Security Analysis

and Portfolio
Management
By Dr. Sarika Rakhyani
 UNIT3
PORTFOLIO ANALYSIS
AND
MANAGEMENT
WHAT IS RISK?
Deviations from the Expectations
Question???

Difference between risk and uncertainty?

What is Return?
Return refers to the gain or loss on an
investment amount over a certain period
of time.
Question??
How can we measure return and risk of a single asset?

There are several ways of calculating Return, but let’s keep it simple!
Simple Return Formula
= (Current Value - Original value)/ Original Value
In terms of securities, can be rewritten as P1-P0/P0 (use this formula to calculate
returns in your presentation)

Again, risk can be measured using different proxies, the most commonly used
measure is the Standard Deviation.
 MARKOWITZ PORTFOLIO MODEL

❖ The Markowitz Portfolio Model, developed by Harry Markowitz (father

of portfolio theory) in 1952, is a foundational concept in Modern Portfolio
Theory (MPT). Also known as Mean-Variance Model.

❖ It provides a systematic framework for selecting a portfolio of assets

that maximizes expected return for a given level of risk (Investors are
Wealth Maximisers) or minimizes risk for a given level of expected return
(Investors are Risk Averse).
 Key Concepts of the Markowitz Portfolio Model

1. Diversification:
o The model emphasizes the importance of diversification to reduce
risk. By combining different assets that are not perfectly correlated,
investors can achieve a more stable return.
2. Expected Return:
o The expected return of a portfolio is the weighted average of the
expected returns of the individual assets.
3. Portfolio Risk (Variance):
o The risk of a portfolio (variance) considers both the individual asset
risks and the correlation between them.
4. Efficient Frontier:
o The model introduces the concept of the efficient frontier, which is a curve
that represents the set of optimal portfolios that offer the highest expected
return for a given level of risk or the lowest risk for a given level of return.
Portfolios lying on the frontier are considered efficient, while those below it
are suboptimal.
5. Risk-Return Trade-off:
o Investors must balance their desire for higher returns with their tolerance
for risk. The Markowitz model helps in understanding this trade-off and in
making informed investment decisions.
6. Optimal Portfolio:
o The optimal portfolio is the one that lies on the efficient frontier and
provides the best risk-return trade-off based on the investor's preferences.
Markowitz’s Model Assumptions

(Wealth maximisers) (Risk averse)

Markowitz’s Model Assumptions
Markowitz’s Model Assumptions
 LIMITATIONS OF MPT
1. The Markowitz model assumes that investors are rational and risk-averse.
The Markowitz model assumes that investors are rational and risk-averse, meaning that they will
always choose a portfolio that maximizes their expected returns while minimizing their risks.
However, this assumption may not always hold true in practice. Investors may sometimes make
irrational decisions or may be willing to take on more risks than the model predicts. Furthermore,
investors may have different risk preferences, which may not be captured by the model.

2. Over-Reliance on Historical Data.

One of the major limitations of the Markowitz Efficient Set is that it relies heavily on historical
data to estimate future returns and risks. However, historical data cannot always predict future
market trends accurately, especially in times of economic or political instability. Therefore,
investors who rely solely on the Markowitz Efficient Set may face unexpected losses.
3. Assumption of Normal Distribution.
The Markowitz Efficient Set assumes that the returns of assets follow a normal distribution, which
means that returns are symmetrically distributed around the mean. However, in reality, market returns are
not always normally distributed, and extreme events such as market crashes can occur. Therefore, the
assumption of normal distribution may not be valid in all market conditions.
4. High Sensitivity to Inputs.
The Markowitz Efficient Set is highly sensitive to input parameters such as expected returns and
covariance matrix. Small changes in these parameters can lead to significant changes in the optimal
portfolio. Therefore, investors need to be careful when selecting input parameters to avoid suboptimal
investment decisions.
5. Neglect of Transaction Costs.
The Markowitz Efficient Set does not consider transaction costs, which can be significant for investors
with large portfolios. Transaction costs, such as brokerage fees and taxes, can reduce the returns of the
portfolio and affect the optimal asset allocation.
6. Lack of Diversification.
The Markowitz Efficient Set assumes that investors have access to all available assets, which may not be
the case in reality. Moreover, the set may not provide sufficient diversification in some cases, especially
when the number of assets is limited.
7. Assumptions about the market.
One of the main criticisms of the Markowitz Efficient Set is that it assumes that the market
is efficient. This means that all available information is already reflected in the prices of
securities. However, this assumption has been challenged by many researchers who argue
that the market is not always efficient.
8. Single-Period Analysis
The Markowitz Efficient Set is designed to optimize portfolios for a single period.
However, investors typically have long-term investment goals, and their portfolio
allocations may need to change over time to reflect changing market conditions and
investment objectives.
9. Challenges in Implementation
Finally, implementing the Markowitz Efficient Set can be challenging, especially for
individual investors with limited resources and expertise. The model requires a significant
amount of data analysis and portfolio optimization, which can be time-consuming and
complex. Additionally, the model may not be suitable for all investors and asset classes,
requiring customization and adjustments. This can make it challenging for individual
investors or small investment firms to use the model effectively.
PORTFOLIO RETURN
The expected return of a portfolio is the weighted average of the
expected returns of the individual assets within the portfolio.

Weights refer to the proportion of your total investment that you

allocate to each asset or security within the portfolio. They
represent the relative importance or size of each asset in the
overall portfolio.
EXAMPLE
 The weight of an asset is calculated by dividing the invested amount in
that asset by the total value of the portfolio.

Example:
You have a portfolio with the following Weights:
• Stock A: ₹50,000
• Stock B: ₹30,000
• Stock C: ₹20,000
 Step 1: Calculate the Total Portfolio Value
Total Portfolio Value=₹50,000+₹30,000+₹20,000=₹100,000

 Step 2: Calculate the Weights for Each Asset

• Weight of Stock A: ₹50,000/₹100,000=0.5 or 50%
• Weight of Stock B: ₹30,000/₹100,000=0.3 or 30%
• Weight of Stock C: ₹20,000/₹100,000=0.2 or 20%
Additional information to calculate the expected return of a portfolio

•Stock A: Weight = 0.5, Expected Return = 8%

•Stock B: Weight = 0.3, Expected Return = 10%
•Stock C: Weight = 0.2, Expected Return = 12%

➢ STEP 3
Calculate the Expected Return for Each Stock:
For each stock, multiply the weight by the expected return:
• Stock A: 0.5×8%=4%
• Stock B: 0.3×10%=3%
• Stock C: 0.2×12%=2.4%
 STEP 4

Sum the Expected Returns to find the Portfolio's Expected Return

Expected Portfolio Return=4%+3%+2.4%=9.4%
 Question
 You have a portfolio consisting of three stocks with the
following investments and expected returns:

• Stock X: ₹60,000 with an expected return of 7%

• Stock Y: ₹25,000 with an expected return of 12%
• Stock Z: ₹15,000 with an expected return of 10%
Answer

The expected return on the portfolio is 8.7%.

PORTFOLIO RISK for 2 Assets
COVARIANCE
 Covariance is a measure of the degree to which two variables
move together relative to their individual mean values over time.

 In portfolio analysis, we are concerned with the covariance of

returns rather than prices.

 A positive covariance means returns o two investments tend to

move in the same direction relative to their individual means
during the same time period.
 COVARIANCE

 A negative covariance indicates that the returns on two

investments tend to move in different directions relative to their
means during specified time intervals.

 The magnitude of the covariance depends on the variances of

the individual return series as well as on the relationship between
the series.
CORRELATION
Correlation is a statistical measure that describes the strength and direction
of a linear relationship between two variables. It quantifies how changes in
one variable are associated with changes in another. The most commonly
used correlation measure is the Pearson correlation coefficient.
 Standardizing the covariance by the product of the individual standard
deviations yields the correlation coefficient, which can vary only in the range
-1 to +1.

 Value Range: The correlation coefficient (ρ) ranges from −1 to +1:

❑ ρ=+1: Perfect positive correlation; as one variable increases, the other also
increases in a perfectly linear manner.
❑ ρ=−1: Perfect negative correlation; as one variable increases, the other
decreases in a perfectly linear manner.
❑ ρ=0: No correlation; there is no linear relationship between the variables.
 Interpretation:

❑ Positive Correlation: Indicates that the variables tend to move in the same
direction. For example, if one variable increases, the other is likely to increase
as well.
❑ Negative Correlation: Indicates that the variables tend to move in opposite
directions. For example, if one variable increases, the other is likely to
decrease.
❑ Magnitude: The closer the correlation coefficient is to ±1, the stronger the
relationship between the two variables.
 Given Data:
• Asset A:
• Weight (A)= 60% or 0.6
• Standard Deviation (σA) = 12% or 0.12
• Asset B:
• Weight (B) = 40% or 0.4
• Standard Deviation (σB) = 20% or 0.20
• Correlation between A and B:
• ρAB=0.3
 wA2σA2=(0.62)×(0.122)=0.36×0.0144=0.005184
 wB2σB2=(0.42)×(0.202)=0.16×0.04=0.0064
 2wAwBσAσBρAB=2×0.6×0.4×0.12×0.20×0.3=0.003456.
 Total Variance of the Portfolio:

Portfolio’s Standard deviation (risk) is

12.26 %
 Question:
 Consider a portfolio consisting of two assets, Asset A and Asset B.
The details are as follows:
• Asset A:
• Weight (A)= 50% or 0.5
• Standard Deviation (σA) = 10% or 0.10
• Asset B:
• Weight (B) = 50% or 0.5
• Standard Deviation (σB) = 15% or 0.15
• Correlation between A and B:
• ρAB=0.4
SOLUTION:
 Consider a portfolio consisting of two assets, Asset A and Asset B.
The details are as follows:
• Asset A:
• Weight (wA) = 60% or 0.6
• Standard Deviation (σA) = 10% or 0.10
• Asset B:
• Weight (wB) = 40% or 0.4
• Standard Deviation (σB) = 15% or 0.15
• Covariance between A and B:
• Cov(A,B)=0.012
Solution:

The portfolio's standard deviation (risk) is approximately

11.4%.
PORTFOLIO RISK IN CASE OF 3
ASSETS
 If correlation (symbols can be either r or
ρ) is given,
σp2​= wA2​σA2​+
wB2​σB2​+
PORTFOLIO
VARIANCE
Take square root of
the given formula to
wC2​σC2​+ compute portfolio risk
in terms of standard
deviation.
2wA​wB​σA​σB​ρAB​+
2wA​wC​σA​σC​ρAC​+
2wB​wC​σB​σC​ρBC
IF COVARIANCE IS GIVEN

σp2​= wA2​σA2​+
wB2​σB2​+
PORTFOLIO
VARIANCE
Take square root of
the given formula to
wC2​σC2​+ compute portfolio risk
in terms of standard
deviation.
2wA​wB​COVAB​+
2wA​wC​COVAC​+
2wB​wC​COVBC
CASE – 3 ASSET PORTFOLIO
EXPECTED RETURN OF
THE PORTFOLIO=10%
NEXT QUESTION
EXPECTED RETURN- 10%
PORTFOLIO RISK-11.92%
EXPECTED RETURN- 10%
PORTFOLIO RISK-11.92%
Lower covariance/correlation between portfolio
securities results in --------?? portfolio standard
deviation.
 EEFICIENT FRONTIER
❖ The efficient frontier is the set of optimal portfolios that offer the
highest expected return for a defined level of risk or the lowest risk
for a given level of expected return.
❖ Portfolios that lie below the efficient frontier are sub-optimal
because they do not provide enough return for the level of risk.
❖ Portfolios that cluster to the right of the efficient frontier are sub-
optimal because they have a higher level of risk for the defined rate
of return.
 An investment’s returns represent the y-axis, while its level of
risk lies on the x-axis. The investment itself is plotted on the
graph according to these two factors. It is then compared to
the curved line of the efficient frontier, which determines if it
falls above or below the efficient frontier—in short, whether
that investment is “efficient.”
 One investor’s efficient frontier can be very different than
another’s. That’s because it considers an investor’s risk
tolerance.
The Optimal Portfolio

 The optimal portfolio contains securities with the greatest potential

returns with an acceptable degree of risk. It also features securities with
the lowest degree of risk for a certain level of return. Optimal returns
tend to lie along the efficient frontier.
 Thus, a risk-ready investor could choose securities right end of the
efficient frontier. Those would likely have a high degree of risk coupled
with high potential returns.
 Meanwhile, securities on the left end of the efficient frontier would be
suitable for more cautious investors.
 An indifference curve plots various combinations of risk-return
pairs that an investor would accept to maintain a given level of
utility.
 If the combinations of risk-return on a curve provide the same
level of utility, then the investor would be indifferent to
choosing one.
 It is a convex, upward curving line and where it meets the
Efficient Frontier, that point of tangency is called the Optimal
Portfolio.
 The utility curve represents the level of satisfaction (or utility)
an investor derives from different combinations of risk and
return.
 Utility theory can help investors select the right portfolio by
using the utility curve to identify the optimal investor
portfolio.
SOURCE: REILLY AND
BROWN
MARKET MODEL/SINGLE-INDEX
MODEL
The market model states that the return on a security
depends on the return of the market portfolio and the
security's responsiveness to it, as measured by beta.
Additionally, the return is influenced by factors unique to
the firm. This concept is also known as the single-index
mode.

William F. Sharpe gave this

model in 1963
 This graph shows how the returns of a specific asset (like a stock) are related to the
overall market returns.
❖ Blue Dots: Each dot represents the actual return of the asset for a given market return.
If the market goes up or down, the asset's return also changes, but not exactly in the
same way.
❖ Red Line: This line shows the average or expected return of the asset based on the
market’s return. If the market goes up by a certain amount, the asset is expected to go
up by a bit more, since the asset’s beta is 1.2 (meaning it's slightly more sensitive to
market changes).
❖ Spread of Blue Dots: The distance of the blue dots from the red line shows how
much the asset's return can vary due to factors other than the market (these are the
unique risks of the asset).
In simple terms, the graph shows how much of the asset’s return is explained by the
market’s movements and how much is due to other, unpredictable factors.
Market Model Ri= Total return of a stock i,
i can be replaced with p for portfolio
ai = alpha
= residual
Beta
 Beta (β) represents the sensitivity and responsiveness of the firm's returns to the
returns on the market index. More technically, beta is defined as the "slope
coefficient that relates the returns for security i to the returns for the aggregate
stock market." Therefore, beta measures systematic risk, that affects all
securities in the market.
 If an investment's beta is equal to 1, then when the market goes up 1%, your
firm (on average) will also be expected to go up 1%. Because this is an average
prediction, beta will not tell you precisely what will happen on any given day.
Rather, it will tell you what is expected to happen on average.
 A higher beta coefficient means more risk in the portfolio or security. On the
other hand, a lower beta coefficient means less risk in the portfolio or security,
which can be more beneficial for an efficient portfolio.
If expected market’s return is 10%
and A’s Beta is 1.5,
A’s expected return is????
 Alpha (α) is the abnormal gain or loss on an investment. It shows how well (or
badly) a stock/portfolio has performed in comparison to a benchmark index
(market). In the previous example, if alpha would have been given as 2%, then the
expected return would have been 17% (2%+15%).
Hence, Expected Return of a security= αi+ βi (Rm)

The residual term (given below) only affects the actual realized return in a given
period, not the expected return, since it's considered to have an average value of
zero over time. Hence, we exclude it when calculating expected return.

 Residual (Error term denoted by εi)

Residuals (εi) explain how much of your security or fund’s returns are being driven
by random miscellaneous movements in the market that cannot be explained by the
asset-pricing model, also known as "idiosyncratic volatility” or “unsystematic
risk”. The residual represents the facts that are not being driven by the market
returns, but rather random firm-specific movements on any given day.
SYSTEMATIC RISK
 Systematic risks are inherent risks that exist in the stock market. They’re also
called “non-diversifiable risks” or “market risks” since they impact the entire
asset class.
 Non-diversifiable means that an organization can’t control, minimize, or avoid
systematic risks. These risks are typically due to external factors like ongoing
geopolitical situations, monetary policies, and natural disasters. For example,
the COVID-19 pandemic was a systematic risk because it impacted the entire
stock market.
➢ Types- Interest rate risk, Market risk, Purchasing power risk.
UNSYSTEMATIC RISK
 Unsystematic risks, also known as “nonsystematic risks,” “specific risks,”
“diversifiable risks,” or “residual risks,” are unique to a specific company or
industry. These risks arise due to various internal and external factors that affect
only the particular organization but not the entire market.
 Some examples of unsystematic risk include labor unrest at a factory, regulatory
changes, and shortages of raw materials.
 Unlike systematic risks, an organization can control, minimize, and possibly
even avoid unsystematic risks.
 Types- Business risk and Financial risk
DIFFERENCE BETWEEN

Systematic
and
Unsystematic risk
• Impact. Systematic risks can potentially affect the entire industry and the
overall economy, whereas unsystematic risks generally affect an organization.
Systematic risks are non-diversifiable, whereas unsystematic risks are
diversifiable.
• Nature. Systematic risks are unavoidable and uncontrollable, whereas
unsystematic risks are avoidable and controllable.
• Factors. Systematic risks result from external factors that occur at a
macroeconomic level, which is why they’re unavoidable and uncontrollable. In
contrast, unsystematic risks result from internal factors occurring within an
organization or externally but in a closely related manner to the organization.
They’re linked to microeconomic factors and are avoidable and controllable.
MARKET MODEL EQUATION

Taking Var on both sides

 Var (Ri) = Var(ai + biRm + ei)

 Var (Ri) = Var (ai) + Var(biRm) + Var (ei)
Total Variance of security returns
= 0 + Systematic Variance + Unsystematic Variance
 SYSTEMATIC UNSYSTEMATIC
VARIANCE VARIANCE

(IN VARIANCE TERMS)

(IN VARIANCE TERMS)

 FOR
EXAMPLE

(IN VARIANCE TERMS)

(IN VARIANCE TERMS) (IN VARIANCE TERMS)

 (IN VARIANCE TERMS)

(IN VARIANCE TERMS)

(IN VARIANCE TERMS) (IN VARIANCE TERMS)

This was for a stock,
Now, lets learn it for the Portfolio!
 TOTAL SYSTEMATIC UNSYSTEMATIC
VARIANCE VARIANCE VARIANCE

(IN VARIANCE TERMS)

(IN VARIANCE TERMS)

Unsystematic risk of the portfolio
QUESTION:
QUESTION:
 Portfolio Beta = 1.3
 Systematic risk (std dev) = 29.06%
 Unsystematic risk (std dev) = 6.4%
 Total portfolio risk = 29.76%

NEXT QUESTION:
Compute –Portfolio risk, Systematic
risk and Unsystematic risk
Total Risk of the Portfolio
THINGS TO KEEP IN MIND:
 TOTAL VARIANCE= SYSTEMATIC VARIANCE + UNSYSTEMATIC
VARIANCE

 TOTAL RISK (IN VARIANCE TERMS)= SYSYTEMATIC RISK (IN

VARIANCE TERMS) + UNSYSTEMATIC RISK (IN VARIANCE TERMS)

 TOTAL RISK (IN STD DEV TERMS) WILL NOT SATISY THE ABOVE
EQUATION
IS NOT EQUAL TO

TOTAL RISK (STD DEV) = SYSTEMATIC RISK (IN STD DEV TERMS) +
UNSTSEMATIC RISK (IN STD DEV TERMS)
 Formally, variance should be written as "squared percentage" (%²) when dealing with
percentage-based data. However, it’s true that many texts, exercises, and questions
simply use "%" for convenience and simplicity. While not technically precise, this is a
common and accepted shorthand in many contexts.
 Whenever Variance/ Covariance is given in %, its actually % squared, therefore if you
convert it into decimals- divide the number by 10,000 (not 100).
 Or you may keep it as it is and solve in % terms only, but remember to take weights
in decimals.
 So, either keep the numbers in %, or in decimals- answer will be same.
 But always keep weights in decimals (ALWAYS).
 The correlation value is already scaled, and beta is unitless, so there's no need to
adjust them.
 Iftwo assets are independent, correlation is ZERO but vice-versa is
not true.
 Variance Standard Deviation Standard
STOCK (in Decimals) (under-root of variance) Deviation (%) Variance (%)

A 0.01 0.1 10 100

B 0.0081 0.09 9 81
As you can notice here, variance -when in % is 100 for stock A, in decimals, it is (100/10000)= 0.01.
Similarly for stock B, it is 81 in %, and 0.0081 (81/10000) in decimals.

Keep this example in mind, and then you can make such a matrix yourself, whenever in confusion.

Another way
Whenever variance is given in %, and you want to convert it in decimals, you may first convert it in
standard deviation by taking its under-root, for example- If variance is 100 % for stock A, you may
under-root and get 10% as standard deviation, and then simply convert it in decimals (10/100)=0.1.

Whatever suits you!

Solution:

 Rx=13 % , Ry=6 %, Rz=8%

Portfolio Return =10%
Portfolio beta= 0.9
Systematic risk (std dev)=4.5 %
Unsystematic risk (std dev) =1.39%
Total risk (std dev)=4.71%
NEXT QUESTION- Different type ahead!
If Expected Return of portfolio is given
Want to compute the weights that will minimize
the portfolio risk?
%2
Find the weight of Asset A and B
at which portfolio variance is
minimized.
NEXT QUESTION-Based on New Concept!
What if I want my portfolio risk to be
ZERO?
CALCULATE WEIGHTS FOR ZERO RISK PORTFOLIO
MARKOWITZ

SINGLE INDEX
MODEL
PRACTICE QUESTION

CALCULATE PORTFOLIO RISK AND

RETURN
Calculate weights for minimum variance
portfolio and portfolio risk.
Pages 184–190 of Reilly and Brown
contain examples of calculating
mean, standard deviation,
covariance, and correlation from
scratch.
 A few FORMULAS that can be
helpful to solve questions.

Mean = Sum of values/Number of Values

IF PROBABILITY IS GIVEN
When working on
historical data

If probabilities are
given
When working
on historical
data
When
working with
probabilities
; see the
example in
the next
slide
 MEAN MEAN P(X-MEAN)(Y-
PROB X Y OF X OF Y X-MEAN Y-MEAN MEAN)

0.2 1 2 2.4 3.3 -1.4 -1.3 0.364

0.3 2 4 -0.4 0.7 -0.084

0.4 3 3 0.6 -0.3 -0.072

0.1 4 5 1.6 1.7 0.272

COVARIANCE 0.48
Rohini Singh Ma’am’s BOOK will cover the following topics of
Unit3
BOOK PAGES 333-340 (PDF PAGES: 346-352)

“Traditional portfolio management for individuals: Objectives, constraints, time

horizon, current wealth, tax considerations, liquidity requirements, and
anticipated inflation. Asset allocation: Asset allocation pyramid, investor life
cycle approach. Portfolio management services: Passive – Index funds,
systematic investment plans. Active – market timing, style investing.

Read theory from Reilly and Brown as well.

THANK YOU ☺