SCHOOL OF BUSINESS ADMINISTRATION AND ACCOUNTANCY

FNMNGT4 INVESTMENT AND PORTFOLIO

MANAGEMENT

Prepared by: A Self-regulated Learning Module

Ruby R. Buccat, LPT, PHD
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 TABLE OF CONTENTS

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 FNMNGT4 – INVESTMENT AND PORTFOLIO MANAGEMENT
This course focuses on Capital Market Theory, its efficiency and implications. It establishes its coherence with the rest of the
financial institutions within the financial environment. The course also deals with the relationship of the financial market with
the government and how the latter stands a powerful influential tool. The course likewise attempts to develop the analytical
ability of the students through various financial case presentations. (updated from CMO39 s.2006, CMO18 s.2017)

GUIDELINES

Each chapter in this module is based on the approved FNMNGT4 syllabus. In short, whether you choose to learn
with the use of this module or online, or both, you basically get the same lessons. What will differentiate you from the
other learners will be how much time and effort you spend to learn more about each and every topic at hand.

The objectives indicated in each chapter can only be achieved if and when the learner actively involves
himself/herself in this learning process. There are three icons that you have to watch out for:

This icon means you need to research.

There will be information that you need to research on so

you can answer the questions or accomplish the activities
required.
This icon means you need to think/reflect.

There are opinionated questions that you need to answer to

demonstrate how much you understand the concepts you
need to learn.
This icon means you need to read.

There are links provided that you should access so that you
can read the articles that will help you better understand the
concepts presented in each chapter.

To assess how much you have learned, quizzes will be given regularly. Likewise, to supplement what you learn
via this module, assignments will be given from time to time. To access your quiz and/or assignment, you have to go
online and check what are posted on your Google Classroom. For this to be possible, be sure that you have a gmail
account. If you don’t have any, please create one. Once ready, send the following information (in indicated format) to
rrbuccat@e.ubaguio.edu :

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 Looking forward to a fruitful term ahead!

CHAPTER 1
Introduction to investments

OBJECTIVES:
1. Determine the objectives of investment.
2. Identify profitable investment vehicles.

Investment is the employment of funds on assets with the aim of earning income or capital appreciation
Investment has two attributes namely time and risk. Present consumption is sacrificed to get a return in the future. The
sacrifice that has to be borne is certain but the return in the future may be uncertain. This attribute of investment
indicates the risk factor. The risk is undertaken with a view to reap some return from the investment.

In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the
future to create wealth. In finance, an investment is a monetary asset purchased with the idea that the asset will provide
income in the future or will later be sold at a higher price for a profit.

CHARACTERISTICS OF INVESTMENT
RETURN
Investments are made with the primary objective of deriving a return. The return may be received in
the form of yield plus capital appreciation. The difference between the sale price and the purchase price is
capital appreciation. The dividend or interest from the investment is the yield.

RISK
Risk is inherent in any investment. This risk may relate to loss of capital, delay in repayment of capital,
non-payment of interest, or variability of returns. While some investments like government securities and bank
deposits are almost riskless, others are riskier.

The risk of an investment depends on the following factors:

1. The longer the maturity period, the larger is the risk
2. The lower the credit worthiness of the borrower, the higher is the risk

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 3. The risk varies with the nature of investment. Investments in ownership securities like
equity shares carry higher risk compared to investments in debt instruments like debentures
and bonds.

SAFETY
The safety of investment implies the certainty of return of capital without loss of money or time. Safety
is another feature which an investor desires for his investments. Every investor expects to get back his capital
on maturity without loss and without delay.

LIQUIDITY
An investment which is easily saleable or marketable without loss of money and without loss of time is
said to possess liquidity.

An investor generally prefers liquidity for his investments, safety of his funds, a good return with
minimum risk or minimization of risk and maximization of return.

OBJECTIVES OF INVESTMENT
 Maximization of return
 Minimization of risk

INVESTMENT VS SPECULATION
Investment involves the allocation of money towards the purchase of an asset which is not to be consumed in
the present but hoping it will generate stable income or is expected to appreciate in the future. The term is used very
widely since it has an impact on every individual in life who desire to establish their financial future.

Speculation does not have a precise definition but involves the purchase of an asset to make profits from
subsequent price change and possible sale. The speculators indulge in marketable assets that do not have a long life.
The speculation involves a relatively higher level of risk and more uncertainty of returns though it can be on the same
lines as an investor. These speculators are generally trained and take action when the game of probabilities is high in
their favor.

INVESTMENT VS GAMBLING
In investing, one attempts to carefully plan, evaluate and allocate funds to various investment outlets which
offer safety of principal and moderate continuous return over a long period of time. Gambling on the other hand,
consists of taking high risks not only for high returns, but also for thrill and excitement.

TYPES OF INVESTORS
Individual Investors
They are large in number but their investable resources are comparatively smaller. The size of the
portfolio of each investor is usually quite small. They are sometimes referred to as retail investors. However, it
is common to use the term to refer to individual investors with modest resources to invest. Many investment
firms make a distinction between their retail clients, more affluent clients with larger amounts, and high- and
ultra-net-worth investors with the largest amounts of investable assets.

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Institutional Investors
Institutional investors are organizations that hold and manage portfolios of assets for themselves or
others. There are many different types of institutional investors with varying investment requirements and
constraints. Institutional investors may invest to advance their mission or they may invest for others to meet
the others’ needs. The following are examples of institutional investors:

a. Mutual Funds
A mutual fund is a pool of money from the public that is invested with an expectation of a profit.
Because of the way it invites people to invest, it is also called pooled or managed fund. The money
that is gathered is used to buy and sell (trade) securities. Securities are assets that have the
potential to grow such as stocks or bonds.

List the Top 10 Mutual Funds (2019) in the Philippines in terms of

Return on Investment (ROI)

Company Fund Name Type ROI

Reference:

b. Pension Funds
Pension funds are created (either by employers or employee unions) to manage the retirement
funds of the employees of companies or the government. Funds are contributed by the employers
and employees during the working life of the employees and the objective is to provide benefits to
the employees post their retirement. The management of pension funds may be in-house or
through some financial intermediary. Pension funds of large organizations are usually very large and
form a substantial investor group for various financial instruments.

The Philippine Pension System: New Buttresses for the Old Multi-Pillar Architecture
http://www.nomurafoundation.or.jp/en/wordpress/wp-
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content/uploads/2019/03/NJACM3-2SP19-05.pdf
c. Endowment Funds
An endowment fund is an investment fund established by a foundation that makes consistent
withdrawals from invested capital. The capital in endowment funds, often used by universities,
nonprofit organizations, museums, churches and hospitals, is generally utilized for specific needs or
to further a company's operating process.

d. Insurance Companies
Insurance companies, both life and non-life, hold large portfolios from premiums contributed by
policyholders to policies that these companies underwrite. There are many different kinds of
insurance policies and the premiums differ accordingly. The investment strategy of insurance
companies depends on actuarial estimates of timing and amount of future claims. Insurance
companies are generally conservative in their attitude towards risks and their asset investments are
geared towards meeting current cash flow needs as well as meeting perceived future liabilities.

List the Top 10 Insurance Companies in the Philippines in terms of Assets

Company Assets

Reference:

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 List the 10 largest life insurance companies worldwide (as of May 2020) by
market capitalization (in billion US$)

Company Country Market Capitalization

Reference:

e. Banks
Assets of banks consist mainly of loans to businesses and consumers and their liabilities
comprise of various forms of deposits from consumers. Their main source of income is from what is
called as the interest rate spread, which is the difference between the lending rate (rate at which
banks earn) and the deposit rate (rate at which banks pay). Banks generally do not lend 100% of
their deposits. They are statutorily required to maintain a certain portion of the deposits as cash and
another portion in the form of liquid and safe assets.

INVESTMENT VEHICLES
These are assets offered by the investment industry to help investors move money from the present to the
future, with the hope of increasing the value of their money. These assets include securities, such as shares, bonds, and
warrants; real assets, such as gold; and real estate. Many investment vehicles are entities that own other investment
vehicles. For example, an equity mutual fund is an investment vehicle that owns shares.

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Direct and Indirect Investments
Investors make direct investments when they buy securities issued by companies and governments and
when they buy real assets such as precious metals and arts.

Investors make indirect investments when they buy the securities of companies, trusts, and partnerships
that make direct investments. The following are examples of indirect investment vehicles:
 Shares in mutual funds and exchange-traded funds
 Limited partnership interests in hedge funds
 Asset-backed securities, such as mortgage-backed securities
 Interests in pension funds

Most indirect investment vehicles are pooled investments (also known as collective investment
schemes) in which investors pool their money together to gain the advantages of being part of a large group.
The resulting economies of scale can significantly improve investment returns.

Indirect investment vehicles provide many advantages to investors in comparison with direct
investments:
 Indirect investments are professionally managed. Professional management is particularly
important when direct investments are hard to find and must be managed.
 Indirect investments allow small investors to use the services of professional managers, whom
they otherwise could not afford to hire.
 Indirect investments allow investors to share in the purchase and ownership of large assets,
such as skyscrapers. This advantage is especially important to small investors who cannot afford
to buy large assets themselves.
 Indirect investments allow investors to own diversified pools of risks and thereby obtain more
stable, although not necessarily better, investment returns. Many indirect investment vehicles
represent ownership in many different assets, each of which typically is subject to specific risks
not shared by the others. For example, a risk of investing in home mortgages is that the
homeowners may default on their mortgages. Defaults on individual mortgages are highly
unpredictable, which makes holding an individual mortgage quite risky. In contrast, the average
default rate among a large set of mortgages is much more predictable. Investing an amount in
shares of a large mortgage pool is much less risky than investing that same amount in a single
mortgage.
 Indirect investments are often substantially less expensive to trade than the underlying assets.
This cost advantage is especially significant for publicly traded investment vehicles that own
highly illiquid assets; recall from the Alternative Investments chapter that liquidity is one of the
benefits of real estate investment trusts compared with real estate limited partnerships or real
estate equity funds. Although the assets in which traded investment vehicles invest may be
difficult to buy and sell, ownership shares in these vehicles can trade in liquid markets.

Direct investments also present some advantages to investors compared with indirect investments:
 Investors exercise more control over direct investments than over indirect investments.
Investors who hold indirect investments generally must accept all decisions made by the
investment managers, and they can rarely provide input into those decisions.

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  Investors choose when to buy or sell their direct investments to minimize their tax liabilities. In
contrast, although the managers of indirect investments often try to minimize the collective tax
liabilities of their investors, they cannot simultaneously best serve all investors when those
investors have diverse tax circumstances.
 Investors can choose not to invest directly in certain securities—for example, in securities of
companies that sell tobacco or alcohol. In contrast, indirect investors concerned about such
issues must seek investments with investment policies that include these restrictions.
 Investors who are wealthy can often obtain high-quality investment advice at a lower cost when
investing directly rather than indirectly.

MAIN TYPES OF FINANCIAL INVESTMENT VEHICLES

 Short term investment vehicles
 Fixed-income securities
 Common stock
 Speculative investment vehicles
 Other investment tools

PRIMARY MARKETS AND SECONDARY MARKETS

Markets in which companies and governments sell their securities to investors are known as primary markets.
Each type of security has its own primary market. Primary markets are where securities first become available to all
investors. The main primary market transactions are public offerings, private placements, and rights offerings.

A company that sells securities to the public for the first time makes an initial public offering (IPO), sometimes
also called a placing or placement. The shares offered consist of new shared issued by the company and may also
include shares that the founders and other early investors in the company want to sell. The IPO provides founders and
other early investors with a means of converting their investments into cash, a process called monetizing.

Investors also trade securities, such as shares and bonds, as well as contracts, such as futures and options.
These trades take place in secondary markets. Trading in secondary markets is the successful outcome of searches in
which buyers look for sellers and sellers look for buyers. Secondary markets are organized either as call markets or as
continuous trading markets. In a call market, participants can arrange trades only when the market is called, which is
usually once a day. In contrast, in a continuous trading market, participants can arrange and execute trades any time
the market is open. Most markets, including alternative trading venues, are continuous.

MEASURES OF RETURN AND RISK

Measures of Historical Rates of Return

Holding Period Return (HPR) measures the total gain or loss that an investor owning a security achieves
over the specified period compared with the investment at the beginning of the period. The return over the
holding period usually comes from two sources: changes in the price (capital gain or loss) and income (dividends
or interest).

income generated + ( ending value−initial value )

Holding Period Return=
¿ itial value

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 Generally, the HPR is expressed in percentages. Frequently, it is annualized to determine the rate of
return per year.

Examples:
1. In January 1, the price of an ordinary share in Company B was P100. On December 31 of the same
year, an ordinary share of Company B was selling for P125. HPR is calculated as follows:

125−100
HPR=
100

HPR = 0.25 or 25%

2. In the same example above, we assume that Company B paid a dividend of P5 per ordinary share.
HPR is calculated as follows:
5+(125−100)
HPR=
100

5+ 25
HPR=
100

30
HPR=
100

HPR = 0.30 or 30%

Sometimes the HPR is converted to an annualized rate for comparison purposes. In such case, the
following formula is used:

Annualized HPR = (1+HPR)1/n-1

Example:
1. Consider an investment that cost P2000 and is worth P2500 after being held for 2 years. The
investment earned a dividend of P100 over the 2-year period. Compute for HPR and annualized
HPR.

100+(2500−2000)
HPR=
2000

100+ 500
HPR=
2000

600
HPR=
2000

HPR = 0.30 or 30%

Annualized HPR = (1+30%)1/2-1

= .14 or 14%

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 Computation of HPR for a portfolio of investments:

Beginning Value Ending Value

A 1,000,000 1,200,000
B 4,000,000 4,200,000
C 15,000,000 16,500,000
20,000,000 21,900,000

( 21,900,000−20,000,000 )
HPR=
20,000,000

HPR = 0.095 or 9.5%

Mean Rates of Return

Arithmetic Mean is also known as the arithmetic average return.

(r 1 +r 2 +…+ r n)
Arithmetic Mean=
n

Geometric Mean provides a more accurate representation of the portfolio value growth than an
arithmetic return.

Geometric Mean=¿

Example:
Consider an investment with the following data:
Beginning Value Ending Value HPR
1 100 115 .15
2 115 138 .20
3 138 110 -.20

(.15+.20−.20)
Arithmetic Mean=
3

Arithmetic Mean=0.05∨5 %

Geometric Mean=¿

= 1.03353 – 1

Geometric Mean = 0.03353 or 3.35%

CALCULATING EXPECTED RATES OF RETURN

The expected return from an investment:

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 Example:
An investor is estimating probabilities for each of the economic scenarios based on past
experience and current outlook:

ECONOMIC CONDITIONS PROBABILITY RATE OF RETURN

Strong economy, no inflation 0.15 0.20
Weak economy, above-average inflation 0.15 -0.20
No major change in economy 0.70 0.10

E(Ri) = [(0.15)(0.20)] + [(0.15)(-0.20)]+[(0.70)(0.10)]

E(Ri) = 0.07

MEASURING THE RISK EXPECTED RATES OF RETURN

Statistical techniques are used to compare the return and risk measures for alternative investments
directly. Two possible measures of risk (uncertainty) have received support in theoretical work on portfolio
theory: the variance and the standard deviation of the estimated distribution of expected returns.

Variance

= [(0.15)(0.20-0.07)2 + (0.15)(-0.20-0.07)2+(0.70)(0.10-0.07)2]
= 0.0141

Standard Deviation

σ =√ 0.0141

σ = 0.11874 or 11.87%

Coefficient of Variation (CV) is a widely used relative measure of risk

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 0.11874
CV =
0.07000

CV =1. 696

DETERMINANTS OF REQUIRED RATES OF RETURN

The required rate of return is the minimum rate of return that you should accept from an investment to
compensate you for deferring consumption. The analysis and estimation of the required rate of return are complicated
by the behavior of market rates over time. First, a wide range of rates is available for alternative investments at any
time. Second, the rates of return on specific assets change dramatically over time. Third, the difference between the
rates available (that is, the spread) on different assets changes over time.

The Real Risk-Free Rate (RRFR)

This is the basic interest rate, assuming no inflation and no uncertainty about future flows. An investor
in an inflation-free economy who knew with certainty what cash flows he or she would receive at what time
would demand the RRFR on an investment. The objective factor that influences the RRFR is the set of
investment opportunities available in the economy. The investment opportunities are determined in turn by the
long-run real growth rate of the economy. A rapidly growing economy produces more and better opportunities
to invest funds and experience positive rates of return. A change in the economy’s long-run real growth rate
causes a change in all investment opportunities and a change in the required rates of return on all investments.

Factors Influencing the Nominal Risk-Free Rate (NRFR)

Nominal rates of interest that prevail in the market are determined by real rates of interest, plus factors
that will affect the nominal rate of interest, such as the expected rate of inflation and the monetary
environment. two other factors influence the nominal risk-free rate (NRFR): (1) the relative ease or tightness in
the capital markets, and (2) the expected rate of inflation.

Risk Premium
An investor typically is not completely certain of the income to be received or when it will be received.
Most investors require higher rates of return on investments if they perceive that there is any uncertainty about
the expected rate of return. This increase in the required rate of return over the NRFR is the risk premium (RP).
Although the required risk premium represents a composite of all uncertainty, it is possible to consider several
fundamental sources of uncertainty.

The major sources of uncertainty are:

 business risk
 financial risk
 liquidity risk
 exchange rate risk

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  country (political) risk

Systematic and Specific Risk

The returns on investments, such as shares, bonds, and real estate, will be affected by general economic
conditions. Returns will also be affected by issues that are specific to the particular investment. These two types
of risk are called systematic risk and specific risk, respectively.

 Systematic risk: The risk created by general economic conditions is known as systematic or market
risk because the risk stems from the wider economic system. For example, if the economy enters a
recession, many companies will see a downturn in their revenues and profits.

 Specific risk: Risk that is specific to a certain company or security is variously known as specific,
idiosyncratic, non-systematic, or unsystematic risk. Examples include the share price response when

a company launches a successful new product (e.g., the Apple iPad) or the response to the negative
news that a promising new drug has failed in trials.

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 CHAPTER 2
Asset allocation decision

OBJECTIVES:
1. Illustrate the individual investor life cycle.
2. Explain the portfolio management
process.
3. Create a portfolio for virtual trading.

Risk drives return. Thus, the practice of investing funds and managing portfolios should focus primarily on
managing risk rather than on managing returns.

ASSET ALLOCATION
This is the process of deciding how to distribute an investor’s wealth among different asset classes for purposes
of investment. An asset class is made up of securities that have similar characteristics, attributes, and risk/return
relationships.

The asset allocation decision is a component of a portfolio management process. Much of an asset allocation
strategy depends on the investor’s policy statement, which includes the investor’s goals or objectives, constraints, and
investment guidelines.

Strategic Asset Allocation

This refers to the long-term mix of assets that is expected to meet the investor’s objectives. The desired
overall risk and return profile of the portfolio is a factor in determining the strategic asset allocation. Strategic
asset allocation typically requires investment managers to estimate the expected risk and return of each asset
class.

Tactical Asset Allocation

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 This refers to a short-term adjustment among asset classes. An investor or manager typically uses a
variety of tools and inputs to make tactical allocation decisions. The decisions may be based on:
 fundamental analyses of economic and political conditions and their likely effects on market
returns,
 market valuation measures relative to past data, or
 trends and momentum in markets.

Top-Down Analysis
A top down analysis begins with consideration of macroeconomic conditions. Based on the current and
forecasted economic environment, analysts evaluate markets and industries with the purpose of investing in
those that are expected to perform well. Finally, specific companies within these industries are considered for
investment.

Bottom-Up Analysis
Rather than emphasizing economic cycles or industry analysis, a bottom up analysis focuses on
company-specific circumstances, such as management quality and business prospects. It is less concerned with
broad economic trends than is the case for top down analysis, but instead focuses on company specifics.

INDIVIDUAL INVESTOR LIFE CYCLE

The Preliminaries
Before embarking on an investment program, one must make sure that other needs are satisfied. No
serious investment plan should be started until one has adequate income to cover living expenses and has a
safety net should the unexpected occur.

Insurance
Life insurance should be a component of any financial plan. Life insurance protects loved ones
against financial hardship should death occur prematurely. The death benefit paid by the insurance
company can help pay medical bills and funeral expenses and provide cash that family members can use
to maintain their lifestyle, retire debt, or invest for future needs.

There are several types of life insurance contracts/policies: term life insurance, universal life
insurance, and variable life insurance. The insurance coverage provides protection against other
uncertainties: health, disability, automobile, home, etc.

Cash Reserve
Emergencies, job layoffs, and unforeseen expenses happen, and good investment opportunities
emerge. When any of these happen, having an ample cash reserve will be helpful. One need not be
forced to sell their investments or other valuable properties to cover unexpected expenses.

Most experts recommend having a cash reserve equivalent to about six months of living
expenses. Cash reserves need not always be in the form of cash. It can also be in liquid investments
and/or bank accounts that can easily be converted into cash with little chance of a loss in value.

In your opinion, how much cash reserve is “enough” or “sufficient”? Why?

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Life Cycle Net Worth and Investment Strategies

Rise and fall of personal net worth over a lifetime

Accumulation Phase. This refers to the time in the in the life cycle of an investment when an individual
or an investor builds up the value of their annuity or investment. This phase essentially begins when a
person starts saving money for retirement. Experts state that the sooner an individual begins the
accumulation phase, the better.

Consolidation Phase. In this stage of the cycle, many of life’s large expenses (house deposits, weddings
etc) will be out of the way. Earnings are likely to be higher too, and therefore, one should have more
capacity to save and invest.

Spending Phase. This typically begins when individuals retire. Living expenses are covered by social
security income and income from prior investments, including employer pension plans.

Gifting Phase. In this stage, individuals believe they have sufficient income and assets to cover their
expenses while maintaining a reserve for uncertainties. Excess assets can be used to provide financial
assistance to relatives or friends, to establish charitable trusts, or to fund trusts as an estate planning
tool to minimize estate taxes.

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Life Cycle Investment Goals

Near-term, high-priority goals are shorter-term financial objectives that individuals set to fund
purchases that are personally important to them.

Long-term, high-priority goals typically include some form of financial independence such as the ability
to retire at a certain age.

Lower-priority goals are just that but are not too critical.

Illustrate your expected investor life cycle and briefly discuss.

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THE PORTOLIO MANAGEMENT PROCESS

THE NEED FOR A POLICY STATEMENT

Understand and Articulate Realistic Investor Goals
Investors need to understand their own needs, objectives, and investment constraints to avoid reckless
decisions.

Standards for Evaluating Portfolio Performance

To evaluate the performance of the portfolio, there should be standards with which it can be compared
to.

Other benefits

INPUT TO THE POLICY STATEMENT

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 Investment Objectives
The investor’s objectives are expressed in terms of both risk and returns. The risk tolerance of the
investor must always be taken into account. The risk tolerance of the prospective investor is influenced by
factors such as financial situation, type of investor, asset class preference, time horizon, and purpose of
investment.

A person’s return objective may be stated in terms of an absolute or a relative percentage return. It
may also be stated in terms of a general goal like capital preservation, current income, capital appreciation, or
total return.

Investment Constraints
Liquidity Needs
A liquid asset is cash on hand or an asset that can be easily converted to cash. In terms of
liquidity, cash is king since cash as legal tender is the ultimate goal.

Time Horizon
Investors with shorter time horizons generally prefer more liquid and less risky investments
because losses are harder to overcome during a short time frame.

Tax Concerns
Taxes vary depending on the nature of the investment made and the investor may find this a
constraint since taxes may impact the possible returns.

Legal and Regulatory Factors

Laws and regulations are implemented to protect the investing public. However, these may also
constrain the investment strategies of individuals and institutions.

Unique Needs and Preferences

This category covers the individual concerns of each investor. Some investors may want to
exclude certain investments from their portfolio solely on the basis of personal preferences or needs.

THE IMPORTANCE OF ASSET ALLOCATION

The objective of asset allocation is to minimize volatility and maximize returns. Financial planners suggest money
should be divided amongst asset categories in such a way that all do not respond to the same market forces in the same
way at the same time. Asset allocation will be different for every investor. There are no “good” or “bad” allocations – an
investor needs to find the one that is right for him based on his own situation. By finding the right mix of asset types,
the investor has more control over how risky his portfolio is.

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 CHAPTER 3
Introduction to portfolio management

OBJECTIVES:
1. Interpret the basic assumptions behind
the Markowitz portfolio theory.
2. Discuss the importance of a diversified
investment portfolio.

Creating 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 one must consider the
relationship among the investments if the goal is to create a portfolio that will meet his investment objectives.

RISK
Risk, in most financial literature, is defined as the uncertainty of future outcomes. Another alternative definition
is the probability of an adverse outcome.

RISK AVERSION
Portfolio theory assumes that investors are basically risk averse. A risk averse investor is someone who prefers
lower returns with known risks rather than higher returns with unknown risks. In other words, among various
investments giving the same return with different level of risks, this investor always prefers the alternative with least
interest. This does not imply though that everybody is risk averse or that investors are completely risk averse in all
financial commitments.

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 Risk aversion for different types of investors

MARKOWITZ PORTFOLIO THEORY

In the 1950s, Harry Markowitz created Modern Portfolio Theory (MPT), which has served as the foundation for
how wealth managers build investment portfolios for their clients. Harry Markowitz won the Nobel Prize in Economics in
1990 for this work. It provides a framework for choosing an asset allocation under a specific set of assumptions that
wealth managers have traditionally accepted as being a reasonable starting point for households.

Markowitz theorized that investors could design a portfolio to maximize returns by accepting a quantifiable
amount of risk. In other words, investors could reduce risk by diversifying their assets and asset allocation of their
investments using a quantitative method.

The Markowitz model is based on several assumptions regarding investor behavior:

1. Investors consider each investment alternative as being represented by a probability distribution of
expected returns over some holding period.
2. Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal
utility of wealth.
3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.
4. 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.
5. 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.

Under these assumptions, a single asset or portfolio of assets is considered to be efficient if no other
asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the
same (or higher) expected return.

Alternative Measures of Risk

One of the best-known measures of risk is the variance, or standard deviation of expected returns. It is a
statistical measure of the dispersion of returns around the expected value whereby a larger variance or standard
deviation indicates greater dispersion. The idea is that the more disperse the expected returns, the greater the
uncertainty of future returns.

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.

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 Instead of using measures that analyze all deviations from expectations, some observers believe that
when you invest you should be concerned only with returns below expectations, which means that you only
consider deviations below the mean value. A measure that only considers deviations below the mean is the
semi-variance. Extensions of the semi-variance measure only computed expected returns below zero (that is,
negative returns), or returns below some specific asset such as T-bills, the rate of inflation, or a benchmark.
These measures of risk implicitly assume that investors want to minimize the damage from returns less than
some target rate. Assuming that investors would welcome returns above some target rate, the returns above a
target return are not considered when measuring risk.

Although there are numerous potential measures of risk, we will use the variance or standard deviation
of returns because (1) this measure is somewhat intuitive; (2) it is a correct and widely recognized risk measure;
and (3) it has been used in most of the theoretical asset pricing models.

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Expected Rates of Return

The expected rate of return for an individual investment is computed as

where:
Wi = the percent of the portfolio in asset i
E(Ri) = the expected rate of return for asset i
Example:

Computation of expected return for an individual risky asset

Probablity Possible Rate of Return Expected Return

.25 .08 .0200
.25 .10 .0250
.25 .12 .0300
.25 .14 .0350
E(R) = .1100

Computation of the expected return for a portfolio of risky assets

Weight Expected Security Return Expected Portfolio Return

(W1) E(R1) [(W1xE(R1)]
.20 .10 .0200
.20 .11 .0330

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 .20 .12 .0360
.20 .13 .0260
E(Rport) = .1150

Variance (Standard Deviation) of Returns for an Individual Investment

The variance, or standard deviation, is a measure of the variation of possible rates of return, R i, from the
expected rate of return [E(Ri)] as follows:

where
Pi is the probability of the possible rate of return, R i

Example:
Possible Rate Expected
Ri - E(Ri) [Ri - E(Ri)]2 Pi [Ri - E(Ri)]2Pi
of Return (Ri) Return E(Ri)
0.08 0.11 0.03 0.0009 0.25 0.000225
0.10 0.11 0.01 0.0001 0.25 0.000025
0.12 0.11 0.01 0.0001 0.25 0.000025
0.14 0.11 0.03 0.0009 0.25 0.000225
0.000500

Variance (σ2) = .0050

Standard Deviation (σ) = .02236

Variance (Standard Deviation) of Returns for a Portfolio

Covariance of Returns
Covariance is a measure of the degree to which two variables “move together” relative to their
individual mean values over time.

A positive covariance means that the rates of return for two investments tend to move in the
same direction relative to their individual means during the same time period.

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 A negative covariance indicates that the rates of return for two investments tend to move in
different dictions relative to their means during specified time intervals over time.

DATE CLOSING DIVIDEND RATE OF CLOSING DIVIDEN RATE OF

PRICE RETURN PRICE D RETURN
Dec-00 60.938 45.688
Jan-01 58.000 -4.82 48.200 5.50
Feb-01 53.030 -8.57 42.500 -11.83
Mar-01 45.160 0.18 -14.20 43.100 0.04 1.51
Apr-01 46.190 2.28 47.100 9.28
May-01 47.400 2.62 49.290 4.65
Jun-01 45.000 0.18 -4.68 47.240 0.04 -4.08
Jul-01 44.600 -0.89 50.370 6.63
Aug-01 48.670 9.13 45.950 0.04 -8.70
Sep-01 46.850 0.18 -3.37 38.370 -16.50
Oct-01 47.880 2.20 38.230 -0.36
Nov-01 46.960 0.18 -1.55 46.650 0.05 22.16
Dec-01 47.150 0.40 51.010 9.35
=-1.81 =1.47

Covab E{[Ri – E(Ri)][Rj– E(Rj)]}

MONTHLY RETURN
DATE COCA-COLA HOME COCA-COLA HOME DEPOT [Ri-E(Ri)]x [Rj-E(Rj)]
(Ri) DEPOT (Rj) Ri-E(Ri) Rj-E(Rj)
Jan-01 -4.82 5.50 -3.01 4.03 -12.13
Feb-01 -8.57 -11.83 -6.76 -13.29 89.81
Mar-01 -14.50 1.51 -12.69 0.04 -0.49
Apr-01 2.28 9.28 4.09 7.81 31.98
May-01 2.62 4.65 4.43 3.18 14.11
Jun-01 -4.68 -4.08 -2.87 -5.54 15.92
Jul-01 -0.89 6.63 0.92 5.16 4.76
Aug-01 9.13 -8.70 10.94 -10.16 -111.16
Sep-01 -3.37 -16.50 -1.56 -17.96 27.97
Oct-01 2.20 -0.36 4.01 -1.83 -7.35
Nov-01 -1.55 22.16 0.27 20.69 5.52

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Dec-01 0.40 9.35 2.22 7.88 17.47
E(Ri) = -1.81 E(Rj) = 1.47 =76.42
Covij = 76.42/12 = 6.37

Covariance and Correlation Covariance is affected by the variability of the two individual
return series.

Covij
rij =
σi σ j
where:
rij = the correlation coefficient of returns
σi = the standard deviation of Rit
σj = the standard deviation of Rjt

This implies that Covij = rijσiσj

Example:
COCA-COLA HOME DEPOT
DATE
Ri-E(Ri) [Ri-E(Ri)]2 Rj-E(Rj) [Rj-E(Rj)]2
Jan-01 -3.01 9.05 4.03 16.26
Feb-01 -6.76 45.65 -13.29 176.69
Mar-01 -12.69 161.01 0.04 0.00
Apr-01 4.09 16.75 7.81 61.06
May-01 4.43 19.64 3.18 10.13
Jun-01 -2.87 8.24 -5.54 30.74
Jul-01 0.92 0.85 5.16 26.61
Aug-01 10.94 119.64 -10.16 103.28
Sep-01 -1.56 2.42 -17.96 322.67
Oct-01 4.01 16.09 -1.83 3.36
Nov-01 0.27 0.07 20.69 428.01
Dec-01 2.22 4.92 7.88 62.08
=404.34 =1240.90

Coca-Cola Home Depot

Variancei = 404.34/12 Variancej = 240.90/12
= 33.69 = 103.41
Standard Deviationi = (33.69)1/2 Standard Deviationj = (103.41) 1/2

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 = 5.80 = 10.17

cov ij
correlation coefficient=
σi σ j

6.37
=
( 5.80 )( 10.17 )

= 0.108

Standard Deviation of a Portfolio

Remember, a correlation of +1.0 would indicate perfect positive correlation, and a value of –1.0
would mean that the returns moved in a completely opposite direction. A value of zero would
mean that the returns had no linear relationship, that is, they were uncorrelated statistically. That
does not mean that they are independent.

Portfolio Standard Deviation Formula

where:
rport = the standard deviation of the portfolio
wi = the weights of the individual assets in the portfolio, where weights are determined by the
proportion of value in the portfolio
2
r i = the variance of rates of return for assets i
Covij = the covariance between the rates of return for assets i and j, where Covij = rijrirj

Demonstration of the Portfolio Standard Deviation Calculation

Equal Risk and Return – Changing Correlations

Example:
Let us assume the following data:
E(R1) = 0.20
σ1 = 0.10
E(R2) = 0.20
σ2 = 0.10
w1 = 0.50
w2 = 0.50

Consider the following alternative correlation coefficients and the covariances they yield. The
covariance term in the equation will be equal to r1,2 (0.10)(0.10) because both standard deviations are
0.10.

a. r1,2 = 1.00; Cov1,2 = (1.00)(0.10)(0.10) = 0.010

b. r1,2 = 0.50; Cov1,2 = (0.50)(0.10)(0.10) = 0.005
c. r1,2 = 0.00; Cov1,2 = 0.000(0.10)(0.10) = 0.000

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 d. r1,2 = –0.50; Cov1,2 = (–0.50)(0.10)(0.10) = –0.005
e. r1,2 = –1.00; Cov1,2 = (–1.00)(0.10)(0.10) =–0.01

or

σ port= √ ¿ ¿
σ port= √( 0.25 )( 0.01 ) + ( 0.25 ) ( 0.01 ) +2(0.25)(0.01)
σ port= √ (0.01)
σ port=0.10

Combining Stocks with Different Returns and Risk

Example:
Let us assume the following data:

Asset E(Ri) Wi σ2i σi

a .10 .50 .0049 .07
b .20 .50 .0100 .10

Covij = rijσiσj
= (0.50)(0.07)(0.10)=0.0035

Case Correlation Coefficient Covariance (Rijσiσj)

a +1.00 .0070
b +0.50 .0035
c 0.00 .0000
d -0.50 -.0035
e -1.00 -.0070

Still assuming the same weights (0.50 – 0.50) in all cases

E(Rport) = 0.50(0.10) + 0.50(0.20)
= 0.15

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 The standard deviation for Case A will be
σ port (a)=√ ¿ ¿
σ port(a)=√ ( 0.001225 ) + ( 0.0025 ) +(0.5)(0.0070)
σ port (a)=√ (0.007225)
σ port(a)=0.085

Constant Correlation with Changing Weights

Example:
Let us assume the following data:

CASE W1 W2 E(RI)
f .00 1.00 .20
g .20 .80 .18
h .40 .60 .16
i .50 .50 .15
j .60 .40 .14
k .80 .20 .12
m 1.00 .00 .10

A Three-Asset Portfolio
Example:
Assume the following data:

Asset Classes E(Ri) σi Wi

Stocks (S) .12 .20 .60
Bonds (B) .08 .10 .30
Cash Equivalent (C) .04 .03 .10

RS,B = 0.25
RS,C = -0.08
RB,C = 0.15

E(Rp) = (0.60)(0.12)+(0.30)(0.08)+(0.10)(0.04)
= 10.00%

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THE EFFICIENT FRONTIER AND OPTIMAL PORTFOLIO

The mean-variance portfolio theory says that any investor will choose the optimal portfolio from the set of portfolios
that:
 Maximize expected return for a given level of risk; and
 Minimize risks for a given level of expected returns.

Again, consider a situation where you have two stocks to choose from: A and B. You can invest your entire wealth in
one of these two securities. Or you can invest 10% in A and 90% in B, or 20% in A and 80%in B, or 70% in A and 30% in B,
or... There are a huge number of possible combinations even in the simple case of two securities. Imagine the different
combinations you have to consider when you have thousands of stocks.

The minimum-variance frontier shows the minimum variance that can be achieved for a given level of expected
return. To construct the minimum-variance frontier of a portfolio:
 Use historical data to estimate the mean, variance of each individual stock in the portfolio, and the correlation of
each pair of stocks.
 Use a computer program to find the weights of all stocks that minimize the portfolio variance for each pre-
specified expected return.
 Calculate the expected returns and variances for all the minimum-variance portfolios determined in step 2 and
then graph the two variables.

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 The outcome of risk-return combinations generated by portfolios of risky assets gives you the minimum variance for
a given rate of return. Logically, any set of combinations formed by two risky assets with less than perfect correlation
will lie inside the triangle XYZ and will be convex.

Investors will never want to hold a portfolio below the minimum variance point. They will always get higher returns
along the positively sloped part of the minimum-variance frontier.

The efficient frontier is the set of mean-variance combinations from the minimum-variance frontier where, for a
given risk, no other portfolio offers a higher expected return.

Any point beneath the efficient frontier is inferior to points above. Moreover, any points along the efficient frontier
are, by definition, superior to all other points for that combined risk-return tradeoff.

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 Portfolios on the efficient frontier have different return and risk measures. As you move upward along the efficient
frontier, both risk and the expected rate of return of the portfolio increase, and no one portfolio can dominate any other
on the efficient frontier. An investor will target a portfolio on the efficient frontier on the basis of his attitude toward risk
and his utility curves.

The concept of efficient frontier narrows down the options of the different portfolios from which the investor may
choose. For example, portfolios at points A and B offer the same risk, but the one at point A offers a higher return for the
same risk. No rational investor will hold the portfolio at point B and therefore we can ignore it. In this case, A dominates
B. In the same way, C dominates D.

In theory, the optimal portfolio is the best portfolio, but in reality, the optimal is often far from the best for any given
investor.

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