Friends, Portfolio Management is another crucial topic for CFA® Program L1 with a weight age of 5%. Last week I sat down to prepare this topic and found it pretty difficult to apprehend some topics like How an Investor chooses his Portfolio and thus had to work quite harder on this topic as compared to other topics. Various graphs are used in explaining the concept and things look fuzzy on first reading.
So, the objective of this blog is simple! To help you all understand the various concepts of Portfolio Management.
What is a Portfolio?
Let us first understand what portfolio means. Portfolio is a combination of an individual’s investments in various financial assets such as bonds, land, stocks, and cash. For example, if an investor Mitchell has shares of TCS &SBI, a small piece of land and some cash in his brokerage account then the combination of all these assets is said to be his portfolio.
There is a famous saying
“Never put all your eggs in one basket”
In the field of Finance Diversification takes care of this. Diversification concept says that when one creates a portfolio one should try to include different investment assets.
I would like to explain it with an example – “Mitchell, impressed with the growth of Infosys shares over last 20 years, decides to invest all his savings of 5 lakhs in buying its shares. As you know Infosys shares plummeted recently, Mitchell has to lose a tremendous amount of money. If he had diversified his investments he would not have been so vulnerable.
Now when an investor like Mitchell thinks of investing, he expects some returns while being willing to bear some risk. For understanding these preferences, Markowitz Model defines some basic principle of Risk & Return.
Risk and Return
Professor Harry Markowitz developed a portfolio model which takes into account not only the expected returns of investors but also includes the level of risk for a particular return. According to Markowitz model:
- Investors measure risk in terms of an investment’s variance or standard deviation.
- Unless the returns of the assets are perfectly positively correlated (they move in the same direction), Investor can reduce risk on investments using Diversification.
- Investors always look to maximize their utility.
How to Choose right Portfolios (Efficient Frontier)
Every investor has different indifference curves (IC) which plot the combination of risk and expected return. A Risk-Averse investor requires a relatively greater increase in expected returns while going for more risk and thus will have a steeper IC while a Risk Seeker would require a much lower return to take that much risk and will have a flatter IC.
While choosing efficient portfolios Capital allocation line is frequently used. CAL represents the possible combinations of risk-free assets and risky assets. If we assume all the investors have the same risk appetite CAL is termed as Capital Market line(CML). Efficient frontier can be plotted as portfolios which have the greatest expected return for each level of risk involved.
Figure 1 explains how an optimal portfolio can be selected. Mitchell with his appetite for risk and return expectations can choose different portfolio weights for risk-free assets and risky assets.
Portfolio risk and return example
Finally, Mitchell is looking to choose a portfolio for him. Figure 2 indicates the return on market portfolio, its standard deviation, and a table that relates weight of market portfolio (M.P), Standard deviation of returns for portfolios and expected return for each portfolio.
If the assumption that investors can both lend (by buying government bonds) and borrow at risk free rate holds then he can invest in borrowing portfolios which means they can borrow at risk free rate while making returns greater than market rate of 11%, But has to bear a market standard (Risk) of more than 20%. (Figure 3)
For example if Mitchell chooses a portfolio with M.P of 1.25 he will borrow 25% of his portfolio assets at Risk free rate(5%) and can expect to have an expected return of 12.5% but at a significant risk of 25%. While if the M.P is less than 1 he will keep investing by choosing from various portfolios on CAL. So, Investment managers should always keep in mind that investors will not bear risk that is not rewarded with greater expected return.
Lastly, I would like to talk about the Types of risk. Investors face two types or Risk – Systematic (Related to market factors like GDP) and Unsystematic (related to firm-specific factors). Unsystematic Risk can be eliminated through diversification for free and hence an investor would bear only systematic risk in search for rewards.
This concludes the basic overview of the important parts of the topic. We can see by following some steps Mitchell can effectively reduce the risk on his portfolio due to markets and can be on the safe side even in times of depression. For any queries or clarifications feel free to comment or drop a mail. Hope it helped you all. Ciao!!