TOS4. An aggressive portfolio takes on great risks in search of great returns. Returns are typically presented in nominal terms which consist of three components: the real risk-free return as compensation for postponing consumption, inflation as compensation for the loss of purchasing power and a risk premium. This Risk is reflected in the variability of the returns from zero to infinity. Suitable securities are those whose prices are relatively stable but still pay reasonable dividends ⦠A weekly return of 2%, when annualized, is as follows: $$ \text{Annualized return} = (1+2\%)^{52} – 1 = 180\% $$. Each investor has his own risk profile, but there is a possibility that he does not have the relevant investment security that matches his own risk profile. Active Portfolio Management: When the portfolio managers actively participate in the trading of securities with a view to earning a maximum return to the investor, it is called active portfolio management. Meaningful diversification is one which involves holding of stocks of more than one industry so that risks of losses occurring in one industry are counterbalanced by gains from the other industry. If we had a return of 12% for 20 months, then the annualized return is as follows: $$ \text{Annualized return} = (1+12\%)^{12/20} – 1 = 7\% $$. Companies can be ranked in the order of return and variance and select into the portfolio those companies with higher returns but with the same level of risk. Real returns are useful for comparing returns over different time periods as inflation rates vary over time. On the other hand alpha and Epsilon (α + ∑) measures the unsystematic risk, which can be reduced by efficient diversification. This pattern of investment in different asset categories, security categories, types of instruments, etc., would all be described under the caption of diversification, which aims at the reduction or even elimination of non- systematic or company related risks and achieve the specific objectives of investors. Computing a geometric mean follows a principle similar to the computation of compound interest. Beta measures the systematic market related risk, which cannot be eliminated by diversification. In order to compute this, we weight the returns of the underlying assets by the amounts allocated to them. This can be positive and negative. Portfolio management is the art of selecting the right investment tools in the right proportion to generate optimum returns with a balance of risk from the investment made. The IRR provides the investor with an accurate measure of what was actually earned on the money invested but does not allow for easy comparison between individuals. When the holding period is longer than one year, we need to express the year as a fraction of the holding period and compound using this fractional number. Share Your PDF File Types of PMS There are three types of Portfolios in PMS, you can choose any of them-Discretionary PMSâ Discretionary Portfolio provides the service provider a right to make decisions on behalf of the client, whether he wants to sell or buy the shares. Defensive Portfolio : Defensive portfolio comprises of stocks with low risk and stable earnings â e.g. Welcome to EconomicsDiscussion.net! a) Investment b) Speculation c) Technical analysis d) Fundamental analysis e Using the same annual returns of 15%, 10%, 12% and 3% as above, we compute the geometric mean as follows: $$ \text{Geometric mean} = [(1+15\%) × (1+10\%) × (1+12\%) × (1+3\%)]^{1/4} – 1 = 9.9\% $$. Diversification of risk in portfolio management - Portfolio should be diversified to the degree at which specific risk has virtually been eliminated. If an investor makes use of derivative instruments within a portfolio or borrows money to invest, then leverage is introduced into the portfolio. Capital Asset Pricing Model When an asset needs to be added to an already well diversified portfolio, Capital Asset Pricing Model is used to calculate the assetâs rate of profit or rate of return (ROI). I. Aggressive Portfolio: An aggressive portfolio comprises of high-risk investments like commodities, futures, options and other securities expecting high returns in the short run. Arithmetic and geometric returns do not take into account the money invested in a portfolio in different time periods. All Rights ReservedCFA Institute does not endorse, promote or warrant the accuracy or quality of AnalystPrep. Traditional Approach: 1. Share Your PPT File, Essay on Financial Economics | Branches | Economics. Before publishing your Articles on this site, please read the following pages: 1. To annualize a return earned for a period shorter than one year, the return must be compounded by the number of periods in the year. Take the following graph to illustrate the above: α or Alpha is the distance between the horizontal axis and line’s intersection with y-axis. If α is a positive return, then that scrip will have higher returns. Arithmetic returns tend to be biased upwards unless the holding period returns are all equal. Portfolio management thus refers to investment of funds in such combination of different securities in which the total risk of portfolio is minimized while expecting maximum return from it. Column 6 is the result of multiplying deviation under column 5 with the probability in column 2 without considering signs. Active Portfolio Management: This type of portfolio management aims to make better returns in contrast to what the market hypothesizes. There is an art, and a science, when it comes to making decisions about investment mix and policy, matching investments to objectives, asset allocation and balancing risk against performance. The square root of variance is standard deviation (sd). The leverage amplifies the returns on the investor’s capital, both upwards and downwards. Thus, the portfolio expected return is the weighted average of the expected returns, from each of the securities, with weights representing the proportionate share of the security in the total investment. The previous year’s returns are compounded to the beginning value of the investment at the start of the new period in order to earn returns on your returns. Passive Portfolio Manageme⦠PORTFOLIO MANAGEMENTWhat is portfolio management? Dow Theory: ADVERTISEMENTS: Charles Dow, the editor of Wall Street Journal, USA, presented this theory through a series of editorials. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Return in Portfolio Investments The typical objective of investment is to make current income from the investment in the form of dividends and interest income. Content Guidelines 2. Asset classes could ⦠If the Beta is minus one, it indicates a negative relationship with the Market Index and if the market goes up by a + 1%, the stock price will fall by 1%. It can normally vary from – 1 to 4- 1. When we talk about the returns from a financial asset, we can broadly classify them into two types. These can be explained with following illustrations, the assumed probabilities of each of the returns and the estimation of absolute deviation and standard deviation, based on them are given for only illustration: Column 5 is deviation of the returns under column 3 from the expected return 15 (Thus -25 = (-10-15). You will notice the workflow logic is the same for each object type. When we have assets for multiple holding periods, it is necessary to aggregate the returns into one overall return. If α = 0, then the regression line goes through the origin and its return simply depends on the Beta times the market return. 1. x̅ is the mean or the weighted average return. Assuming that investor puts his funds in four securities, the holding period return of the portfolio is described in the table below: The above describes the simple calculation of the weighted average return of a portfolio for the holding period. So the portfolio manager according to the risk-taking capacity and the kind of returns calculated provides a portfolio structured in tandem with that. It measures the unsystematic risk of the company. The answers to this question lie in the investor’s perception of risk attached to investments, his objectives of income, safety, appreciation, liquidity and hedge against loss of value of money etc. A. Arithmetic mean = 5.3%; Geometric mean = 5.2%, B. Arithmetic mean = 4.0%; Geometric mean = 3.6%, C. Arithmentic mean = 4.0%; Geometric mean = 3.9%, $$ \text{Arithmetic mean} = \frac {8\% + (-2\%) + 6\%} {3} = 4\% $$, $$ \text{Geometric mean} = [(1+8\%) × (1+(-2\%)) × (1+6\%)]^{1/3} – 1 = 3.9\% $$, Calculate and interpret major return measures and describe their appropriate uses. A monthly return must be compounded 12 times, a weekly return 52 times and a daily return 365 times. Understanding Active Return Active return refers to the portion of returns (profit or loss) in an investment portfolio that can be directly attributed to the active management decisions made by the portfolio manager Portfolio Manager Portfolio managers manage investment portfolios using a six-step portfolio management process. For example, a year relative to a 20-month holding period is a fraction of 12/20. Privacy Policy3. (Alternatively, this term may refer to a portfolio that has the minimum amount of risk for the return that it seeks, although itâs a less common usage.) Now, the variance is sum of the weighted squared deviations, namely, .0008. Disclaimer Copyright, Share Your Knowledge If there is no relation between them, the coefficient of correction can be zero. investments in high quality, blue-chip stocks . Passive Portfolio: When the This means itâs generating the highest possible return at your established risk tolerance . Tax considerations like capital gains tax and tax on interest or dividend income will need to be deducted from the investment to determine post-tax returns. Passive portfolio management Passive portfolio management is a process where the portfolio manager creates a fixed portfolio aligning it with current trends in the market. In general, returns are presented pre-tax and with no adjustment for the effects of inflation. The Company with a higher return of 11.5% has a higher risk than the other company. ADVERTISEMENTS: Portfolio theories guide the investors to select securities that will maximize returns and minimize risk. Reducing the Risk of Certain Asset Classes Thus (.04)2 = .0016 and this multiplied by the probability of it 0.25 gives .0004 and so on. So for example, the portfolio could include real estate, fixed deposits with banks, mutual funds, shares, and bonds. These theories can be classified into different categories as depicted in figure 6.1. When the return of company XYZ is compared with that of company ABC, we have to take into account, their expected return and standard deviation of the return. It is the percentage change in the price of the stock regressed (or related) to the percentage changes in the market Index. Return and standard deviation and variance of portfolios can also be compared in the same manner. The basic equation for calculating risk can be formulated as a regression equation-, Where, y = Return in the security in a given period and, α = The intercept where the regression line crosses the y-axis. A risk averse investor always prefer to ⦠β or Beta describes the relationship between the stock’s return and the Market index return. Portfolio optimization should result in what investors call an âefficient portfolioâ. It is important to be able to compute and compare different measures of return to properly evaluate portfolio performance. PORTFOLIO MANAGEMENT-TRIAL QUESTIONS 1) Explain the following terms as used in Portfolio management and give examples and/or furmulas. A geometric return provides a more accurate representation of the portfolio value growth than an arithmetic return. Portfolio management involves selecting and managing an investment policy that minimizes risk and maximizes return on investments. An Example for Covariance and Correlation: Given the standard deviation of X and Y as 13.23 and 9.75 in the portfolio of two securities the covariance between them has to be estimated. We note the geometric return is slightly less than the arithmetic return. Second, some financial assets may also offer capital appreciation as the prices of these securities change themself. Return on Portfolio: Each security in a portfolio contributes returns in the proportion of its investment in security. You A net return is the return post-deduction of fees. First, financial assets may provide some income in the form of dividends or interest payments. The IRR is the discount rate applied to determining the present value of the cash flows such that the cumulative present value of all the cash flows is zero. Articles on this site, please read the following characteristics: which company do you prefer an rate. 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