mainly concerned with two properties of an asset: risk and return.

The essence of his theory is that risk of an individual asset hardly matters to an investor. What really matters is the contribution it adds to the investor's overall risk.

By turning his principle into a useful technique for selecting the right portfolio from a range of different assets, he developed the 'Mean Variance Analysis' in 1952.

2.2 MARKOWITZ MODEL OF RISK-RETURN OPTIMIZATION :

The Optimal Portfolio as per Markowitz Theory is investor specific.

The portfolio selection problem can be divided into two stages:

(1) finding the mean-variance efficient portfolios

and

(2) selecting one such portfolio.

Investors do not like risk and the greater the riskiness of returns on an investment, the greater will be the returns expected by investors.

There is a trade-off between risk and return which must be reflected in the required rates of return on investment opportunities.

The standard deviation (or variance) of return measures the total risk of an investment. It is not necessary for an investor to accept the total risk of an individual financial instrument.

Investors can diversify to reduce risk. As number of

holdings approach larger, a good deal of total risk is removed by diversification.

1.2.2 Assumptions of the Model:

It is a common phenomenon that the diversification of investments in the portfolio leads to reduction

in variance of the return, even for the same level of expected return.

This model has taken into account risks associated with investments - using variance or standard deviation of the return.

This model is based on the following assumptions:

(i) The return on an investment adequately summarises the outcome of the investment.

(ii) The investors can visualise a probability distribution of rates of return.

(iii) The investors' risk estimates are proportional to the variance of return they perceive for a financial instrument or portfolio.

(iv) Investors base their investment decisions on two criteria i.e. expected return and variance of

return.

(v) All investors are risk averse. For a given expected return he prefers to take minimum risk, for

a given level of risk the investor prefers to get maximum expected return.

(vi) Investors are assumed to be rational in so far as they would prefer greater returns to lesser ones given equal or smaller risk and are risk averse. Risk aversion in this context means merely that, as between two investments with equal expected returns, the investment with the smaller risk would be preferred.

(vii) ‘Return’ could be any suitable measure of monetary inflows like NPV but yield has been the

most commonly used measure of return, so that where the standard deviation of returns is referred to it is meant the standard deviation of yield about its expected value.

2.3 Efficient Frontier:

Markowitz has formalised the risk return relationship and developed the concept of efficient frontier using the Mean-Variance Dominance Principle.

For selection of a portfolio, comparison between combinations of portfolios is essential. As a rule, a portfolio is dominating another portfolio in terms

of mean and variance if there is another portfolio with:

(a) A lower expected value of return and same or higher standard deviation (risk).

(b) The same or higher standard deviation (risk) but a lower expected return.

Markowitz has defined the diversification as the process of combining assets that are less than

perfectly positively correlated in order to reduce portfolio risk without sacrificing any portfolio returns.

If an investors’ portfolio is not efficient he may:

(i) Increase the expected value of return without increasing the risk.

(ii) Decrease the risk without decreasing the expected value of return, or

(iii) Obtain some combination of increase of expected return and decrease risk.

This is possible by switching to a portfolio on the efficient frontier.

If all the investments are plotted on the risk-return space, individual financial instruments would be dominated by portfolios, and the efficient frontier would be containing all Efficient Portfolios

(An Efficient Portfolio has the highest return among all portfolios with identical risk and the lowest risk among all portfolios with identical return). Fig – 1 depicts the boundary of possible investments in financial instruments, A, B, C, D, E and F; and B, C, D, are lying on the efficient frontier.

The best combination of expected value of return and risk (standard deviation) depends upon the investors’ utility function.

The individual investor will want to hold that portfolio of financial instruments which places him on the highest indifference curve, choosing from the set of available portfolios.

The dark line at the top of the set is the line of efficient combinations, or the efficient frontier. The optimal portfolio for an investor lies at the point where the indifference curve for the concerned investor touches the efficient frontier.

This point reflects the risk level acceptable to the investor in order to achieve a desired return and provide maximum return for the bearable level of risk. The concept of efficient frontier and the location of the optimal portfolio are explained with the help of Fig-2.

n Fig-2 A, B, C, D, E and F define the boundary of all possible investments out of which investments

in B, C and D are the efficient portfolios lying on the efficient frontier.

The attractiveness of the Investment proposals lying on the efficient frontier depend on the investors' attitude to risk. At point B, the level of risk and return is at optimum level. The returns are highest at point D, but simultaneously it carries higher risk than any other investment.

The shaded area in Fig-3 represents all attainable or feasible portfolios, that is all the combinations of risk and expected return which may be achieved with the available securities. The efficient frontier contains all possible efficient portfolios and any point on the frontier dominates any point to the right of it or below it.

Consider the portfolios represented by points B and E. B and E promise the same expected return E(R1) but the risk associated with B is σ (R1) whereas the risk associated with E is σ (R2).

Investors, therefore, prefer portfolios on the efficient frontier rather than interior portfolios given the assumption of risk aversion; obviously, point A on the frontier represents the portfolio with the least possible risk, whilst D represents the portfolio with the highest possible rate of return with highest risk.

The investor has to select a portfolio from the set of efficient portfolios lying on the efficient frontier. This will depend upon his risk-return preference. As different investors have different preferences, the optimal portfolio of securities will vary from one investor to another.

3. POST - MODERN PORTFOLIO THEORY:

The post-modern portfolio theory (PMPT) is a portfolio optimization methodology that uses the downside risk of returns instead of the mean variance of investment returns used by the modern portfolio theory (MPT).

Both theories describe how risky assets should be valued, and how rational investors should utilise diversification to achieve portfolio optimization. The difference lies in each theory's definition of risk, and how that risk influences expected returns.

The theory uses the standard deviation of negative returns as the measure of risk, while the modern portfolio theory uses the standard deviation of all returns as a measure of risk.

After economist Harry Markowitz pioneered the concept of MPT in 1952, later winning the Nobel Prize for Economics for his work centred on the establishment of a formal quantitative risk and return framework for making investment decisions, the MPT remained the primary school of thought on portfolio management for many decades and it continues to be utilised by financial managers.

Rom and Ferguson noted two important limitations of the MPT: its assumptions that the investment returns of all portfolios and securities can be accurately represented by a joint elliptical distribution, such as the normal distribution, and that the variance of portfolio returns is the right measure of investment risk.

Rom and Ferguson then refined and introduced their theory of PMPT in a 1993 article in The Journal of Performance Management. The PMPT has continued to evolve and expand as academics worldwide have tested these theories and verified that they have merit.

3.1Components of the Post-Modern PortfolioTheory (PMPT):

The differences in risk, as defined by the standard deviation of returns, between the PMPT and the MPT is the key factor in portfolio construction. The MPT assumes symmetrical risk whereas the PMPT assumes asymmetrical risk. Downside risk is measured by target semi-deviation, termed downside deviation, and captures what investors fear most: having negative returns.

The Sortino ratio was the first new element introduced into the PMPT rubric by Rom and Ferguson, which was designed to replace MPT’s Sharpe ratio as a measure of risk-adjusted return, and improved upon its ability to rank investment results. Volatility skewness, which measures the ratio of a distribution’s percentage of total variance from returns above the mean to the returns below the mean, was the second portfolio-analysis statistic to be added to the PMPT rubric.

3.2 Post-Modern Portfolio Theory (PMPT) vs. Modern Portfolio Theory (MPT) :

The MPT focuses on creating investment portfolios with assets that are non-correlated; if one asset is negatively impacted in a portfolio, other assets are not necessarily so. This is the idea behind diversification. For example, if an investor has oil shares and technology shares in their portfolio and new government regulation on oil companies hurts the profits of oil companies, their shares will lose value; however, the technology shares won't be affected. The gains in the tech stocks will offset the losses of the oil shares.

The MPT is the primary method in which investment portfolios are constructed today. The theory is the basis behind passive investing. There are, however, many investors that seek to increase their returns beyond what passive investing can bring or reduce their risk in a more significant way; or both. This is known as seeking alpha; returns that beat the market, and is the idea behind actively managed portfolios, most often implemented by investment managers, particularly hedge funds.

This is where the post-modern portfolio theory comes into play, whereby portfolio managers seek to understand and incorporate negative returns in their portfolio calculations.