Chapter 9 - An introduction to Portfolio Management At the end of this chapter, the students should be able to: • Define the risk aversion, and what evidence indicates that investors are generally risk averse? • Discuss the basic assumptions behind the Markowitz portfolio theory. • Describe risk, and what are some of the alternative measures of risk used in investments. • Discuss what is Portfolio management. • Apply the usage of Portfolio management in Investment. Core Values “For I know the plans I have for you, declares the LORD, plans for welfare and not for evil, to give you a future and a hope.” - Jeremiah 29:11 Learning Activities and resources CFA-Series-Investment-Analysis-And-Portfolio-Management-Reilly-Brown-7th-Ed Fundamentals-of-Investments-Valuation-and-Management-5th-Edition https://www.investopedia.com/terms/p/portfoliomanagement.asp Introduction One of the major advances in the investment field during the past few decades has been the recognition that the creation of an optimum investment portfolio is not simply a matter of combining a lot of unique individual securities that have desirable risk-return characteristics. Specifically, it has been shown that you must consider the relationship among the investments if you are going to build an optimum portfolio that will meet your investment objectives. The recognition of what is important in creating a portfolio was demonstrated in the derivation of portfolio theory. This chapter explains portfolio theory step by step. It introduces you to the basic portfolio risk formula that you must understand when you are combining different assets. When you understand this formula and its implications, you will increase your understanding of not only why you should diversify your portfolio but also how you should diversify. The subsequent chapters introduce asset pricing models including capital market theory and multifactor models with an emphasis on determining the appropriate risk measure for individual assets. Before presenting portfolio theory, we need to clarify some general assumptions of the theory. This includes not only what we mean by an optimum portfolio but also what we mean by the terms risk aversion and risk. One basic assumption of portfolio theory is that as an investor you want to maximize the returns from your investments for a given level of risk. To adequately deal with such an assumption, certain ground rules must be laid. First, your portfolio should include all of your assets and liabilities, not only your stocks or even your marketable securities but also such items as your car, house, and less-marketable investments, such as coins, stamps, art, antiques, and furniture. The full spectrum of investments must be considered because the returns from all these investments interact, and this relationship between the returns for assets in the portfolio is important. Hence, a good portfolio is not simply a collection of individually good investments. Risk Aversion Portfolio theory also assumes that investors are basically risk averse, meaning that, given a choice between two assets with equal rates of return, they will select the asset with the lower level of risk. Evidence that most investors are risk averse is that they purchase various types of insurance, including life insurance, car insurance, and health insurance. Buying insurance basically involves an outlay of a given amount to guard against an uncertain, possibly larger outlay in the future. When you buy insurance, this implies that you are willing to pay the current known cost of the insurance policy to avoid the uncertainty of a potentially large future cost related to a car accident or a major illness. Further evidence of risk aversion is the difference in promised yield (the required rate of return) for different grades of bonds that supposedly have different degrees of credit risk. Specifically, the promised yield on bonds increases as you go from AAA (the lowestrisk class) to AA to A, and so on—that is, investors require a higher rate of return to accept higher risk. While recognizing this diversity of attitudes, our basic assumption is that most investors com mi ng large sums of money to developing an investment por olio are risk averse. Therefore, we expect a positive relationship between expected return and expected risk. Notably, this is also what we generally find in terms of long-run historical results—that is, there is generally a positive relationship between the rates of return on various assets and their measures of risk as shown in Chapter 3. Definition of Risk Although there is a difference in the specific definitions of risk and uncertainty, for our purposes and in most financial literature the two terms are used interchangeably. In fact, one way to define risk is the uncertainty of future outcomes. An alternative definition might be the probability of an adverse outcome. Subsequently, in our discussion of portfolio theory, we will consider several measures of risk that are used when developing the theory. MARKOWITZ PORTFOLIO THEORY In the early 1960s, the investment community talked about risk, but there was no specific measure for the term. To build a portfolio model, however, investors had to quantify their risk variable. The basic portfolio model was developed by Harry Markowitz, who derived the expected rate of return for a portfolio of assets and an expected risk measure. The Markowitz model is based on several assumptions regarding investor behavior: • Investors consider each investment alternative as being represented by a probability distribution of expected returns over some holding period. • Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth. • Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth. • Investors base decisions solely on expected return and risk, so their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only. • For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected return, investors prefer less risk to more risk. Alternative Measures of Risk Another measure of risk is the range of returns. It is assumed that a larger range of expected returns, from the lowest to the highest return, means greater uncertainty and risk regarding future expected returns. Expected Rates of Return The expected return on an investment is the expected value of the probability distribution of possible returns it can provide to investors. The return on the investment is an unknown variable that has different values associated with different probabilities. Expected return is calculated by multiplying potential outcomes (returns) by the chances of each outcome occurring, and then calculating the sum of those results (as shown below). For example, For example, if an investment has a 50% chance of gaining 20% and a 50% chance of losing 10%, the expected return would be 5% = (50% x 20% + 50% x -10% = 5%). For example, a model might state that an investment has a 10% chance of a 100% return and a 90% chance of a 50% return. The expected return is calculated as: Expected Return = 0.1(1) + 0.9(0.5) = 0.55 = 55%. Portfolio Management Portfolio management is the art and science of selecting and overseeing a group of investments that meet the long-term financial objectives and risk tolerance of a client, a company, or an institution. Understanding Portfolio Management Professional licensed portfolio managers work on behalf of clients, while individuals may choose to build and manage their own portfolios. In either case, the portfolio manager's ultimate goal is to maximize the investments' expected return within an appropriate level of risk exposure. Portfolio management requires the ability to weigh strengths and weaknesses, opportunities and threats across the full spectrum of investments. The choices involve trade-offs, from debt versus equity to domestic versus international and growth versus safety. Key Elements of Portfolio Management • Asset Allocation The key to effective portfolio management is the long-term mix of assets. Generally, that means stocks, bonds, and "cash" such as certificates of deposit. There are others, often referred to as alternative investments, such as real estate, commodities, and derivatives. Asset allocation is based on the understanding that different types of assets do not move in concert, and some are more volatile than others. A mix of assets provides balance and protects against risk. Investors with a more aggressive profile weight their portfolios toward more volatile investments such as growth stocks. Investors with a conservative profile weight their portfolios toward stabler investments such as bonds and blue-chip stocks. • Diversification The only certainty in investing is that it is impossible to consistently predict winners and losers. The prudent approach is to create a basket of investments that provides broad exposure within an asset class. Diversification is spreading risk and reward within an asset class. Because it is difficult to know which subset of an asset class or sector is likely to outperform another, diversification seeks to capture the returns of all of the sectors over time while reducing volatility at any given time. Real diversification is made across various classes of securities, sectors of the economy, and geographical regions. • Rebalancing Rebalancing is used to return a portfolio to its original target allocation at regular intervals, usually annually. This is done to reinstate the original asset mix when the movements of the markets force it out of kilter. For example, a portfolio that starts out with a 70% equity and 30% fixed-income allocation could, after an extended market rally, shift to an 80/20 allocation. The investor has made a good profit, but the portfolio now has more risk than the investor can tolerate. Rebalancing generally involves selling high-priced securities and putting that money to work in lower-priced and out-of-favor securities. The annual exercise of rebalancing allows the investor to capture gains and expand the opportunity for growth in high potential sectors while keeping the portfolio aligned with the original risk/return profile. • Active Portfolio Management Investors who implement an active management approach use fund managers or brokers to buy and sell stocks in an attempt to outperform a specific index, such as the Standard & Poor's 500 Index or the Russell 1000 Index. An actively managed investment fund has an individual portfolio manager, co-managers, or a team of managers actively making investment decisions for the fund. The success of an actively managed fund depends on a combination of in-depth research, market forecasting, and the expertise of the portfolio manager or management team. Portfolio managers engaged in active investing pay close attention to market trends, shifts in the economy, changes to the political landscape, and news that affects companies. • Passive Portfolio Management Passive portfolio management, also referred to as index fund management, aims to duplicate the return of a particular market index or benchmark. Managers buy the same stocks that are listed on the index, using the same weighting that they represent in the index. A passive strategy portfolio can be structured as an exchange-traded fund (ETF), a mutual fund, or a unit investment trust. Index funds are branded as passively managed because each has a portfolio manager whose job is to replicate the index rather than select the assets purchased or sold. The management fees assessed on passive portfolios or funds are typically far lower than active management strategies. Summary The basic Markowitz portfolio model derived the expected rate of return for a portfolio of assets and a measure of expected risk, which is the standard deviation of expected rate of return. Markowitz shows that the expected rate of return of a portfolio is the weighted average of the expected return for the individual investments in the portfolio. The standard deviation of a portfolio is a function not only of the standard deviations for the individual investments but also of the covariance between the rates of return for all the pairs of assets in the portfolio. In a large portfolio, these covariances are the important factors. Review Questions • Discuss the Portfolio Management. • • • Explain the Markowitz portfolio theory. Discuss the Key Elements of Portfolio Management. Why do most investors hold diversified portfolios?
