G.L.

BAJAJ INSTITUTE OF TECHNOLOGY AND MANAGEMENT

RESEARCH PROJECT REPORT ON

“A STUDY ON PORTFOLIO MANAGEMENT RISK AND INVESTMENT

BEHAVIOUR”
TOWARDS THE PARTIAL FULLFILLMENT FOR THE AWARD OF DEGREE OF

MASTER OF BUSINESS ADMINISTRATON (MBA)

(Dr. A.P.J. Abdul Kalam Technical University, Lucknow, Uttar Pradesh)

by

AMAN KUMAR GUPTA

(2201920700037)

Session 2023-24

Under the Supervision of

Dr. Aarti Loomba

 DECLARATION

I hereby declare that the work presented in this report entitled “A STUDY ON PORTFOLIO
MANAGEMENT RISK AND INVESTMENT BEHAVIOUR”, was carried out by me. I have not
submitted the matter embodied in this report for the award of any other degree or diploma
of any other University or Institute. I have given due credit to the original authors/sources
for all the words, ideas, diagrams, graphics, computer programs, experiments, results, that
are not my original contribution. I have used quotation marks to identify verbatim
sentences and given credit to the original authors/sources.

I affirm that no portion of my work is plagiarized, and the experiments and results reported
in the report are not manipulated. In the event of a complaint of plagiarism and the
manipulation of the experiments and results, I shall be fully responsible and answerable.

Name : Aman Kumar Gupta

Roll. No. 2201920700037

Specialization : Marketing and Finance

(Student’s Signature)
 G. L. BAJAJ
INSTITUTE OF TECHNOLOGY & MANAGEMENT
Approved by A.I.C.T.E. & affiliated to Dr. A.P.J. Abdul Kalam Technical University

Date:

CERTIFICATE
This is to certify that Aman Kumar Gupta Roll No. 2201920700037 has

undertaken this project titled “A STUDY ON PORTFOLIO MANAGEMENT RISK

AND INVESTMENT BEHAVIOUR ” for the partial fulfillment of the award of

Master of Business Administration degree from Dr. A P J Abdul Kalam Technical

University, Lucknow (U. P.), India.

I wish him/ her all the best for his/her bright future ahead.

Project Supervisor

Department of Management
Studies

Head of Department

Department of Management

Studies
 ACKNOWLEDGEMENT

I feel great pleasure to submit this report as the culmination of efforts by my teachers and

me. This is the last step of my path leading to graduate degree in Management through

M.B.A.

This project is the result of my hard work, sincerity, and devotion, & put my best to

complete and in turn, gain lots of knowledge and confidence from this project.

I am deeply thankful to my project guide Dr. Aarti Loomba, Faculty Guide, G.L Bajaj

Institute of Technology & Management, Gr. Noida for her constant support and guide this

Research project report has been successful completed.

Lastly, I am very thankful to my parents and all those people has been supported me

directly or indirectly, without their constant support and help this research report

never be successful completed.

Aman Kumar Gupta

(2201920700037)

1
 TABLE OF CONTENTS

Page No.

EXECUTIVE SUMMARY 3
CHAPTER ONE
 Introduction to Investment 4-12

CHAPTER TWO
 Literature Review of Portfolio Management 12-66

CHAPTER THREE
 Research Methodology 66
 Objective of the Study 67

CHAPTER FOUR
 Analysis and Interpretation of Data 68-76

CHAPTER FIVE

 Findings of study 78
 Recommendations 79-80
 Conclusion 81
 Limitations 82
 Bibliography 83

2
 EXECUTIVE SUMMARY

As we all know that every topic of research has its own importance and it’s slightly tough to gather
the information that is required completely for a particular subject. There are different ways of
presenting an idea in your report. It’s obvious that defining a topic and its objective is not easy,
but making the proper start in order to do something, which is of some use, is different.

It is matter of privilege for me that I got an opportunity to do Research work on the topic “Portfolio
Management Risk and Behavior of Investors”. The project includes study of various terms and
facts related with the portfolio management and study regarding how to create and manage
portfolio in order to increase its efficiency and effectiveness.

The aim of the research report is to get overview of Portfolio Management. To understand how to
diversify risk in portfolio. The objective is to cope with risk and return situations while making
investment. To make investment in securities which are more profitable as compared to others.

In this research report main emphasis is given on:

 How to make investment in various securities.

 Overview of portfolio management.
 How to construct and manage portfolio.
 Risk and return in portfolio
 How to select a portfolio.
 Why investors make investment.
 How to diversify risk in portfolio.
 Perceived problem of an investor while making investment.
 How to increase profitability in investment.

The research report is prepared in order to aware investors while making investment and as a result
investors make investment in more profitable securities which ultimately increase their earnings
and increase their economic status in society. The research report also helps in making balance
between risk and return in investment.

3
CHAPTER – 1

4
 INVESTMENT
Investment is the application of money for earning more money. Investment also means savings

or savings made through delayed consumption.

According to economics, investment is the utilization of resources in order to increase income

or production output in the future.

An amount deposited into a bank or machinery that is purchased in anticipation of earning

income in the long run is both examples of investments. Although there is a general broad

definition to the term investment, it carries slightly different meanings to different industrial

sectors.

Types of Investment

There are many ways to invest our money. Of course, to decide which investment vehicles are

suitable for us, we need to know their characteristics and why they may be suitable for a particular

investing objective.

1. Bonds

2. Stocks

3. Mutual funds

[Link], Futures

5. FOREX

6. Gold

7. Real Estate, Etc.

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1) Bonds

Grouped under the general category called fixed-income securities, the term bond is commonly

used to refer to any securities that are founded on debt. When we purchase a bond, we are lending

out our money to a company or government. In return, they agree to give interest on our money

and eventually pay back the amount we lent out.

The main attraction of bonds is their relative safety. If we are buying bonds from a stable

government, our investment is virtually guaranteed, or risk-free. The safety and stability, however,

come at a cost because there is little risk, there is little potential return. As a result, the rate of

return on bonds is generally lower than other securities.

2) Stocks

When we purchase stocks, or equities, as our advisor might put it, we become a part owner of the

business. This entitles us to vote at the shareholders meeting and allows us to receive any profits

that the company allocates to its owners. These profits are referred to as dividends.

While bonds provide a steady stream of income, stocks are volatile i.e., they fluctuate in value on

a daily basis. When we buy a stock, we aren't guaranteed anything. Many stocks don't even pay

dividends, in which case, the only way that we can make money is if the stock increases in value

– which might not happen. Compared to bonds, stocks provide relatively high potential returns.

Of course, there is a price for this potential: we must assume the risk of losing some or all of our

investment.

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3) Mutual Fund

A mutual fund is a collection of stocks and bonds. When we buy a mutual fund, we are pooling

our money with a number of other investors, which enables us (as part of a group) to pay a

professional manager to select specific securities for us. Mutual funds are all set up with a specific

strategy in mind, and their distinct focus can be nearly anything: large stocks, small stocks, bonds

from governments, bonds from companies, stocks and bonds, stocks in certain industries, stocks

in certain countries, etc.

The primary advantage of a mutual fund is that we can invest our money without the time or the

experience that are often needed to choose a sound investment. Theoretically, we should get a

better return by giving our money to a professional rather than if we were to choose investments

our self. In reality, there are some aspects about mutual funds that we should be aware of before

choosing them.

4) Alternative Investments: Options, Futures, FOREX, Gold, Real Estate, Etc.

So, generally there are two basic securities: equity and debt, better known as stocks and bonds.

While many investments fall into one of these two categories, there are numerous alternative

vehicles, which represent the most complicated types of securities and investing strategies. But we

don't need to worry about alternative investments at the start of our investing career. They are

generally high-risk/high-reward securities that are much more speculative than plain old stocks

and bonds. It is true that there is the opportunity for big profits, but they require some specialized

knowledge. So, if we don't know what we are doing, we get our self into a lot of trouble. Experts

and professionals generally agree that new investors should focus on building a financial

foundation before speculating.

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 The Investment Process

As investors, we would all like to beat the market handily, and we would all like to pick "great"

investments on instinct. However, while intuition is undoubtedly a part of the process of investing,

it is just part of the process. As investors, it is not surprising that we focus so much of our energy

and efforts on investment philosophies and strategies, and so little on the investment process. It is

far more interesting to read about how Peter Lynch picks stocks and what makes Warren Buffett

a valuable investor, than it is to talk about the steps involved in creating a portfolio or in executing

trades. Though it does not get sufficient attention, understanding the investment process is critical

for every investor for several reasons:

 The investment process outlines the steps in creating a portfolio, and emphasizes the

sequence of actions involved from understanding the investor’s risk preferences to asset

allocation and selection to performance evaluation. By emphasizing the sequence, it

provides for an orderly way in which an investor can create his or her own portfolio or

a portfolio for someone else.

 The investment process provides a structure that allows investors to see the source of

different investment strategies and philosophies. By so doing, it allows investors to take

the hundreds of strategies that they see described in the common press and in investment

newsletters and to trace them to their common roots.

 The investment process emphasizes the different components that are needed for an

investment strategy to by successful, and by so doing explain why so many strategies

that look good on paper never work for those who use them.

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It does not emphasize individual investors or push an investment philosophy. It does not focus

heavily on coming up with strategies that beat the market, though there is reference to some of

them in the course of the book. Instead, it talks about the process of investing and how this process

is the same no matter what investment philosophy one might have.

The book is built around the investment process. The process always starts with the investor and

understanding his or her needs and preferences. For a portfolio manager, the investor is a client

and the first and often most significant part of the investment process understands the client’s

needs the client’s tax status and most importantly, his or her risk preferences. For an individual

investor constructing his or her own portfolio, this may seem simpler, but understanding one’s

own needs and preferences is just as important a first step as it is for the portfolio manager.

The next part of the process is the actual construction of the portfolio, which we divide into

three sub-parts. The first of these is the decision on how to allocate the portfolio across

different asset classes defined broadly as equities, fixed income securities and real assets

(such as real estate, commodities and other assets). This asset allocation decision can also be

framed in terms of investments in domestic assets versus foreign assets, and the factors driving

this decision. The second component is the asset selection decision, where individual assets are

picked within each asset class to make up the portfolio. In practical terms, this is the step where

the stocks that make up the equity component, the bonds that make up the fixed income component

and the real assets that make up the real asset component are picked. The final component is

execution, where the portfolio is actually put together, where investors have to trade off

transactions cost against transactions speed. While the importance of execution will vary across

investment strategies, there are many investors who have failed at this stage in the process.

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The final part of the process, and often the most painful one for professional money managers, is

the performance evaluation. Investing is after all focused on one objective and one objective

alone, which is to make the most money you can, given the risk constraints we operate under.

Investors are not forgiving of failure and unwilling to accept even the best of excuses, and loyalty

to money managers is not a commonly found trait. By the same token, performance evaluation is

just as important to the individual investor who constructs his or her own portfolio, since the

feedback from it should largely determine how that investor approaches investing in the future.

These parts of the process are summarized in Figure 1. The first major section is on understanding

client needs and preferences, where we look at not only how to think about risk in investing but

also at how to measure an investor’s willingness to take risk. The second section looks at the asset

allocation decision, while the third section examines different approaches to selecting assets. The

fourth section takes a brief look at the execution decision, and the fifth section develops different

approaches to evaluating performance.

10
Investment Process Chart

11
CHAPTER – 2

12
 PORTFOLIO MANAGEMENT

What is Portfolio?
A portfolio may be defined as a collection of assets or a carefully blend combination of assets,

which are related and which gives a maximum return with minimum risk. Portfolio is a collection

of businesses, each of which makes a distinct contribution to the overall corporate performance

and which should be managed accordingly.

Objective of financial management: the finance manager concern with the selecting 'basket of

asset and the basket of securities. This basket of investment is also known as portfolio of assets

or investment.

What is Portfolio Management?

The portfolio management means achieving and maintaining a portfolio so as to get the best

possible return with minimum risk involved.

The art and science of making decisions about investment mix and policy, matching investments

to objectives, asset allocation for individuals and institutions, and balancing risk against

performance.

Portfolio Theories

1. Traditional Portfolio Theory

2. Modern Portfolio Theory

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1. Traditional Portfolio Theory

Traditional portfolio theory is a portfolio management practice in which only two parameters

of investment avenues are considered, i.e. (a) returns and (b) risk. The correlation between

securities is not considered. Generally, investors have following concepts while formulating

the portfolio:

 Low or reasonable returns can be achieved when risk is low.

 Risk is considered in totality; it is not sub-divided into systematic and non-systematic.

 Selection of securities is done by matching risk and returns.

 Diversification under the portfolio is generally done on the basis of class of securities-

equity or debt, maturity of bonds, selecting different industries.

Steps for Portfolio Creation under Traditional Approach

 Deciding about Portfolio Objectives and Constraints

 Diversification according to traditional system

 Allocation of funds

 Execution

Features of Traditional Approach

 Securities are evaluated individually

 Only risk and return are considered

 Traditional system of diversification

 Matching of risk and return for the allocation of funds

 Risk is considered in totality

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1. Modern Portfolio Theory

Modern Portfolio Theory was for the first time given by Harry Markowitz. This theory stress

upon the fundamentals that, creation of portfolio depends upon the relationship between the

returns, expected returns represented by mean and the variability of these returns represented

by standard deviation/variance. Portfolio The modern portfolio theory favors the concept of

Efficient Frontier. Modern Portfolio Theory believes that investors possess utility curve, with

the help of which portfolio selection can be done by tracing the efficient frontier.

This theory is based on following principles:

a. Principle of Risk: Emphasis of this principle is on the fundamental that selection of

securities in the portfolio is to be done by comparing risks and returns of securities.

Securities should not be included in the portfolio only on the basis of their returns.

b. Principle of Diversification: MPT advocates that risk of a portfolio can be minimized

with the help of diversification. This can be done by considering the correlation of

securities with each other. The securities to be included in the portfolio should have as far

as possible negative correlation coefficient. In a two-security portfolio the risk can even be

minimized to zero, if securities have a perfect negative correlation.

c. Principle of Portfolio Effect: This principle of portfolio says that one should never put all

his egg in one basket. A portfolio should contain more than one share/debenture. By

including a sizeable number of securities in a portfolio, one can minimize non-systematic

risk. This happens because poor performance of one gets adjusted against the better

performance of another.

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d. Principle of Dominance: MPT advocates that fundamental of dominant portfolio/share.

A dominant portfolio is the one which out performs others on risk return parameter. A

portfolio or security attains such position if it provides maximum returns for a given level

of risk or has minimum risk for a given level of returns as compared to any other

portfolio/security in the market.

e. Principle of market risk: It is the market risk which is much more important while

selecting the securities for a portfolio. Market risk means the risk of a share on account of

its association with market wide factors. These market wide factors influence the

performance of almost all the shares in the market.

f. Principle of beta: Beta represents sensitivity of a security with respect to the market

movements. Beta is calculated by considering the covariance of the share with the market

portfolio/index.

g. Principle of trade-off between risk and return: The MPT believes that investors are

rational investors and they make the investment by following the fundamentals of higher

the risk, higher will be the returns and lower the risk, lower will be the returns.

h. Principle of avoidance: This principle states that we can eliminate investment in such

securities which have a high degree of non-systematic risk, because such security is likely

to wipe out the returns of rest of the securities in the portfolio. This means non-systematic

risk can be avoided completely by not investing in a risk having high non-systematic risk

component.

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 Process of Portfolio Management

Security
Analysis

Portfolio Portfolio
Evaluation Construction

Portfolio Portfolio
Revision Selection

1. Security Analysis

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 over-priced securities.

There are two alternative approaches to security analysis, namely:

a) Fundamental Analysis

b) Technical Analysis

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2. Portfolio Construction

A portfolio is a group of securities held together as investment. Investors invest their funds in a

portfolio of securities rather than in a single security because they are risk averse. By constructing

a portfolio, investors attempt to spread risk by not putting all their eggs into one basket. Thus,

diversification of one’s holdings is intended to reduce risk in investment.

3. Portfolio Selection

Portfolio analysis provides the input for the next phase in portfolio management which is portfolio

selection. The goal of portfolio construction is to generate a portfolio that provides the highest

returns at a given level of risk. The inputs from portfolio analysis can be used to identify the set of

efficient portfolios. From this set of efficient portfolios, the optimal portfolio has to be selected for

investment.

4. Portfolio Revision

The investor has to revise his portfolio in the light of the developments in the market. This revision

leads to purchase of some new securities and sale some of the existing securities from the portfolio.

The mix of securities and their proportion in the portfolio changes as a result of the revision.

5. Portfolio Evaluation

Portfolio evaluation provides a mechanism for identifying weaknesses in the investment process

and for improving these deficient areas. It provides a feedback mechanism for improving the entire

portfolio management process.

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 CONCEPT OF RISK AND RETURN

Investor has many motives for investing. The most important of all is to earn a return on their

investment. The investors not only like return but also dislike risk. So, in order to discuss he

portfolio selection with risk and return context, what is required is the

 clear understanding of what is risk &return

 what creates them

 how they can measure

1. Return

Investments involve the tradeoff between current and future consumption. It is this trade off, the

delay of current consumption by allocating resources into investment assets with an expectation

of generating more resources for future consumption, that determine the rate of return and risk.

The return is actually a mode for compensating the loss of current consumption opportunity. Hence

the rate of return is also described as the rate of exchange of between future and current

consumption.

Generally, the rate of a return of an investment act as an incentive for deferring current

consumption. The other rationale for rate of return is the time value of money in which the degree

of purchasing power in the future is affected by inflation. For instance, the value of money today

is greater than the future as in the event of a future inflation rise, more money is needed to purchase

an item than it was before.

The compensation does end with the tradeoff but it’s also affected by uncertainty as inflow of

resources (future cash flow) is contingent upon future events that are favorable to the investment

asset. But future events that negatively affect the future cash flow could occur as well; therefore,

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the issue of risk arises. And as such taking the risk in investing requires compensation as well, and

the rate of return is adjusted accordingly to the degree of uncertainty.

 Measurement of Return

a) Estimated Yield = Expected Cash Income / Current Price of Asset

b) Actual Yield = Cash Income / Amount Invested

 Expected Return

So far the discussion of return was in the context of realized return, another important element is

expected return, which is the future return of an investment asset subjected to future conditions or

events. Realized return and expected return will be the same if future expectations are met. There

could be a range of possible returns, which are usually forecasted beforehand, and each of the

forecasted return will be given a probability weight obtained from analyzing data and prudent

extrapolation.

Alternatively, expected return can be described as the expected average return of an investment.

2. Risk

The mathematical notion of investment risk is fronted by the statistical measure of variance, which

is the deviation of each observation (returns) from the expected value (average return). Each point

is then given a weight with heavier weights given to observations nearer to the average.

However, the standard practice is to use standard deviation rather than deviation which is the

square root of the variance and therefore retains the same risk ranking.

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  Types of Risk

a) Undiversifiable Risk: It is also known as "systematic" or “market risk”. Undiversifiable

risk is associated with every company. Causes are things like inflation rates, exchange

rates, political instability, and war and interest rates. This type of risk is not specific to a

particular company and/or industry, and it cannot be eliminated or reduced through

diversification; it is just a risk that investors must accept.

b) Diversifiable Risk: This risk is also known as "unsystematic risk", and it is specific to a
company, industry, market, economy or country; and it can be reduced through

diversification. The most common sources of unsystematic risk are business risk and

financial risk. Thus, the aim is to invest in various assets so that your assets are not all

affected the same way by market events.

The basic concepts of risk and return, which form the main elements of the investment framework,

there are no clear-cut prescribed methods of making a successful investment but these two

elements provide an investor with the tools to evaluate the choice of alternatives. For instance,

Asset A and Asset B have the same expected return of 10% but A has a lower standard deviation

(risk) of 0.02 and B is 0.05, and in the assumption of a risk adverse investor, Asset A will be the

better choice of investment.

Anyone who has invested in anything is familiar with the trade-off between risk and return whether

we have consciously weighed the options and thought about it or not. Before we have bought into

an investment, we have decided that we are able to stomach the risk is hopes of certain returns.

And in order to make long term financial progress we need to decide what level of risk you can

handle while at the same time remaining comfortable with our investments.

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Investment risk can be defined as the chance that an investment’s actual return will be different

than expected. Risk also means that there is the possibility of losing some, if not all, or our whole

investment. Where there are low levels of uncertainty, there are low potential returns. The opposite

is true for high levels of uncertainty.

However, it is important, that higher risk does not equal higher returns. Higher risk only gives us

the possibility for higher returns. There are also greater potential losses.

Now, it is important to bring up the concept of the risk premium. Too many try to balance their

risk against the wrong return. If they’re going to take a risk in the stock market, they’re looking

for a return of about %11 percent or so. Now, would we be willing to take the same risk for only

6%? Because this is what we are doing essentially.

Take a look at U.S. Government bonds and what they are paying. Let’s say that they’re offering a

5% return. Because these types of bonds are virtually risk free, they represent a risk-free rate of

return. Mutual funds may have losses of -6% one year and gains of 20% the next for an average

of around 11%. The difference between the 11% and the 5% is called the risk premium. The risk

you take by investing in mutual funds is for the additional 6% return.

Risk Premium

Risk premium refers to the amount which is by an investor as a result of profit from a risky

investment i.e., made by an investment.

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 PORTFOLIO AND DIVERSIFICATION

Diversification in finance is a risk management technique, related to hedging, that mixes a wide

variety of investments within a portfolio. Because the fluctuations of a single security have less

impact on a diverse portfolio, diversification minimizes the risk from any one investment.

A simple example of diversification is this one. On a particular is land the entire economy consists

of two companies: one that sells umbrellas and another that sells sunscreen. If a portfolio is

completely invested in the company that sells umbrellas, it will have strong performance during

the rainy season, but poor performance when the weather is sunny. The reverse occurs if the

portfolio is only invested in the sunscreen company, the alternative investment: the portfolio will

be high performance when the sun is out, but will tank when clouds roll in. To minimize the

weather-dependent risk in the example portfolio, the investment should be split between the

companies. With this diversified portfolio, returns are decent no matter the weather, rather than

alternating between excellent and terrible.

There are three primary strategies used in improving diversification:

1. Spread the portfolio among multiple investment vehicles, such as stocks, mutual funds, bonds,

and cash.

2. Vary the risk in the securities. A portfolio can also be diversified into different mutual fund

investment strategies, including growth funds, balanced funds, index funds, small cap, and large

cap funds. When a portfolio includes investments with varied risk levels, large losses in one area

are offset by other areas.

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3. Vary securities by industry, or even by geography. This will minimize the impact of industry-

or location-specific risks. The example portfolio above was diversified by investing in both

umbrellas and sunscreen. Another practical application of this kind of diversification is mixing

investments between domestic and international funds. By choosing funds in many countries,

events within any one country's economy have less effect on the overall portfolio.

Although diversification reduces the risk of a portfolio, it does not necessarily reduce the returns.

As a result, diversification is referred to as the only free lunch in finance.

1) Types of diversification

a) Horizontal diversification
Horizontal diversification is when a portfolio is diversified between same-type investments. It

can be a broad diversification (like investing in several NASDAQ companies) or more

narrowed (investing in several stocks of the same branch or sector). In the example above, the

move to invest in both umbrellas and sunscreen is an example of horizontal diversification. As

usual, the broader the diversification the lower the risk, from any one investment.

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In the above graph, the portfolio represented by point A is inefficient. Following the horizontal

line, there are other portfolios with the same returns but lower risk. Along the vertical line, there

are other portfolios that have the same risk but higher returns.

b) Vertical diversification

Vertical diversification is investment between different types of securities. Again, it can be a very

broad diversification, like diversifying between bonds and stocks, or a more narrowed

diversification, like diversifying between stocks of different branches. Continuing the example

from the introduction, a vertical diversification would be taking some money from umbrella and

sunscreen stock and investing it instead in bonds issued the government of the island.

While horizontal diversification lessens the risk of investing entirely in one security, vertical

diversification goes beyond that and protects against market and/or economical changes.

2) Return expectations while diversifying

The average of all the returns in a diverse portfolio can never exceed that of the top-performing

investment, and will almost always be lower than the highest return. This is unavoidable, and is

the cost of the risk insurance that diversification provides. However, strategies exist that allow the

portfolio's manager to maximize returns while still keeping risk as low as possible. Although

detailed calculations are beyond the scope of this article, these strategies seek to maximize returns

by giving different portfolio weights to investments based on their risk and return expectations.

3) Intra-portfolio correlation

Diversification can be quantified by the intra-portfolio correlation. This is a statistical

measurement between negative one and positive one that measures the degree to which the various

assets in a portfolio can be expected to perform in a similar fashion or not. A measure of -1 means

25
that the assets within the portfolio perform perfectly oppositely: whenever one asset goes up, the

other goes down. A measure of 0 means that the assets fluctuate independently, i.e., that the

performance of one asset cannot be used to predict the performance of the others. A measure of 1,

on the other hand, means that whenever one asset goes up, so do the others in the portfolio. To

eliminate diversifiable risk completely, one needs an intra-portfolio correlation of -1.

The formula for calculating intra-portfolio correlation is

Where Q is the intra-portfolio correlation, Xi is the fraction invested in asset I, Xj is the fraction

invested in asset j, Pij is the correlation between assets i and j (another number between 1 and -1

that measures how similarly assets i and j perform compared to each other), and n is the number

of different assets.

4) Portfolio Protection in Diversification and Discipline

For establishing a strategy that tempers potential losses in a bear market, the investment

community preaches the same thing that the real estate market preaches for buying a house:

"location, location, location".

Diversification is a battle cry for many financial planners, fund managers, and individual investors

alike. When the market is booming, it seems almost impossible to sell a stock for any less than the

price at which you bought it. When the indices are on their way up, it may seem foolish to be in

26
anything but equities. But because we can never be sure of what the market will do at any moment,

we cannot forget the importance of a well-diversified portfolio (in any market condition).

 Equities are wonderful, but spread the wealth. Don't put all of your investment in one stock

or one sector. Create your own virtual mutual fund by investing in a handful of companies

you know, trust, and perhaps even use in your day-to-day life. People will argue that

investing in what we know will leave the average investor too heavily retail-oriented, but

knowing a company or using its goods and services can be a healthy and wholesome

approach to this sector.

 Consider adding index funds or fixed-income funds to the mix. Investing in securities that

track various indices make a wonderful long-term diversification investment for our

portfolio. By adding some fixed-income solutions, we are further hedging our portfolio

against market volatility and uncertainty.

 Add to our investments on a regular basis. Lump sum investing may be a sucker's bet. If

we have $10,000 to invest, utilize the technique called dollar-cost-averaging. This approach

is used to smooth out the peaks and valleys created by market volatility: we invest money

on a regular basis into a specified portfolio of stocks or funds.

 Know when to get out. Our long-term investments should not be our short-term

investments gone awry. Buying and holding and dollar-cost-averaging are wonderful

strategies with which to interact with the markets for a long period of time. But just because

we have our investments on autopilot does not mean that we should ignore the forces at

work. Stay current with your investment and remain in tune with overall market conditions.

Know what is happening in the companies in which we own stock.

 Keep a watchful eye on commissions. If we are not the trading type, understand what you

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 are getting for the fees you are paying. Some firms charge a monthly fee, while others charge

transactional fees. Be cognizant of what we are paying and what we are getting for it. So, the

cheapest choice is not always the best.

Investing can (and should) be fun. It can be educational, informative and rewarding. By taking a

disciplined approach and utilizing the diversification, buy-and-hold and dollar-cost-averaging

strategies, we may find investing rewarding even in the worst of times. Keep an eye on our future.

5) The Importance of Diversification

Diversification is a technique that reduces risk by allocating investments among various financial

instruments, industries and other categories. It aims to maximize return by investing into different

areas that would each react differently to the same event. Most investment professionals agree that,

although it does not guarantee against loss, diversification is the most important component of

reaching long-range financial goals while minimizing risk. Here we look at why this is true, and

how to accomplish diversification in our portfolio.

BETA COEFFICIENT (finance)

The beta coefficient, in terms of finance and investing, describes how the expected return of a

stock or portfolio is correlated to the return of the financial market as a whole.

An asset with a beta of 0 means that its price is not at all correlated with the market; that asset is

independent. A positive beta means that the asset generally follows the market. A negative beta

shows that the asset inversely follows the market; the asset generally decreases in value if the

market goes up.

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1.1) Definition

The formula for the Beta of an asset within a portfolio is,

Where ra measures the rate of return of the asset, rp measures the rate of return of the portfolio

of which the asset is a part and Cov (ra,rp) is the covariance between the rates of return. In the

CAPM formulation, the portfolio is the market portfolio that contains all risky assets, and so the

rp terms in the formula are replaced by rm, the rate of return of the market.

Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred

to as a measure of the sensitivity of the asset's returns to market returns, its non-diversifiable

risk, its systematic risk or market risk. On an individual asset level, measuring beta can give

clues to volatility and liquidity in the marketplace. On a portfolio level, measuring beta is

thought to separate a manager's skill from his or her willingness to take risk.

The beta coefficient was born out of linear regression analysis. It is linked to a regression

analysis of the returns of a portfolio (such as a stock index) (x-axis) in a specific period versus

the returns of an individual asset (y-axis) in a specific year. The regression line is then called the

Security Characteristic Line (SCL).

where, α is called the asset's alpha coefficient and βa is called the asset's beta coefficient. Both

coefficients have an important role in Modern portfolio theory.

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For an example, in a year where the broad market or benchmark index returns 25% above the risk-

free rate suppose two managers gain 50% above the risk-free rate. Since this higher return is

theoretically possible merely by taking a leveraged position in the broad market to double the beta

so it is exactly 2.0, we would expect a skilled portfolio manager to have built the outperforming

portfolio with a beta somewhat less than 2, such that the excess return not explained by the beta is

positive. If one of the managers' portfolios has an average beta of 3.0, and the others has a beta of

only 1.5, then the CAPM simply states that the extra return of the first manager is not sufficient to

compensate us for that manager's risk, whereas the second manager has done more than expected

given the risk. Whether investors can expect the second manager to duplicate that performance in

future periods is of course a different question.

1.2) Investing

By definition, the market itself has an underlying beta of 1.0, and individual stocks are ranked

according to how much they deviate from the macro market (for simplicity purposes, the S&P 500

is usually used as a proxy for the market as a whole). A stock that swings more than the market

(i.e., more volatile) over time has a beta whose absolute value is above 1.0. If a stock moves less

than the market, the absolute value of the stock's beta is less than 1.0.

More specifically, a stock that has a beta of 2 follows the market in an overall decline or growth,

but does so by a factor of 2; meaning when the market has an overall decline of 3% a stock with a

beta of 2 will fall 6%. Betas can also be negative, meaning the stock moves in the opposite direction

of the market: a stock with a beta of -3 would decline 9% when the market goes up 3% and

conversely would climb 9% if the market fell by 3%.

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Higher-beta stocks mean greater volatility and are therefore considered to be riskier, but are in turn

supposed to provide a potential for higher returns; low-beta stocks pose less risk but also lower

returns. In the same way a stock's beta shows its relation to market shifts, it also is used as an

indicator for required returns on investment (ROI). If the market with a beta of 1 has an expected

return increase of 8%, a stock with a beta of 1.5 should increase return by 12%.

This expected return on equity, or equivalently, a firm's cost of equity, can be estimated using the

Capital Asset Pricing Model (CAPM). According to the model, the expected return on equity is a

function of a firm's equity beta (βE) which, in turn, is a function of both leverage and asset risk

(βA):

Where:

 KE = firm's cost of equity

 RF = risk-free rate (the rate of return on a "risk free investment"

 RM = return on the market portfolio

Because:

And

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Firm Value (V) = Debt Value (D) + Equity Value (E)

1.3) Estimation of Beta

To estimate Beta, one needs a list of returns for the asset and returns for the index; these returns

can be daily, weekly or any period. Next, a plot should be made, with the index returns on the x-

axis and the asset returns on the y-axis, in order to check that there are no serious violations of the

linear regression model assumptions. The slope of the fitted line from the linear least-squares

calculation is the estimated Beta. The y-intercept is the alpha.

1.4) Extreme and interesting cases

 Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile

stocks.

 Beta can be zero. Some zero-beta securities are risk-free, such as treasury bonds and cash.

However, simply because a beta is zero does NOT mean that it is risk free. A beta can be zero

simply because the correlation between that item and the market is zero. An example would be

betting on horse racing. The correlation with the market will be zero, but it is certainly not a risk-

free endeavor.

 A negative beta simply means that the stock is inversely correlated with the market. Many

gold-related stocks are beta-negative.

 A negative beta might occur even when both the benchmark index and the stock under

consideration have positive returns. It is possible that lower positive returns of the index

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 coincide with higher positive returns of the stock, or vice versa. The slope of the regression

line, i.e., the beta, in such a case will be negative.

 Using beta as a measure of relative risk has its own limitations. Most analysis considers
only the magnitude of beta. Beta is a statistical variable and should be considered with its

statistical significance (R square value of the regression line). Higher R square value

implies higher correlation and a stronger relationship between returns of the asset and

benchmark index.

EFFICIENT FRONTIER

Harry Markowitz first defined the efficient frontier in his ground-breaking (1952) paper that

launched portfolio theory. That theory considers a universe of risky investments and explores what

might be an optimal portfolio based upon those possible investments.

The notion of "optimal" portfolio can be defined in one of two ways:

1. For any level of volatility, consider all the portfolios, which have that volatility. From

among them all, select the one, which has the highest expected return.

2. For any expected return, consider all the portfolios which have that expected return. From

among them all, select the one, which has the lowest volatility.

Each definition produces a setoff optimal portfolio.

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 Definition (1) produces an optimal portfolio for each possible level of risk.

Definition (2) produces an optimal portfolio for each expected return.

Actually, the two definitions are equivalent. The set of optimal portfolios obtained using one

definition is exactly the same set, which is obtained from the other. That set of optimal portfolios

is called the efficient frontier. This is illustrated in fig:

Efficient Frontier

The shaded region corresponds to the achievable risk-return space. For every point in that region,

there will be at least one portfolio that can be constructed and has the risk and return corresponding

to that point. The efficient frontier is the gold curve that runs along the top of the achievable region.

Portfolios on the efficient frontier are optimal in both the sense that they offer maximal expected

return for some given level of risk and minimal risk for some given level of expected return.

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In fig, the green region corresponds to the achievable risk-return space. For every point in that

region, there will be at least one portfolio constructible from the investments in the universe that

has the risk and return corresponding to that point. The yellow region is the unachievable risk-

return space. No portfolios can be constructed corresponding to the points in this region.

The gold curve running along the top of the achievable region is the efficient frontier. The

portfolios that correspond to points on that curve are optimal according to both definitions (1) and

(2) above.

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 CONSTRUCTION & MANAGING PORTFOLIO

1) Setting Portfolio Goals

The liquidity of an investment signifies the ease or ability to convert investments to cash without

a substantial loss in the principal or original amount invested. The rate of return pertains to an

investment's gain or loss over a specific time period. Return levels usually parallel risk levels;

meaning a high-risk level investment may yield a higher return. The risk tolerance of a client will

play a major role in portfolio management, as comfort levels towards potential for loss differ

greatly among investors.

2) Portfolio Construction

Portfolio Construction is all about investing in a range of funds that work together to create an

investment solution for investors. Building a portfolio involves understanding the way various

types of investments work, and combining them to address your personal investment objectives

and factors such as attitude to risk the investment and the expected life of the investment.

Together with the fact find completed by IFAs, we have created a Risk Profiler that helps

identify an investor’s attitude to risk and therefore better identify a combination of investments

to build a portfolio

With over 2,000 investment funds domiciled in the UK, spanning the full range of asset classes

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 and world markets it is easy to become confused when choosing which investments to make. It is

even more difficult to choose the right combination of investment to potentially meet your

investment goals.

2.1) Steps for creating a portfolio

a) Fact finds – Determine needs and objectives

b)Do a risk profile – objective measurement of risk

c) Asset Allocation – determining the right combination of assets – the most important part of

the portfolio construction process.

d)Fine tune our portfolio – select funds and fund managers

e) Regular review

If we want to make the most of our money, every decision we make about our portfolio is as

important as the last

2.1.1) Step 1: Determining the Appropriate Asset Allocation

Ascertaining our individual financial situation and investment goals is the first task in constructing

a portfolio. Important items to consider are age, how much time are needed to grow our

investments, as well as amount of capital to invest and future capital needs.

A second factor to take into account is our risk tolerance. Are we the kind of person who is willing

to risk some money for the possibility of greater returns? Everyone would like to reap high returns

year after year, but if we are unable to sleep at night when our investments take a short-term drop,

chances are the high returns from those assets are not worth the stress. As we can see, clarifying

our current situation and our future needs for capital, as well as our risk tolerance, together will

determine how our investments should be allocated among different asset classes. The possibility

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of greater returns comes at the expense of greater risk of losses (a principle known as the risk/return

trade off) -we don't want to eliminate risk so much as optimize it for our unique condition and

style. For example, the young person who won't have to depend on his or her investments for

income can afford to take greater risks in the quest for high returns. On the other hand, the person

nearing retirement needs to focus on protecting his or her assets and drawing income from these

assets in a tax-efficient manner.

Generally, the more risk we can bear, the more aggressive our portfolio will be, devoting a larger

portion to equities and less to bonds and other fixed-income securities. Conversely, the less risk

that's appropriate, the more conservative our portfolio will be. Here are two examples: one suitable

for a conservative investor and another for the moderately aggressive investor.

The main goal of a conservative portfolio is to protect its value. The allocation shown above would

yield current income from the bonds, and would also provide some long-term capital growth

potential from the investment in high-quality equities.

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A moderately aggressive portfolio satisfies an average risk tolerance, attracting those willing to

accept more risk in their portfolio in order to achieve a balance of capital growth and income.

2.1.2) Step 2: Achieving the Portfolio Designed in Step 1

Once we've determined the right asset allocation, we simply need to divide our capital between the

appropriate asset classes. On a basic level, this is not difficult: equities are equities, and bonds are

bonds. But we can further break down the different asset classes into subclasses, which also have

different risks and potential returns. For example, an investor might divide the equity portion

between different sectors and market caps, and between domestic and foreign stock. The bond

portion might be allocated between those that are short term and long term, government versus

corporate debt and so forth.

 There are several ways we can go about choosing the assets and securities to fulfill our

asset allocation strategy (remember to analyze the quality and potential of each investment

you buy - not all bonds and stocks are the same):

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 Stock picking - Choose stocks that satisfy the level of risk we want to carry in the equity

portion of our portfolio - sector, market cap and stock type are factors to consider. Analyze

the companies using stock screener s to short-list potential picks, than carry out more in-

depth analysis on each potential purchase to determine its opportunities and risks going

forward. This is the most work-intensive means of adding securities to our portfolio, and

requires us to regularly monitor price changes in our holdings and stay current on company

and industry news. Bond picking - When choosing bonds, there are several factors to

consider including the coupon, maturity, the bond type and rating, as well as the general

interest rate environment.

Mutual funds - Mutual funds are available for a wide range of asset classes and allow you

to hold stocks and bonds that are professionally researched and picked by fund managers.

Of course, fund managers charge a fee for their services, which will detract from your

returns. Index funds are another choice as they tend to have lower fees since they mirror an

established index and are thus passively managed.

Exchange-traded funds (ETFs) - If we prefer not to invest with mutual funds, ETFs can

be a viable alternative. We can basically think of ETFs as mutual funds that trade like a

stock. ETFs are similar to mutual funds in that they represent a large basket of stocks -

usually grouped by sector, capitalization, country and the like - except they are not actively

managed, but instead track a chosen index or other basket of stocks. Because they are

passively managed, ETFs offer cost savings over mutual funds while providing

diversification. ETFs also cover a wide range of asset classes and can be a useful tool to

round out our portfolio.

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2.1.3) Step 3: Re-assessing Portfolio Weightings

Once we have an established portfolio, we need to analyze and rebalance it periodically because

market movements may cause our initial weightings to change. To assess our portfolio's actual

asset allocation, quantitatively categorize the investments and determine their values' proportion

to the whole.

The other factors that are likely to change over time are our current financial situation, future needs

and risk tolerance. If these things change, we may need to adjust our portfolio accordingly. If our

risk tolerance has dropped, we may need to reduce the number of equities held. Or perhaps we're

now ready to take on greater risk and your asset allocation requires a small proportion of our assets

to be held in riskier small-cap stocks. Essentially, to rebalance, you need to determine which of

your positions are over-weighted and those that are under-weighted.

For example, say we are holding 30% of our current assets in small-cap equities, while our asset

allocation suggests us should only have 15% of your assets kept in that class. We need to determine

how much of this position we need to reduce and allocate to other classes.

2.1.4) Step 4: Rebalancing Strategically

Once we have determined which securities we need to reduce and by how much, decide which

under-weighted securities we will buy with the proceeds from selling the over-weighted securities.

To choose our securities, use the approaches discussed in step 2.

When selling assets to rebalance our portfolio, take a moment to consider the tax implications of

readjusting our portfolio. Perhaps our investment in growth stocks has appreciated strongly over

the past year, but if we were to sell all of our equity positions to rebalance our portfolio, we may

41
incur significant capital gains taxes. In this case it might be more beneficial to simply not

contribute any new funds to that asset class in the future while continuing to contribute to other

asset classes. This will reduce our growth stocks' weighting in our portfolio over time without

incurring capital gain taxes. At the same time, however, always consider the outlook of our

securities. If we suspect that those same over-weighted growth stocks are ominously ready to fall,

we may want to sell in spite of the tax implications. Analyst opinions and research reports can be

useful tools to help gauge the outlook for our holdings. And tax-loss selling is a strategy we can

apply to reduce tax implications.

2.2) Asset Allocation

The process of dividing a portfolio among major asset categories such as bonds, stocks or cash.

The purpose of asset allocation is to reduce risk by diversifying the portfolio

The ideal asset allocation differs based on the risk tolerance of the investor. For example, a young

executive might have an asset allocation of 80% equity, 20% fixed income, while a retiree would

be more likely to have 80% in fixed income and 20% equities.

2.2.1) Achieving Optimal Asset Allocation

The important task of appropriately allocating your available investment funds among different

assets classes can seem daunting, with so many securities to choose from. Here we will illustrate

what asset allocation is, its importance and how you can determine your appropriate asset mix and

maintain it.

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What Is Asset Allocation?

Asset allocation refers to the strategy of dividing your total investment portfolio among various

asset classes, such as stocks, bonds and money market securities. Essentially, asset allocation is an

organized and effective method of diversification.

To help determine which securities, asset classes and subclasses are optimal for our portfolio, let's

define some briefly:

 Large-cap stock: These are shares issued by large companies with a market get

capitalization nearly greater than $10 billion.

 Mid-cap stock: These are issued by mid-sized companies with a market cap generally
between $2 billion and $10 billion.

 Small-cap stock: These represent smaller-sized companies with a market cap of less

than $2 billion. These types of equities tend to have the highest risk due to lower liquidity.

 International securities: These types of assets are issued by foreign companies and listed

on a foreign exchange. International securities allow an investor to diversify outside of his

or her country, but they also have exposure to country risk - the risk that a country will not

be able to honor its financial commitments.

 Emerging markets: This category represents securities from the financial markets of a

developing country. Although investments in emerging markets offer a higher potential

return, there is also higher risk, often due to political instability, country risk and lower

liquidity

 Fixed-income securities - The fixed-income asset class comprises debt securities that pay

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 the holder a set amount of interest, periodically or at maturity, as well as the return

of principal when the security matures. These securities tend to have lower volatility than

equities, and have lower risk because of the steady income they provide. Note that though

the issuer promises payment of income, there is a risk of default. Fixed-income securities

include corporate and government bonds.

 Money market: Money market securities are debt securities that are extremely liquid

investments with maturities of less than one year. Treasury bills make up the majority of

these types of securities.

 Real-estate investment trusts (REITs) - REITs trade similarly to equities, except the

underlying asset is a share of a pool of mortgages or properties, rather than ownership of a

company.

2.2.3) Maximizing Return While Minimizing Risk

The main goal of allocating our assets among various asset classes is to maximize return for our

chosen level of risk, or stated another way, to minimize risk given a certain expected level of

return. Of course, to maximize return and minimize risk, we need to know the risk-return

characteristics of the various asset classes. The following chart compares the risk and potential

return of some of the more popular ones:

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As we can see, equities have the highest potential return, but also the highest risk. On the other

hand, Treasury bills have the lowest risk since the government backs them, but they also provide

the lowest potential return.

The chart also demonstrates that when we choose investments with higher risk, our expected

returns also increase proportionately. But this is simply the result of the risk-return trade-off. They

will often have high volatility and are therefore suited for investors who have a high-risk tolerance

(can stomach wide fluctuations in value), and who have a longer time horizon.

It's because of the risk-return trade-off - which says we can seek high returns only if we are willing

to take losses - that diversification through asset allocation is important. Since different assets have

varying risks and experience different market fluctuations, proper asset allocation insulates our

entire portfolio from the ups and downs of one single class of securities. So, while part of our

portfolio may contain more volatile securities - which we've chosen for their potential of higher

returns - the other part of our portfolio devoted to other assets remains stable. We might be familiar

with the risk-reward concept, which states that the higher the risk of a particular investment, the
45
higher the possible return. But many investors do not understand how to determine the level of

risk their individual portfolios should bear. This article provides a general framework that any

investor can use to assess his or her personal level of risk and how this level relates to different

investments.

Because of the protection it offers, asset allocation is the key to maximizing returns while

minimizing risk.

What is Right for Us

As each asset class has varying levels of return for a certain risk, our risk tolerance, investment

objectives, time horizon and available capital will provide the basis for the asset composition of

our portfolio.

To make the asset allocation process easier for clients, many investment companies create a series

of model portfolios, each comprising different proportions of asset classes. These portfolios of

different proportions satisfy a particular level of investor risk tolerance. In general, these model

portfolios range from conservative to very: aggressive

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Conservative portfolios generally allocate a large percent of the total portfolio to lower-risk
securities such as fixed-income and money market securities.

Our main goal with a conservative portfolio is to protect the principal value of our portfolio. As

such, these models are often referred to as "capital preservation portfolios".

Even if we are very conservative and prefer to avoid the stock market entirely, some exposure

can help offset inflation. We could invest the equity portion in high-quality blue-chip companies,

or an index fund, since the goal is not to beat the market.

A moderately conservative portfolio is ideal for those who wish to preserve a large portion of

the portfolio’s total value, but are willing to take on a higher amount of risk to get some inflation

protection.

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A common strategy within this risk level is called "current income". With this strategy, we choose

securities that pay a high level of dividends or coupon payments.

Moderately aggressive model portfolios are often referred to as “balanced portfolios" since the

asset composition is divided almost equally between fixed-income securities and equities in order

to provide a balance of growth and income.

Since these moderately aggressive portfolios have a higher level of risk than those conservative

portfolios mentioned above, select this strategy only if we have a longer time horizon (generally

more than five years), and have a medium level of risk tolerance.

Aggressive portfolios mainly consist of equities, so these portfolios' value tends to fluctuate

widely. If we have an aggressive portfolio, our main goal is to obtain long-term growth of capital.

As such the strategy of an aggressive portfolio is often called a "capital growth" strategy.

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To provide some diversification, investors with aggressive portfolios usually add some fixed-

income securities.

Very aggressive portfolios consist almost entirely of equities. As such, with a very aggressive

portfolio, our main goal is aggressive capital growth over a long-time horizon.

Since these portfolios carry a considerable amount of risk, the value of the portfolio will vary

widely in the short term.

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2.4) Maintaining Our Portfolio

Once we have chosen our portfolio investment strategy, it is important to conduct periodic

portfolio reviews, as the value of the various assets within our portfolio will change, affecting

the weighting of each asset class. For example, if we start with a moderately conservative portfolio,

the value of the equity portion may increase significantly during the year, making your portfolio

more like that of an investor practicing a balanced portfolio strategy, which is higher-risk.

In order to reset our portfolio back to its original state, we need to rebalance our portfolio.

Rebalancing is the process of selling portions of our portfolio that have increased significantly,

and using those funds to purchase additional units of assets that have declined slightly or increased

at a lesser rate. This process is also important if our investment strategy or tolerance for risk has

changed.

3) Determining Risk and the Risk Pyramid

We might be familiar with the risk-reward concept, which states that the higher the risk of a

particular investment, the higher the possible return. But many investors do not understand how to

determine the level of risk their individual portfolios should bear. This article provides a general

framework that any investor can use to assess his or her personal level of risk and how this level

relates to different investments.

4) Determining Our Risk Preference

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 With so many different types of investment to choose from, how does an investor

determine how much risk he or she can handle? Every individual is different, and it’s

hard to create a steadfast model applicable to everyone, but here are two important things

we should consider when deciding how much risk to take:

 Time Horizon: Before we make any investment, we should always determine the amount

of time we have to keep our money invested. If we have $20,000 to invest today but need

it in one year for a down payment on a new house, investing the money in higher-risk

stocks is not the best strategy. The riskier an investment is, the greater its volatility or price

fluctuations, so if our time horizon is relatively short, we may be forced to sell your

securities at a significant a loss.

With a longer time, horizon, investors have more time to recoup any possible losses and are

therefore theoretically be more tolerant of higher risks. For example, if that $20,000 is meant for

a lakeside cottage that we are planning to buy in ten years, we can invest the money into higher-

risk stocks because there is be more time available to recover any losses and less likelihood of

being forced to sell out of the position too early.

 Bankroll: Determining the amount of money we can stand to lose is another important

factor of figuring out our risk tolerance. This might not be the most optimistic method of

investing; however, it is the most realistic. By investing only money that you can afford to

lose or afford to have tied up for some period of time, we won't be pressured to sell off any

investments because of panic or liquidity issues.

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 Investment Risk Pyramid

After deciding on how much risk is acceptable in our portfolio by acknowledging our time horizon

and bankroll, we can use the risk pyramid approach for balancing our assets.

This pyramid can be thought of as an asset allocation tool that investors can use to diversify their

portfolio investments according to the risk profile of each security. The pyramid, representing the

investor's portfolio, has three distinct tiers:

 Base of the Pyramid: The foundation of the pyramid represents the strongest portion,

which supports everything above it. This area should be comprised of investments that are

low in risk and have foreseeable returns. It is the largest area and composes the bulk of our

assets.

 Middle Portion: This area should be made up of medium-risk investments that offer a

stable return while still allowing for capital appreciation. Although riskier than the assets

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 creating the base, these investments should still be relatively safe.

 Summit: Reserved specifically for high-risk investments, this is the smallest area of the

pyramid (portfolio) and should be made up of money we can lose without any serious

repercussions. Furthermore, money in the summit should be fairly disposable so that we

don't have to sell prematurely in instances where there are capital losses.

Personalizing the Pyramid

Not all investors are created equally. While others prefer less risk, some investors prefer even more

risk than others who have a larger net worth. This diversity leads to the beauty of the investment

pyramid. Those who want more risk in their portfolios can increase the size of the summit by

decreasing the other two sections, and those wanting less risk can increase the size of the base. The

pyramid representing your portfolio should be customized to our risk preference.

It is important for investors to understand the idea of risk and how it applies to them. Making

informed investment decisions entails not only researching individual securities but also

understanding our own finances and risk profile. To get an estimate of the securities suitable for

certain levels of risk tolerance and to maximize returns, investors should have an idea of how much

time and money they have to invest and the returns they are looking for.

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 THEORIES OF PORTFOLIO SELECTION

1) Modern Portfolio Theory

If we were to craft the perfect investment, we would probably want its attributes to include high

returns coupled with little risk. The reality, of course, is that this kind of investment is next to

impossible to find. Not surprisingly, people spend a lot of time developing methods and strategies

that come close to the "perfect investment". But none is as popular, or as compelling, as modern

portfolio theory (MPT). Here we look at the basic ideas behind MPT, the pros and cons of the

theory, and how MPT affects the management of our portfolio.

1.1) The Theory

One of the most important and influential economic theories dealing with finance and investment,

MPT was developed by Harry Markowitz and published under the title "Portfolio Selection" in the

1952 Journal of Finance. MPT says that it is not enough to look at the expected risk and return of

one particular stock. By investing in more than one stock, an investor can reap the benefits

of diversification - chief among them, a reduction in the riskiness of the portfolio. MPT quantifies

the benefits of diversification, also known as not putting all of our eggs in one basket.

For most investors, the risk they take when they buy a stock is that the return will be lower than

expected. In other words, it is the deviation from the average return. Each stock has its

own standard deviation from the mean, which MPT calls "risk".

54
The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any

single one of the individual stocks (provided the risks of the various stocks are not directly related).

Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that

pays off when it doesn't rain. A portfolio that contains both assets will always pay off, regardless

of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an

all-weather portfolio.

In other words, Markowitz showed that investment is not just about picking stocks, but about

choosing the right combination of stocks among which to distribute one's nest eggs.

1.2) Two Kinds of Risk

Modern portfolio theory states that the risk for individual stock returns has two components:

 Systematic Risk - These are market risks that cannot be diversified away. Interest rates,

recessions and wars are examples of systematic risks.

 Unsystematic Risk - Also known as "specific risk", this risk is specific to individual stocks

and can be diversified away as we increase the number of stocks in our portfolio (see

Figure). It represents the component of a stock's return that is not correlated with general

market moves.

For a well-diversified portfolio, the risk - or average deviation from the mean - of each stock

contributes little to portfolio risk. Instead, it is the difference - or covariance - between individual

stocks' levels of risk that determines overall portfolio risk. As a result, investors benefit from

holding diversified portfolios instead of individual stocks.

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 Figure

1.3) The Efficient Frontier

Now that we understand the benefits of diversification, the question of how to identify the best

level of diversification arises. Enter the efficient frontier.

For every level of return, there is one portfolio that offers the lowest possible risk, and for every

level of risk, there is a portfolio that offers the highest return. These combinations can be plotted

on a graph, and the resulting line is the efficient frontier. Figure shows the efficient frontier for

just two stocks - a high risk/high return technology stock (Satyam) and a low risk/low return

consumer products stock (Coca Cola).

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 Figure

Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected

return for a given level of risk. A rational investor will only ever hold a portfolio that lies

somewhere on the efficient frontier. The maximum level of risk that the investor will take on

determines the position of the portfolio on the line.

Modern portfolio theory takes this idea even further. It suggests that combining a stock portfolio

that sits on the efficient frontier with a risk-free asset, the purchase of which is funded by

borrowing, can actually increase returns beyond the efficient frontier. In other words, if we were

to borrow to acquire a risk-free stock, then the remaining stock portfolio could have a riskier profile

and, therefore, a higher return than you might otherwise choose.

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1.4) What MPT Means for Us

Modern portfolio theory has had a marked impact on how investors perceive risk, return and

portfolio management. The theory demonstrates that portfolio diversification can reduce

investment risk. In fact, modern money managers routinely follow its precepts.

That being said, MPT has some shortcomings in the real world. For starters, it often requires

investors to rethink notions of risk. Sometimes it demands that the investor take on a perceived

risky investment (futures, for example) in order to reduce overall risk. That can be a tough sell to

an investor not familiar with the benefits of sophisticated portfolio management techniques.

Furthermore, MPT assumes that it is possible to select stocks whose individual performance is

independent of other investments in the portfolio. But market historians have shown that there are

no such instruments; in times of market stress, seemingly independent investments do, in fact, act

as though they are related.

Then there is the question of the number of stocks required for diversification. How many is

enough? Mutual funds can contain dozens and dozens of stocks. Investment guru William J.

Bernstein says that even 100 stocks are not enough to diversify away unsystematic risk. By

contrast, Edwin J. Elton and Martin J. Gruber, in their book "Modern Portfolio Theory and

Investment Analysis" (1981), conclude that you would come very close to achieving optimal

diversity after adding the twentieth stock.

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2) CAPITAL ASSET PRICING MODEL

The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically

appropriate required rate of return of an asset, if that asset is to be added to an already well-

diversified portfolio, given that asset's non- diversifiable risk. The model takes into account the

asset's sensitivity to non- diversifiable risk (also known as systemic risk or market risk), often

represented by the quantity beta (β) in the financial industry, as well as the expected return of the

market and the expected return of a theoretical risk-free asset.

Jack Treynor, William Sharpe, John Lintner and Jan Mossin introduced the model independently,

building on the earlier work of Harry Markowitz on diversification and modern portfolio theory.

Sharpe received the Nobel Memorial Prize in Economics for this contribution to the field of

financial economics.

(The Security Market Line, seen here in a graph, describes a relation between the beta and

the asset's expected rate of return.)

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 .)

An

estimation of the CAPM and the Security Market Line (purple) for the Dow Jones

Industrial. Average over the last 3 years for monthly data

2.1) The Formula

The CAPM is a model for pricing an individual security (asset) or a portfolio. For individual

security perspective, we made use of the security market line (SML) and its relation to expected

return and systematic risk (beta) to show how the market must price individual securities in relation

to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security

in relation to that of the overall market. Therefore, when the expected rate of return for any security

is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market

is equal to the market reward-to-risk ratio, thus:

Individual security’s / beta = Market’s securities (portfolio)

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 Reward-to-risk ratio Reward-to-risk ratio

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the

above equation and solving for E (Ri), we obtain the Capital Asset Pricing Model (CAPM).

Where:

= the expected return on the capital asset

= the risk-free rate of interest

= (Beta coefficient) the sensitivity of the asset returns to market returns, Or

also,

= the expected return of the market

=sometimes known as the market premium or risk premium

(the difference between the expected market rate of return and the risk-free rate of return).

Note 1: The expected market rate of return is usually measured by looking at the arithmetic average

of the historical returns on a market portfolio (i.e., S&P 500).

61
Note 2: The risk-free rate of return used for determining the risk premium is usually the arithmetic

average of historical risk-free rates of return and not the current risk-free rate of return.

2.2) Assumptions of CAPM

All Investors:

1) Aim to maximize utilities.

2) Are rational risk-averse.

3) Are price takers i.e., they cannot influence prices.

4) Can lend and borrow unlimited under the risk-free rate of interest.

5) Securities are all highly divisible into small parcels.

6) No transaction or taxation costs incurred.

2.3) What CAPM Means for Us

This model presents a very simple theory that delivers a simple result. The theory says that the

only reason an investor should earn more, on average, by investing in one stock rather than another

is that one stock is riskier. Not surprisingly, the model has come to dominate modern financial

theory. But does it really work?

It's not entirely clear. The big sticking point is beta. When Professors Eugene Fama and Kenneth

French looked at share returns on the New York Stock Exchange, the American Stock Exchange

and Nasdaq between 1963 and 1990, they found that differences in betas over that lengthy period

62
did not explain the performance of different stocks. The linear relationship between beta and

individual stock returns also breaks down over shorter periods of time. These findings seem to

suggest that CAPM may be wrong.

While some studies raise doubts about CAPM's validity, the model is still widely used in the

investment community. Although it is difficult to predict from beta how individual stocks might

react to particular movements, investors can probably safely deduce that a portfolio of high-beta

stocks will move more than the market in either direction, or a portfolio of low-beta stocks will

move less than the market.

2.4) Shortcomings of CAPM

 The model assumes that asset returns are (jointly) normally distributed random

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 variables. It is however frequently observed that returns in equity and other markets are not

normally distributed. As a result, large swings (3 to 6 standard deviations from the mean)

occur in the market more frequently than the normal distribution assumption would expect.

 The model assumes that the variance of returns is an adequate measurement of risk. This

might be justified under the assumption of normally distributed returns, but for general

return distributions other risk measures (like coherent risk measures) will likely reflect the

investors' preferences more adequately.

 The model does not appear to adequately explain the variation in stock returns. Empirical

studies show that low beta stocks may offer higher returns than the model would predict.

Some data to this effect was presented as early as a 1969 conference in Buffalo, New York

in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself

rational (which saves the Efficient Market Hypothesis but makes CAPM wrong), or it is

irrational (which saves CAPM, but makes the EMH wrong – indeed, this possibility makes

volatility arbitrage a strategy for reliably beating the market).

 The model assumes that given a certain expected return investors will prefer lower risk

(lower variance) to higher risk and conversely given a certain level of risk will prefer higher

returns to lower ones. It does not allow for investors who will accept lower returns for

higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders

will pay for risk as well.

 The model assumes that all investors have access to the same information and agree about

the risk and expected return of all assets (homogeneous expectations assumption).

 The model assumes that there are no taxes or transaction costs, although this assumption

may be relaxed with more complicated versions of the model.

64
 The market portfolio consists of all assets in all markets, where each asset is weighted by

its market capitalization. This assumes no preference between markets and assets for

individual investors, and that investors choose assets solely as a function of their risk-return

profile. It also assumes that all assets are infinitely divisible as to the amount, which may

be held or transacted.

 The market portfolio should in theory include all types of assets that are held by anyone as

an investment (including works of art, real estate, human capital...) In practice, such a

market portfolio is unobservable and people usually substitute a stock index as a proxy for

the true market portfolio. Unfortunately, it has been shown that this substitution is not

innocuous and can lead to false inferences as to the validity of the CAPM, and it has been

said that due to the unobservability of the true market portfolio, the CAPM might not be

empirically testable. This was presented in greater depth in a paper by Richard Roll in

1977, and is generally referred to as Roll's critique.

65
CHAPTER – 3

66
 RESEARCH METHODOLOGY

The research report is prepared with the help of secondary sources. The data collected while
preparing the report is mainly from Secondary data.

SOURCES OF DATA COLLECTION

1) Secondary Sources

The secondary data includes following:

 Reference Books such as S. Kevin
 Various Websites such as NSE, Money Control, BSE.
 Various data collected from News Papers and Magazines

OBJECTIVE OF THE STUDY

The objective of the research report is following:

 To understand how to manage and construct a portfolio

 To know how to diversify portfolio
 To analyze investors behavior
 To cope with risk and return situations
 To maximize profitability and value of portfolio
 To aware investors regarding risk factor

67
CHAPTER – 4

68
 ANALYSIS AND INTERPRETATION OF DATA

PRACTICAL STUDY OF SOME SELECTED SCRIPS

PORTFOLIO - A PORTFOLIO – B

BHEL

RELIANCE ENERGY WIPRO

CROMPTION GREAVES JINDAL STEEL

CALCULATION OF RETUN AND RISK:

 Ri
EXPECTED RETURN E (Ri) 
N

69
 PORTFOLIO-A

BHARAT HEAVY ELECTRONICS LIMITED (BHEL):

DATE SHARE PRICE (X) (X-X') (X-X')2

20 JUNE 42.10 2.735 7.480

21 JUNE 44.75 0.085 0.007

22 JUNE 43.65 1.185 1.404

23 JUNE 43.30 1.535 2.356

24 JUNE 45.55 0.715 0.511

27 JUNE 45.95 1.115 1.243

28 JUNE 46.30 1.465 2.146

29 JUNE 46.15 1.315 1.729

30 JUNE 44.95 0.115 0.013

1 JULY
45.65 0.815 0.664

EXPECTED RETURN =448.35/10 = 44.835=X’

(X-X') 2 = 17.553

RISK = 17.553 = 4.189

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 RELIANCE ENERGY

DATE SHARE PRICE (X) (X-X') (X-X')2

20 JUNE 11.10 0.715 0.511

21 JUNE 11.45 1.065 1.134

22 JUNE 11.40 1.015 1.030

23 JUNE 11.60 1.215 1.476

24 JUNE 11.85 1.465 2.146

27 JUNE 11.80 1.415 2.002

28 JUNE 11.80 1.415 2.002

29 JUNE 11.75 1.365 1.863

30 JUNE 11.50 1.115 1.243

1 JULY 11.40 1.015 1.030

EXPECTED RETURN = 103.85/10 = 10.385 =X’

(X-X)2 =14.437

RISK = 14.437 = 3.799

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 CROMPTON GREAVES

DATE SHARE PRICE (X) (X-X') (X-X')2

20 JUNE 329 8.8 77.44

21 JUNE 325 12.8 163.84

22 JUNE 326 11.8 139.24

23 JUNE 330 7.8 60.84

24 JUNE 344 6.2 38.44

27 JUNE 346 8.2 67.24

28 JUNE 342 4.2 17.64

29 JUNE 346 8.2 67.24

30 JUNE 340 2.2 4.84

1 JULY 350 12.2 148.84

EXPECTED RETURN = 3378/10 = 337.8 =X’

(X-X') 2 = 785.6

RISK = 785.6 = 28.02

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 PORTFOLIO - B

WIPRO

DATE SHARE PRICE (X) (X-X') (X-X')2

20 JUNE 414.65 5.33 28.4089

21 JUNE 425.15 5.17 26.7289

22 JUNE 411.25 8.73 76.2129

23 JUNE 419.05 0.93 0.8649

24 JUNE 418.75 1.23 1.5129

27 JUNE 424.90 4.92 24.2064

28 JUNE 427.25 7.27 52.8529

29 JUNE 420.75 0.77 0.5929

30 JUNE 416.05 3.93 15.4449

1 JULY 422 2.02 4.0804

EXPECTED RETURN =4199.8 /10 =419.98 = X’

(X-X') 2 = 230.86

RISK = 23.086 =4.804

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 JINDAL STEEL

DATE SHARE PRICE (X) (X-X') (X-X')2

20 JUNE 313.30 10.06 101.20

21 JUNE 326.90 3.54 12.53

22 JUNE 307.45 15.91 253.12

23 JUNE 309.85 13.51 182.52

24 JUNE 317.60 5.76 33.17

27 JUNE 322.50 0.86 0.73

28 JUNE 333.05 9.69 93.89

29 JUNE 340.7 17.34 300.67

30 JUNE 329.35 5.99 35.88

1 JULY 332.95 9.59 91.96

EXPECTED RETURN = 3233.65/10 = 323.365 = X’

(X-X') 2 = 1105.67

RISK = 1105.67 =33.25

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 PORTFOLIO-A

THE RISK AND RETURN OF EACH COMPANY

IN PORTFOLIO A IS:

SL. No COMPANY RETURN RISK

1 BHEL 44.835 4.189

2 RELIANCE ENERGY 10.385 3.799

3 CROMPTON GREAVES 337.8 28.02

PORTFOLIO-B

THE RISK AND RETURN OF EACH COMPANY IN PORTFOLIO B IS:

SI. No COMPANY RETURN RISK

1 WIPRO 419.98 4.804

2 JINDAL STEEL 323.365 33.25

75
 INTERPERATION

From the above figures, it is clear that in total there is a high return on portfolio B companies when

compared with portfolio A companies. But at the same time if we compare the risk, it is clear that

risk is less for companies in portfolio B when compared with portfolio A companies. As per the

Markowitz an efficient portfolio is one with “Minimum risk, maximum profit” therefore, it is

advisable for an investor to work out his portfolio in such a way where he can optimize his returns

by evaluating and revising his portfolio on a continuous basis.

76
CHAPTER – 5

77
 FINDINGS OF THE STUDY

The study includes a number of findings which is revealed while preparing a research report in
order to increase the effectiveness of the report. The findings are as follows:

 Investors make investment in order to increase the earning capacity of person.

 Higher the risk, higher would be the ratio of return.
 People don’t invest in securities due to higher degree of risk involved in it.
 Diversification of different securities helps in minimizing the risk.
 Govt. securities are safer for investment as compared to other securities.
 Asset allocation is the key to maximizing returns while minimizing risk.
 Main goal of conservative portfolio is to protect the principal value of the portfolio.
 Aggressive portfolios mainly consist of equities, so the portfolios' value tends to fluctuate
widely.
 Beta mainly refers to systematic risk.
 Portfolio Construction is all about investing in a range of funds that work together to create
an investment solution for investors.
 If we prefer not to invest with mutual funds, ETFs can be a viable alternative.
 Two important things we should consider when deciding how much risk to take are time
horizon and bankroll.
 Money market securities deal with short-term investment.
 Selection of securities is done by matching risk and returns.

 Only few people make investment on regular basis in different securities.

 Most of the people make investment for short period of time i.e. less than a period of 1
year.
 People need money in order to satisfy the needs and wants from time to time.

78
 RECOMMENDATIONS

 Investing rules to be remembered.

 Don't speculate unless it's full-time job

 Beware of barbers, beauticians, waiters-of anyone -bringing gifts of inside information or

tips.

 Before buying a security, it’s better to find out everything one can about the company, its

management and competitors, its earnings and possibilities for growth.

 Don't try to buy at the bottom and sell at the top. This can't be done-except by liars.

 Learn how to take your losses and cleanly. Don't expect to be right all the time. If you have

made a mistake, cut your losses as quickly as possible

 Don't buy too many different securities. Better have only a few investments that can be

watched.

 Make a periodic reappraisal of all your investments to see whether changing developments

have altered prospects.

 Study your tax position to known when you sell to greatest advantages.

 Always keep a good part of your capital in a cash reserve. Never invest all your funds.

 Don't try to be jack-off-all-investments. Stick to field you known best.

 Purchasing stocks, you do not understand if you can't explain it to a ten-year-old, just don't

invest in it.

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 Over diversifying: This is the most oversold, overused, logic-defying concept among

stockbrokers and registered investment advisors.

 Not recognizing difference between value and price: This goes along with the failure to

compute the intrinsic value of a stock, which are simply the discounted future earnings of

the business enterprise.

 Failure to understand Mr. Market: Just because the market has put a price on a business

does not mean it is worth it. Only an individual can determine the value of an investment

and then determine if the market price is rational.

 Failure to understand the impact of taxes: Also known as the sorrows of compounding, just

as compounding works to the investor's long-term advantage, the burden of taxes because

pf excessive trading works against building wealth

 Too much focus on the market whether or not an individual investment has merit and value

has nothing to do with that the overall market is doing.

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 CONCLUSIONS

A high-performing portfolio is every investor's goal. First, we need to develop our own

objectives and strategies i.e.:

a) Determine what items or events we're saving for. These can be retirement, a new home,

children's education or anything else we choose.

b)Determine when we want to retire, purchase a home or send your children to college, to help

us to decide what percentage return we need to earn on our initial investment.

c) Decide how much money to invest. Invest what we can comfortably afford now; keeping in

mind that we can change that amount later.

d)Determine how much risk we are willing to take. Many investments generate high returns and

are riskier than others.

e) Once we decide the amount, we are willing to invest, the returns we want to achieve, when we

need the money and how much risk we are willing to accept, put together our investment

portfolio.

1. More transparency should be maintained in order to increase the effectiveness and efficiency

of investment.

2. NAV should be disclosed from time-to-time so that investors know status of their funds

regularly.

3. There should be more flexibility in making investment.

4. Awareness regarding various investment policies should be created from time to time.

Portfolio is collection of different securities and assets by which we can satisfy the basic objective

"Maximize yield minimize risk. Further' we have to remember some important investing rules.

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 LIMITATIONS OF THE STUDY

 Lack of time to collect detailed information.

 The research is for current market situations, which changes with time

 The responses depend on individual behavior which may be affected by psychological factors,
social factors like family, friend and peer group.

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 BIBLIOGRAPHY

BOOKS

 Portfolio management by Prasana Chandra , S. Kevin

 Financial Management by Ravi M. Kishore

WEBSITES

 [Link]

 [Link]

 [Link]

 [Link]

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