Concept of a Portfolio

Portfolio: The group of assets such as stocks and bonds held by an investor is termed as a portfolio.

Purpose of constructing a Portfolio:

Generally, investors prefer to invest in a portfolio rather than a single security as the risk involved in a
portfolio is less than that involved in an individual asset due to the phenomenon of diversification.
Diversification is a strategy designed to reduce risk by spreading the portfolio across different or
diverse investments. The basic goal in diversification is to capture a high return by investing in
different stocks while avoiding as much risk as possible. The principle of diversification tells that
spreading an investment across many assets will eliminate some of the risks, but not all. There is a
minimum level of risk that cannot be eliminated by diversification, which is referred to as non-
diversifiable risk. The amount of risk reduction through diversification also depends upon the degree of
positive correlation between the various assets in the portfolio. The lower the positive correlation,
greater will be the amount of risk reduction.

Assumptions of the Portfolio Theory:

1) It is based on the assumption that investors are risk-averse. They prefer to hold well-diversified
portfolios instead of investing their entire wealth in a single asset or security. The individual is
concerned only about the expected return and risk of the portfolio rather than individual assets or
securities.
2) The returns of the securities are normally distributed. This implies that the mean and the
standard deviation form the foundation of the portfolio analysis.

Portfolio Return:
Each stock in a portfolio has its own expected return and risk.
The return (actual or expected) of a portfolio is a weighted average of the returns of the individual
securities, where the weights represent the proportion of the individual securities in the portfolio.

n
Symbolically, kp= w k
i 1
i i

where, kp is the return on the portfolio.

ki is the return of the ith security in the portfolio.
wi is the proportion of the ith security in the portfolio.

Portfolio risk:
The risk (as measured by standard deviation) of the portfolio is not a simple weighted average of the
risk of the individual securities in it; the portfolios risk will be smaller than the weighted average of
the standard deviations of the assets.
The basic formula for computing the standard deviation of an n-security portfolio is:
1/2
n n
= w i w j ij i j
i 1 j1

where, is the standard deviation of the portfolio,
wi is the weight of the ith security
wj is the weight of the jth security
i is the standard deviation of the ith security
j is the standard deviation of the jth security.
ij is the correlation coefficient between the ith and the jth security.

Risks Affecting a Portfolio:

The total risk in the case of an individual security can be divided into two parts:
(1) Diversifiable risk or unsystematic risk: It affects a single asset or only a small group of
assets. Since these risks are specific to individual companies or assets, they are sometimes referred
to as unique or asset-specific risks. This risk arises from the uncertainties which are unique to
individual securities and which are diversifiable if a large number of securities are combined to
form well-diversified portfolios.
Examples of unsystematic risks:
Workers declare strike in a company.
The R&D expert of a company leaves.
The company is not able to obtain adequate quantity of raw material from the supplier.
(2) Non-Diversifiable or systematic risk: It influences a large number of assets, each to a greater
or lesser extent. This risk arises on account of economy-wide uncertainties and the tendency of the
securities to move together with changes in the market. It is also referred to as market risk. This
part of the risk cannot be reduced through diversification. Thus investors are exposed to market
risk even when they hold well-diversified portfolios of securities.

Examples of Systematic risk:

The Reserve Bank of India introduces a restrictive credit policy.
The corporate tax is increased.
The inflation rate increases.

Note: Since the systematic risk present in an asset cannot be eliminated by diversification, the expected
return on a risky asset depends only on that assets systematic risk. As unsystematic risk can be
eliminated by diversification, there is no reward for bearing it.

Risk reduction through diversification:

Total Portfolio risk

Diversifiable
risk

Non-diversifiable
risk

2 4 6 8 10 12 14 16 18 20 22
NUMBER OF SECURITIES IN A PORTFOLIO

From the above graph we observe that,

(i) Diversification reduces only the unsystematic risk whereas the systematic risk remains constant.
(ii) Beyond a certain point, the diversifying effect of each additional stock diminishes due to increase
in the positive correlation between the assets.

Beta: A measure of systematic risk

Beta measures the relative risk associated with an individual portfolio as measured in relation to the
risk of the market portfolio.
The Market Portfolio represents the most diversified portfolio of risky assets an investor could buy
since it includes all risky assets.
The expected return and the risk premium on an asset depend only on its systematic risk. Since assets
with larger betas have greater systematic risks, they will have greater expected returns.
Mathematically beta can be expressed as:
Non - diversifiable risk of asset or portfolio j
j
Risk of market portfolio

If Beta is greater than 1, it indicates that the stock is more risky when compared to the market
portfolio.
If Beta=1 then it indicates average risk.
If beta is less than 1, then it indicates that the security is less risky than the market portfolio.
Beta of a Portfolio: The beta of a portfolio is a weighted average of the beta of the individual
securities, where the weights represent the proportion of the individual securities in the portfolio.
n
p w i i , where
i 1
p is the beta of the portfolio,
wi is the weight associated with the ith security, and
i is the beta associated with the ith security.
Measuring Beta: Sharpes Single Index Model
The Single Index Model establishes a linear relationship between the return on a security (or portfolio)
and the return on the market portfolio. According to it: kj = j j k m e j
where, kj is the return on the security and km is the market return.
j represents the slope of the above regression relationship and measures the responsiveness
of the security (or portfolio) to the general market. It can be computed as the ratio of covariance
Cov(k j k m )
between the securitys return and market return, to the variance of the market. j =.
Var(k m )
The alpha parameter represents the intercept of the fitted line and indicates what the return on
the security will be when market return is zero. It is computed as: j k j jk m
The term ej represents the unexpected return resulting from influences not identified by the
model and is referred to as random or residual return.
A graphical representation of this model is the Characteristic regression line.

Capital Asset Pricing Model (CAPM):

The CAPM establishes a linear relationship between the required rate of return on a security
and its systematic or non-diversifiable risk as measured by Beta.
Mathematically, it is represented as: kj= Rf + j (km- Rf)
where kj is the required rate of return on the security,
km is the return on market portfolio, and
Rf is the risk free rate of return.
The term j (km- Rf) indicates the risk premium on the security and the term (km- Rf) indicates the
market risk premium.
.
Assumptions under the CAPM model:
(1) Investors are risk-averse.
(2) Investors make their decisions based on a single- period horizon.
(3) There are no transactions costs in the financial markets.
(4) Taxes do not affect the choice of buying an asset.
(5) All individuals assume that they can buy assets at the going market price and
they all agree on the nature of risk and returns associated with each investment.

The Security Market Line:

The CAPM model can be graphically represented by the security market line.

SML

Risk Premium
km

Rf

Defensive BETA Aggressive

Securities =1 Securities

Any individuals expected return and beta should lie on the SML.
Rf is the intercept of the SML.
km-Rf is the slope of the SML.

Using SML to evaluate securities:

- If the expected rate of return on a security is greater than the required rate of return, it
indicates that the security is undervalued because its average return is high for the level of risk it
bears. Such a stock lies above the SML.
- If the expected rate of return is less than the required rate of return then the security is
over-valued. Such a stock is unattractive as it is expected to produce a rate of return lower than the
stocks with similar betas and it lies below the SML.
- The above two categories of stocks should move towards equilibrium by going through
D 0 (1 g)
a temporary price adjustment. The expected return on the security is computed as: g.
P0
Assuming that Betas remain the same, the expected return of the undervalued stock has to be
brought down to be equal to the required rate of return by increasing the purchase price of the
security.
Similarly for the overpriced security, the purchase price of the security has to be brought down so
that its expected rate of return rises and becomes equal to its required rate of return.

Example:
The following details are given for Security X and Security Y. Are the two securities at
equilibrium with the market?
Security X:
Risk free rate = 5%; Beta = 1.1 and Market return = 10%
Last paid dividend = Rs 1.50; Current Purchase price = Rs 10.
Growth rate = 3%
Security Y:
Risk-free rate= 4%; Beta = 1.3; Market return = 10%.
Last paid dividend = Rs 1.20; Current Purchase Price = Rs 25; Growth rate =3%.

Solution: Security X:
The required rate of return using CAPM is kj= Rf + j (km- Rf)
i.e kx= 5%+1.1 (10%-5%) = 10.5%.

D 0 (1 g) 1.5(1 .03)
The expected rate of return = g = .03 = 18.45%
P0 10
The expected rate of return of the security X is greater than the required rate of return. Therefore,
Security X is under-priced and is not at equilibrium. For the security to be at equilibrium, the
purchase price should be increased.
At equilibrium, required rate of return = expected rate of return.
1.5(1 .03)
10.5% = .03 .
P0
Hence, P0 should be Rs 20.60; and the purchase price should increase from Rs 10 to Rs 20.60 in
order to reach equilibrium.

Security Y:
The required rate of return using CAPM is kj= Rf + j (km- Rf)
i.e kx= 4%+1.3 (10%-4%) = 11.8%.

D 0 (1 g) 1.2(1 .03)
The expected rate of return = g = .03 = 7.94%
P0 25
The expected rate of return of the Security X is greater than the required rate of return. Therefore,
the Security X is over-priced and is not at equilibrium. For the security to be at equilibrium, the
purchase price should be decreased.
At equilibrium, required rate of return = expected rate of return.
1.2(1 .03)
11.8% = .03
P0
Hence, P0 should be Rs 14.05 and the purchase price should decrease from Rs 25 to Rs 14.05 in
order to reach equilibrium.

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