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• Portfolio is a combination of securities such as stocks, bonds, and money market instruments.• The process of blending together the broad classes so as to obtain return with minimum risk is called PORTFOLIO CONSTRUCTION.• Diversification of investments helps to spread risk over many assets and thus reduces unsystematic risk.
• TRADITIONAL APPROACH: investors need’s in terms of income and capital appreciation are evaluated and appropriate securities are selected to meet the needs of investor.• MARKOWITZ EFFICIENT FRONTIER APPROACH: portfolios are constructed to maximise the expected return for a given level of risk as it views portfolio construction in terms of expected return and the risk associated.
• It deals with two major decisions :-(a) Determining the objectives of the portfolio.(b) selection of securities to be included in the portfolio.
2) 3) Selection of1) Analysis of Determination portfolio constrains of objective 5) 4) Assessment diversification of risk and return
• Income needsa) Need for current income.b) Need for constant income.• Liquidity• Safety of the principal• Time horizon• Tax consideration• temperament
• Current income• Growth in income• Capital appreciation• Preservation of capital
• Objectives and asset mix• Growth in income and asset mix• Capital appreciation and asset mix• Safety of principal and asset mix
• Tradition approach has some basic assumption like the investor prefers larger to smaller return from securities which requires taking risk.• The risk are namely interest rate risk, purchasing power risk ,financial risk and market risk.• The ability to achieve higher return is dependent upon his/her ability to judge risk and his ability to take specific risk.
Selection of• Top quality bonds can industries minimise financial risk while stocks provide better inflation protection. Selection of company in industry• Depending on the preference and needs of investor appropriate combination is selected. Determining the size of participation
• Harry Markowitz put forward this model in 1952.• It assists in the selection of the most efficient by analysing various possible portfolios of the given securities. By choosing securities that do not move exactly together, the HM model shows investors how to reduce their risk.
• Assumptionsi. Risk of a portfolio is based on the variability of returns from the said portfolio.i. An investor is risk averse.ii. An investor either maximizes his portfolio return for a given level of risk or maximizes his return for the minimum risk.
• To choose the best portfolio from a number of possible portfolios, each with different return and risk, two separate decisions are to be made:1. Determination of a set of efficient portfolios.2. Selection of the best portfolio out of the efficient set.
• A portfolio that gives maximum return for a given risk, or minimum risk for given return is an efficient portfolio. Thus, portfolios are selected as follows:(a) From the portfolios that have the same return, the investor willprefer the portfolio with lower risk, and(b) From the portfolios that have the same risk level, an investorwill prefer the portfolio with higher rate of return.
• The shaded area PVWP includes all the possible securities an investor can invest in. The efficient portfolios are the ones that lie on the boundary of PQVW.• The boundary PQVW is called the Efficient Frontier.
• Figure in right shows the risk-return indifference curve for the investors.• Each curve to the left represents higher utility or satisfaction.
• The investors optimal portfolio is found at the point of tangency of the efficient frontier with the indifference curve.• R is the point where the efficient frontier is tangent to indifference curve C3, and is also an efficient portfolio.
• All portfolios so far have been evaluated in terms of risky securities only, and it is possible to include risk-free securities in a portfolio as well.• A portfolio with risk-free securities will enable an investor to achieve a higher level of satisfaction. This has been explained further.
• R1 is the risk-free return.• R1PX is drawn so that it is tangent to the efficient frontier and known as the Capital Market Line (CML).• The P portfolio is known as the Market Portfolio and is also the most diversified portfolio.
RP = IRF + (RM - IRF)σP/σM• Where,RP = Expected Return of PortfolioRM = Return on the Market PortfolioIRF = Risk-Free rate of interestσM = Standard Deviation of the market portfolioσP = Standard Deviation of portfolio(RM - IRF)/σM is the slope of CML. (RM - IRF) is a measure of the riskpremium, or the reward for holding risky portfolio instead of risk-free portfolio.σM is the risk of the market portfolio. Therefore, the slope measures the rewardper unit of market risk.
• The portion from IRF to P, is investment in risk-free assets and is called Lending Portfolio. In this portion, the investor will lend a portion at risk-free rate.• The portion beyond P is called Borrowing Portfolio, where the investor borrows some funds at risk- free rate to buy more of portfolio P.
• It requires lots of data to be included. An investor must obtain variances of return, covariance of returns and estimates of return for all the securities in a portfolio.• There are numerous calculations involved that are complicated because from a given set of securities, a very large number of portfolio combinations can be made.• The expected return and variance will also have to computed for each securities.