SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT
LESSON 31:
PORTFOLIO EVALUATION
Construction Revision and Evaluation
The portfolio theory is the basis of portfolio management and
relates to the efficient portfolio investmei1t in financial and
physical assets, including shares and debentures of companies.
A portfolio of an individual or a corporate unit is the holding
of securities and investment in financial assets. These holdings
arc the result of individual preferences and decisions of the
holders regarding risk and return and a host of other consider-
ations.
Fact Sheet - Clients’ Data Base
The following preferences of the investor are to be noted first
in investment decisions. These will constitute the data base of
the investor or client.
1. Income and savings decisions - how much income can be
saved for contingencies and the present position of wealth,
income and savings of the Investor.
2. Asset preferences profile - preference for riskless assets like
bank deposits or for risky stock market investment:
a. The degree of risk the investor is capable of taking and
willing to take;
b. the risk aversion and preference for safety and certainty;
c. requirements of regular income;
d. objective of capital appreciation;
e. objective of speculative gains; etc.
3. Investor’s objectives, constraints and financial
commitments.
4. Tax brackets into which the investor falls and his preference
for planning the tax liability.
5. Time horizon in which investment should fructify or
results expected. These and other factors constitute the
“Fact Sheet” of the investor on the basis of which the
individual portfolio is to be structured, constructed and
managed. The motives for saving are varied depending on
the individuals. For example, provision for insurance,
contingencies, contribution of PF, pension funds, etc.,
which arc mostly contractual obligations, provision for
future income, etc., are some of the motives. Some of the
savers arc influenced by interest return or stable income
while others are by speculative gains or get-rich-quick
motive.
Objectives of Investors
The investors’ objectives are to be specified in the first place.
The objective may be income, capital appreciation or a future
provision for contingencies such as marriage, death, birth, etc.
Provision for retirement and accident could be covered by
contractual obligations like insurance and contributions to PF
and pension funds. A certain amow1t of savings has to be kept
as cash with themselves or in deposit with banks or post offices
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164
to facilitate daily transactions for purchase and sale. While cash
earns no interest, savings deposit with banks, co-operatives and
POs would earn 3% to 5% on savings accounts. But when
inflation is prevalent in the economy at an average rate of 6-8%,
this return of 3-5.% will provide only a net negative return to
the savers. So the an10unts kept in the form of cash and
deposit with banks, etc., should normally be the bare mini-
mum. The rest of the amount has to be spread in various
investment avenues, earning higher returns than the normal
inflation rate of 8-10%. These investment avenues are discussed
in a separate chapter.
Motives for Investment
The investor has to set out his priorities of investment keeping
the following motives in mind. All investors would like to
have:
1. Capital appreciation.
2. Income.
3. Liquidity or marketability.
4. Safety or security.
5. Hedge against inflation.
6. A method of tax plaIU1ing.
The investor gets his income from the dividend or yield or
interest. There will be capital appreciation also in the case of
equities. The liquidity and safety of an investment will depend
upon the marketability and the credit rating of the borrower,
namely, the company or the issuer of securities. These character-
istics vary between assets and securities. An investor is also
concerned in having a tax plan to reduce his tax commitments
so as to maximise the take home income. For this purpose,
investor should specify his income bracket, his liabilities and his
preference for tax planning etc. The -investment avenues have
certain characteristics of risk and return and also of some tax
concessions attached to them. These tax provisions as such can
influence the investors in a very big way as these provisions will
alter the risk return scenario of investment alternatives. It is,
therefore, necessary that all these avenues should be assessed in
tems of yields, capital appreciation, liquidity, safety and tax
implications. The investment strategy should be based on the
above objectives after a thorough srudy of the goals of the
investor, in the background of characteristics of the investment
avenues.
Tax Provisions
It is apt to start with the tax-exempt incomes of the securities
in which investment can be made. The incomes by way of
interest on PSU bonds, N.S. certificates, securities of the Central
Government and those deposits specified by the Central
Government like RBI Relief Bonds arc exempted from income
tax subject to certain limits or conditions. The P.O: deposits,
certificates and other claims operated by the POs are exempted
along with others from income-tax up to a limit of Rs. 15,000.
11.621.3
This limit is inclusive of a sub-limit of Rs. 3,000, for UTI his preferences. The manager has to keep a list of such invest-

SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT

income distribution. Thus exemption is, however, not ment avenues along with the return-risk profile, tax
applicable to Indira Vikas Patra, Kissan Vikas Patra and NSC implications, yields and other return such as convertible
VITI Issue. Deposits in PPF and NSS are exempted from taxes options, bonus, rights, etc. A ready reckoned giving out the
in the year of deposit and subject to some limits in the year of analysis of the risks involved in each investment and the
withdrawal except in the case of NSS, which is, however, taxable corresponding returns should be kept.
in the year of withdrawal. PPF is the best method of tax saving Risk-Return Analysis
upto a limit. Under the category of insurance, in addition to All investments have some risks. Investment in shares of
LIC policies, the ULIP (of UTI) enjoys popularity due to the companies has larger risks or, uncertainty. These risks arise out
tax shelters: of variability of returns or yields and uncertainty of preciation
Capital Gains or depreciation of share prices, loss of liquidity etc. The risk
Capital gains refer to profits earned on the transfer of capital over time can be repre-sented (SMl) Security sented by the
assets, sale or exchange, etc. These gains are long-term gains, if variance of the Market UNe returns, while the return over time
they are held for more than 36 months for all assets except is capital appreciation plus payout, divided by the pur-chase
shares of a company for which this period is 12 months. Long- price of the share.
term capital gains are taxable at a lower rate of20%. Under
Sections 54£ and 54F of the Income-tax Act, the long-term
capital gains are exempt, if these funds are invested in Central
Government securities, UTI and CGI Schemes and other speci-
fied bonds of semi-government bodies. In the year 2000-01,
this exemption is extended only to investments in bonds of
NABARD and NHAI and Infrastructure Bonds.
Income from interest on debentures and on company deposits
is tax deductible at source, if it exceeds Rs. 2,500 p.a. The
exemption available from income tax for NSS deposits up to
Rs. 40,000 was since withdrawn in 1992-93. Tax exemption is
also available in respect of income from government securities,
semi government bonds, bank deposits, income from mutual
Normally, the higher the risk that the investor takes, the higher
funds, etc., upto a limit. In the budget for 1990-91, a new
is the return. There is, however, a riskless return on capital of
scheme called Equity linked Saving Scheme was announced by
about 6.5%, which is the bank rate charged by the RBI or long-
the government under Section 88A of Income Tax Act to
term yield on Government securities at around 7% to 9%. This
provide a tax rebate of 20% of the investment made in the
riskless return refers to lack of variability of return and no
eligible assets and new issues, or eligible M.P. Scheme. This was
uncertainly in the repayment of capital. Bur other risks such as
extended upto a limit of total investment of Rs. 70,000 p.a. in
loss of liquidity due to parting with money etc., may, however,
1996-97, in respect of investments in selected avenues such as
remain bur are rewarded by the total return on the capital. The
Insurance, P.F., PPF, NSS and Infrastructure bonds, etc.
risk free return and variable return are shown in the adjacent fig.
Portfolio Construction The risk-return relationship can be represented in a diagram-
Portfolio construction refers to the allocation of funds among a matic form as in Fig. below2
variety of financial assets open for investment. Portfolio theory Risk-return is subject to variation and the objective of the
concerns itself with the principals governing such allocation. portfolio manager is to reduce that variability and thus reduce
The objective of the theory is to elaborate the principles in the risk by choosing an appropriate portfolio. There arc two
which the risk can be minimised, subject to a desired level of types of risks, namely,
return on the portfolio or maximise the return, subject to the
a. Market risk or systematic risk, and
constraint of a tolerable level of risk.
b. Company risk or unsystematic risk.
Thus, the basic objective of portfolio management is’ to
maxin1ise yield and minimise risk. The other antiquely The unsystematic risk can be reduced by diversifying the
objectives are as per the needs of investors, namely: portfolio of scrip’s up to an optimum level of about 15 shares.
These scrips should be so chosen that the risks on each of them
1. Regular income or stable return; are diverse and their variability of return is also different. By
2. Appreciation of capital; investing in such a diverse set of scrips, the total risk can be
3. Market ability and liquidity; reduced as some of them may have positive and oth-ers
negative covariance and they may vary in the degree of risk as
4. Safety of investment; and
well. The risk that can be reduced is called unsystematic risk and
5. Minimising of tax liability. these risks are represented diagrammatically in Fig. here.
In pursuit of these objectives, the portfolio manager has to set
out all the various alternative investments along with their
projected return and risk and choose invest- investments which
satisfy the requirements of the individual investor and cater to

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11.621.3 165

SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT
The details are discussed in an earlier Chapter.
The unsystematic risk can be lowered by diversifying into a
basket of scrips. Thus, at the level of 15 scrips in the diagram,
the lowest level of risk is obtained at the point M .on the AB
curve representing the unsystematic risk of the investor. Thus, a
degree of diversification of investment is a necessary prerequi-
site of portfolio management and for reducing the risk. But
beyond the point M, the portfolio becomes unmanageable and
diseconomies operate as to increase risk rather than reduce it.
In the management of a portfolio, the problem of risk
manageIl,1ent is vital. Given the individual preference of
portfolio holders, the portfolio is to be constructed in such a
manner that it is exposed to the minimum risks which the
owner can carry, subject to which the returns are to be
maximised. Although the market-related risks cannot be
reduced, the company-related risks can be eliminated through a
proper diversification. As shown in the above diagram, a proper
portfolio diversification into around 15 scrips of different
groups of industries and companies would be able to reduce
the company-related risks involved almost to a negligible
proportion. But these companies and industries should not be
unduly related or interdependent or under the same umbrella
of industry groups or family of industrialists. An optimum
degree of diversification can be secured which would minimise
risk- and optimise return, if the covariance of scrips included in
the portfolio is less than 1 or negative.
Time Horizon of Strategy
Every investment strategy should have a time horizon from a
short period of one year to a few years. Capital gains is consid-
ered long-term if equity investment at least one year and other
types of investment for at least three years. If investment is to
be a\assessed every year, the past experience shows that the
equity prices, reflected by the BSE Sensitive Index, may show
varying degrees of rise or fall per annum, but over a period of 3
to 5 years, the market index invariably showed a rise of anything
above the normal inflation rate per annum. So investment
strategy should be for a medium time period of 3 to 5 years.
Portfolio management encompasses three major categories of
activities:.
1. Asset allocation - type of assets to be chosen among fixed
income securities of the governed or private corporate units,
preferred stock debentures or equities, etc., of various
groups of industries.
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166
2. Review and shifts as between classes of asset~ to take
advantage of risk- return characteristics, or changes in them.
3. Security selection within each asset class such as choosing a
higher growth type of companies (blue chips).
Types of Risk
The risk is measured statistically by the degree of variance or
standard deviation of returns. There is also a risk involved in
time period of holding (the longer the period, the greater the
risk) called liquidity premium. The holding of security is subject
to the default risk in repayme!1t of principal called default
premium. The risks also arise due to interest rate variability,
purchasing power changes, business default or financial failures.
They can be named as interest rate risk, purchasing power risk,
business risk, and financial risk, which are all part of systematic
risks which lead to a risk premium. These are to be rewarded by
a higher return in the market than can be secured on risk-free
assets.
The above is the market-related risk. Besides, there is also
group-related risk pertaining to a group of industries or firms.
There is also a specific risk related to a company.
As per the Markowitz model,3 the investors are generally risk-
averse. To suit such investors, the portfolio has to be so
designed as to maximise returns for a given level of risk. It is
theoretically possible to identify an efficient portfolio, which
satisfies the requirements of risk-return for an individual
investor. This is possible through a detailed analysis of
information on each security in each of the asset classes in terms
of expected risk (variance of return) and expected return, and
covariance
of each of the security with every other security. In simple
language, this efficient portfolio is a well-diversified portfolio
comprising many securities with a low covariance so that the
degree of risk is the lowest possible. Companies under different
industry groups and different family managements and with
different characteristics are to be chosen in that portfolio.
Efficient Portfolio
To construct an efficient portfolio, we have to conceptualise
various combina-tions of investments in a basket and designate
them as portfolios 1 to n. Then the expected returns from these
portfolios are to be worked out. The risk on these portfolios is
to be estimated by measuring the standard deviation of
different portfolio returns. To reduce the risk, investors have to
diversify into a number of securities whose risk-return profiles
vary.
Thus, portfolios carry returns to compensate for interest risk
(risk-free return) + a premium for purchasing power risk,
market risk, business risk and financial risk. Some risks consti-
tute unsystematic risks, which can be reduced or eliminated - by
diversification. Thus, for each individual security. and for a
combination of securities represented by the basket in the BSE
Sensitive Index or National Index, the expected returns and
standard deviations can be worked out. The expected return has
to be weighted by the probable chance of getting the return
through proper weights and the weighted average return should
be worked out.
If we compare portfolio Nos. 4 and 5, we see that for the same
standard deviation of 5, portfolio No.5 gives an expected return
11.621.3
of 11 % higher than that on No.4, thereby making it an efficient 45°), then, on an average, one percentage return on the market

SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT

portfolio. If we compare portfolio NOs. 6 and 7, we see that basket will be associated with a one percentage return on the
with the same return of 12% in both the portfolios, standard individual scrip. If Beta is greater than one it will give a larger
deviation is lower in portfolio No.6. Thus, portfolio No.6 is an return than the average market return. These high Beta scrips are
efficient portfolio. very volatile and risk is also high. On the other hand, if Beta is
These points can be depicted as in Fig. below. The expected less than 1 (called defensive scrips), the risk is low and the return
return is shown on the Y-axis and standard deviation measur- is also lower than the market return. Depending on the
ing risk on the X-axis. The points connecting the expected investor’s choice, the Beta is to be selected and scrips with such
return with its standard deviation can be shown as AB graph, Beta should be held in the portfolio Fig. 44.5 depicts Beta as the
constituting the feasible opportunity set. The outermost point angle made by the line of regression between market return and
on this graph is the most efficient portfolio, say, M on the AB the individual scrip return.
graph while the AB graph is called the efficient frontier. M is the
most efficient combination for the individual under consider-
ation (Ref. lnvestmmt Managenu:nt by Simha, Hemlata and
Balakrishnan).
The individual investor is generally risk-averse according to the
well-known author Markotwitz. His objectives are influenced by
the stage of life, his financial circumstances and psychological
makeup. A young investor may have, for example, a higher level
of tolerance of risk than a retired person or a middle-aged
person. The latter prefers a larger income with less risk. There is
a trade-off between risk and return.
According to the capital pricing model, efficient frontier is
defined as a risk -return trade-off curve. It is efficient because it
provides the maximum return at a given level of risk of the
investor. The investor’s capacity to take risk sets the point of
optimum efficiency on this curve, which is the best for him.
Diversification of securities and assets in the port- folio reduces
the risk, provided their covariance is low and they are dissimilar
in nature. The total risk is measured by the standard deviation
of the return, and market risk by the concept of Beta. Beta
reflects that part of a portfolio’s return and variation in returns
which is at-tributable to the overall movement of the market
rather than to any unique character tic of the company.

Market Efficiency Theorem

The efficient frontier of Markowitz and the use of Beta can be
graphically represented as in Figs. AB is the capital market line,
representing the market possibilities of risk and return (given
by the BSE Index). On the same graph, the efficient frontier
curve is drawn as EF. At point M, for the given risk of OR, the
return is maximised for the investor at OC.
In actual practice, Beta can be derived by the formula: Price of
Scrip A (% age)/ Prices of scrips included in BSE Index (% age)
- the relation of the individual scrip to that of the basket of
scrips as represented by the BSE Index. If Beta is 1 (slope is
Since the behaviour of the market is outside the control of the
investor, he can only reduce the specific component of risk by
choosing the individual scrips with proper Betas to achieve the
result of diversification and lower the risk. The comparative
risks of alternative well-diversified portfolios can be measured
by their Betas. If the markets are efficient, the performance of
any portfolio would average out to that of the performance of
the market and nobody can out perform the market.
In the real world, there are three different levels of efficiency of
the stock market, namely, the weak form, the semi-strong form
and the strong form. These concepts -are useful in portfolio
management for investors, and are discussed in details in an
earlier chapter.
In the weak form, the successive changes in stock prices are
independent of each other and the historical market data are
already embodied in the existing price.
In the semi-strong form, stock prices adjust rapidly to all new
public informa-tion, both market and non-market data, and
action taken after the event will produce no more than random
results.

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11.621.3 167
 In the strong form, stock prices fully reflect not only public
SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT
information but privately-held information which may later
become public.
If, in the real world, the market efficiency is of a strong fom1,
then the performance of any basket of scrips in any portfolio is
as good as any other and no individual investor can out
perform the market. If however, the market efficiency is of a
weak form, there is scope for selection of a portfolio which is
optimal for the investor in terms of risk and return and yet out
perform the market by a proper choice of aggressive scrips with
Betas suitable for the purpose.
Diversification
Risk in a portfolio can be reduced by a proper diversification
into a number of scrips. The companies chosen should not be
too many or too few but of an optimum size as to be effi-
ciently manageable. The economies of scale in management
apply to this analysis. It will be seen from Fig. 44.6 that the
higher the risk, higher is the return in till normal process. The
risk-return relationship is shown in the graph.
Depending upon the investor’s preferences and his in-come
requirements, the strategy of investment should be at A, B or C
respectively. Assuming that he takes some risk at B or C, this
risk can be reduced so far as it concerns the specific company
risk, but the market risk is out- X side the control of the
portfolio manager. The risk can be reduced by a proper
diversification of scrips invested. It is also possible to have a
combination of A, B and C positions in a portfolio so as to
have a diversified risk- return pattern.
In order In order that this diversification secures the results in
an optimal manner, the number of scrips chosen should be
limited to 12-15. As, Fig. shows, 91e risk is first reduced as the
number of companies is increased but after a point, the risk
again increases due to the operation of diseconomies of scale.
The risk can be lowered from OM to O~ by increasing the
number of companies from 5 to 15, after which risk cannot be
lowered as the curve AB representing the unsystematic risk
starts going up again.
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168
The optimum number of companies should be such that they
are of divergent qualities in tCffi1S of performance, product,
lines, management, marketing, etc. Such a diversification only
can secure reduction of risk :iiJ.d maximisation of rerums. In
this process, a proper selection of scrips with, Betas of
aggressive nature (B > 1) and some with defensive nature (B <
1) should be chosen, depending upon the individual preferences
of the investor. In the selection of these companies, all the
processes e},:plained.
The optimum number of companies should be such that they
are of divergent qualities in tCffi1S of performance, product,
lines, management, marketing, etc. Such a diversification only
can secure reduction of risk and maximisation of returns. In
this process, a proper selection of scrips with, Betas of aggres-
sive nature (B > 1) and some with defensive nature (B < 1)
should be chosen, depending upon the individual pref-erences
of the investor. In the selection of these companies all the
process explained above under portfolio management should
be followed and after analysis and assessment, investment
should be made.
Portfolio Management
Portfolio management is a process en-compassing many
activities of investment in assets and securities. It is a dynamic
and flexible concept and involves continuous and systematic
analysis, judgment and operations. The objective of this service
is to help the novices and uninitiated investors with the
expertise of professionals in portfolio management. Firstly it
involves construction of a portfolio based upon the fact sheet
of the investor giving but his objectives, constraints, preferences
for risk and return and his tax liability. Secondly, the portfolio is
reviewed and adjusted from time-to-time in tune with the
market conditions. The adjustment is done through changes in
the weighting pattern of the securities and asset classes in the
portfolio. The shifting of assets and securities will take advan-
tage of changes in market’ conditions and in prices in the
securities and assets in the portfolio. Thirdly, the evaluation of
portfolio performance is to be done by the manager in terms of
targets set for risk and return and changes in the portfolio are to
be affected to meet the changing conditions.
11.621.3
Elements of Portfolio Management
1. Identification of the investors’ objectives, constraints and
preferences, which will help formulate the investment policy.
2. Strategies are to be developed and implemented in tune
with the invest-ment policy formulated. This will help the
selection of asset classes and securities in each class
depending upon their risk-return attributes.
3. Review and monitoring of the performance of the
portfolio by continuous overview of the market conditions,
companies’ performance and investors’ circumstances.
4. Finally the evaluation of the portfolio for the results to
compare with the targets and needed adjustments have to
be made in the portfolio to the emerging conditions and to
make up for any shortfalls in achievement vis-a-vis targets.
The collection of data on the ,investors’ preferences, objectives,
etc., is the foundation of portfolio management. This gives an
idea of channels of investment in terms of asset classes to be
selected and securities to be chosen based upon the liquidity
requirements, time horizon, taxes, asset preferences of inves-
tors, etc. These are the building blocks for construction of a
portfolio.
According to these objectives and constraints, the investment
policy can be formulated. This policy will by down the weights
to be given to different asset classes of investment such as
equity shares, preference shares, debentures, company depos-its,
etc., and the proportion of funds to be invested in each class
and selection of assets and securities in each class are made on
this basis. The next stage is to formulate the investment
strategy for a time horizon for income and capital appre-ciation
and for a level of risk tolerance. The investment strategies
developed by the portfolio managers have to be correlated with
their expectation of the capital market and the individual sectors
of industry. Then a particular combination of assets is chosen
on the basis of investment strategy and manager’s expectations
of the market.
Execution of Strategy
The next stage, namely, implementation and execution of this
investment process, is the most critical process in the portfolio
management. Here the research, analysis and the judgments of
the manager are very essential inputs in the process. His
initiative, innovation and judgments would be the basis of his
success in management. The performance of the portfolio is
evaluated and adjustments are made in me portfolio composi-
tion from time-to-time. This is called monitoring and
restructuring of portfolios for improving the performance to
make it optimal and efficient. The changes in investor’s
conditions and in the market conditions and in industry
performance are taken into account in the portfolio adjust-
ments.
The portfolio thus constructed may relate to the needs of a
given level of income, a provision for contingencies and a
preference for fixed income, etc.,. of the investor.
Some investors would prefer assets like real estate, gold,
debentures or bonds giving a fixed income while a few would
prefer riskless investments in PSU bonds - short- term or long-
term government securities, etc. Certain risk-takers may prefer
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11.621.3
invest-ment in high-yielding growth stocks and venture
SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT
equities.
Monitoring
Monitoring of the portfolios is a continuous upgrading and
changes in asset composition to take advantage of the market
conditions and economic and industry performance. Portfolio
monitoring is a continuous on-going assessment of the current
portfolio to the goals, changes in investors’ preferences, capital
market conditions and expectations. The monitoring requires a
periodic meeting with investors to know the changes in the
conditions, continuous review of the investment policy relative
to investors’ preferences.
The current investment strategy reflects the capital market
conditions and expectations and any changes in them will bring
out the changes in optimal conditions in the portfolio. The
portfolio is thus subjected to the ongoing review and assess-
ment to change the composition of the portfolio in tune with
the change conditions in the market and of the investor.
To give specific examples, if market conditions and the
prospects of the cement industry are likely to be better in the
coming year, as judged by the Government policy changes vis-a-
vis the steel industry, then the investor references can be better
satisfied by shifting from steel shares to cement shares. Besides,
within the cement industry, a manager may shift from a poorly
performing company like Orient Cement to a better performing
company like India Cement. Similarly, changes can take place as
between different asset classes such as moving from debentures
to equities and vice versa or from income stocks to growth
stocks, etc.
Thus, portfolio changes can be brought about by the changes in
market expectations and from the half yearly results or yearly
result$ of the companies, industry and economy. These
adjustments. of the portfolio may also be initiated due to
changes in the managers’ expectations off the company and
market or asset classes. Certain changes in asset classes may have
a time limit as a critical input. Thus, purchases and sales of
equity shares on the stock market arc to be well-timed .based
upon the assessment of the market technical position. This
requires technical analysis in addition to fundamental analysis.
In fact, any shift of the investment from one type of asset to
another requires a careful analysis of time, risk-return and host
of other factors. .
An important characteristic of the portfolio is risk reduction,
which can be achieved by a diversification of the portfolio into
the various asset classes and securities within the asset class.
169
 Changes in security prices or market expectations of the asset class will change to bring back the portfolio to the targeted
SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT

manager may have necessitated changes in the asset composi- level of Beta and duration. portfolio revision will take place and
tion. The efficient frontier in terms of modern portfolio theory composition of portfolio will change. A change in interest rate
may itself change the composition of the portfolio due to the will also affect the portfolio through change in duration.
change in the Beta value in the longer time horizon. The Constant market changes necessitate readjustment of portfolio
composition has to be changed to bring portfolio back to the leading to purchases and sales of equities, bonds etc., which in
optimal conditions and back to the efficient frontier line. turn will result in change in Beta and duration.
The investment alternatives for portfolio management are set
out below: Thus, any portfolio requires constant monitoring and revision.
Operatior1s on a portfolio will thus take place on a daily basis,
1. Asset Classes keeping in mind, the targeted Beta, duration and return. .
a. Equity - new issues Changes in investor’s financial status, his preferences and market
b. Equity - old issues’ conditions, will also require changes in portfolio composition.
c. Preference shares The next stage is performance evaluation which is referred to
later. Before we discuss evaluation, it is necessary to set out
d. Debentures - convertible and non-convertible - new and old some Theoretical tools like security analysis, Markotwitz model,
issues risk-return evaluation ‘etc. These are referred to below, briefly,
e. PSU Bonds although they were set out in detail, in earlier Chapters.
f. Government Securities Security Pricing and Portfolio Management
g. Company deposits, etc. Portfolio Management is based upon Security Analysis which is
2. Industry Groups an Analysis of Share prices.
a. Textiles (1) Analysis at Macro Level (2) Analysis at Macro Level
b. Cement of Market of Company

c. Aluminum
d. Petrochemicals
e. Fertilizers
f. Paper, etc.
3. High Income Yielding Securities; Blue chips and growth
stock. Regular dividend paying companies at a stable rate are
income yielding shares. The blue chips are not only
dividend paying regularly but their performance is above the
average and the dividend distributions may increase over Markowitz Model of Portfolio Theory
time. The growth stocks arc shares with a large scope for This Portfolio Model is based on the exposure to market risk
capital appreciation in addition to good dividends. and the degree of diversification of the portfolio. ‘The Beta of
the portfolio provides a measure of exposure to market risk
4. Companies with export orientation and those with only
and the coefficient of determination, namely, R2 provides a
domestic demand.
measure of diversification.
5. Companies based on location as those in the west, south,
Cross sectional measures are used for risk estimates for
east and north of India.
individual holdings, that comprise the portfolio, The individual
6. Type of management, viz., family type, professional type, Scrips in the portfolio have their own Betas, which are weighted
etc. by the proportion of the funds invested in each.
Building of the Portfolio
The portfolio construction, as referred to earlier, is made on the
basis of the investment strategy, set out for each investor.
Through ‘choice of asset classes, instruments of investments
and the specific scrips, say of bonds or equities of different risks
and return characteristics, the choice of tax characteristics, risk
level and other features of investments, are decided upon. The
construction of Portfolio and other elements in the portfolio
management are already set out in Fig..
Portfolio Revision
After fixing the target Beta and duration of the portfolio, the Depending on the risk preference of the investor, weights can
investment activity starts with the selection of Scrips and be changed to get the desired portfolio Beta to less than 1.1 or
Bonds, etc. Bur the portfolio once constructed undergoes more than 1.1 (got in the above Table).
changes due to changes in market prices and a reassessment of In the same way, the portfolio R2 or R can be calculated and
companies and the portfolio Beta and the proportion in each compared with the market return and its R2 or R. The standard

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170 11.621.3
deviation for the portfolio can be compared with that of the
Market Index return and its R to ensure that its R is suitable to
the investors risk preferences.
William Sharpe has suggested a new model. Instead of
comparing the risk of each Scrip to every other Scrip, it can be
compared with market risk, which leads to the comparison of
market return to Scrip Return. He takes into account only the
systematic Risk on the Portfolio (Beta).
Ri = α + β I + c
α is the intercept of the straight line.
β is slope of the straight line or β co-efficient.
I is expected return on Market Index, and e is the Random
component. The sharpe Index method has given us two
components of Risk.
Systematic Risk = B2 x Variance of Index.
= β2 O2
Unsystematic Risk = Total Variance of a Portfolio
Security Return – Systematic Risk = e2
= β2 O2 + e2
Total Risk of Market = Systematic Risk covered by Beta and
Unsystematic Risk covered by diversification.
Risk Analysis
While the risks of fixed interest securities cm be known as they
arc rated by agencies like lCRA and Crisil, the risk on equities
cannot be assessed and has to be borne by the investor. The risk
on equities is more than on bonds, debentures or fixed
deposits and not amenable to scientific measurement as that is
the residual risk of the firm. These risks may be due to
inflation, interest rate changes, financial risk, business risk,
market risk, liquidity risks, and other risks. Some of them relate
to the market and economy and hence not controllable while
the others are company specific in nature, which can be con-
trolled and reduced by diversification. Thus, investment in
more than one company and industry is necessary for reducing
risks. Investment in too many companies, may not be desirable
but investment in two companies in steel industry is not having
the same risks as invesffi1ent in one Steel Company and one
drug company. Risk concepts and related aspects are dealt with
already in another chapter.
Evaluation of Portfolio Performance
Investment analysts and Portfolio Managers continuously
monitor and evaluate the results of their performance. The
revision of portfolio investments is conducted on the basis of
such monitoring and evaluation. The ability of Managers to our
perform the market depends on their expertise and experience.
The basic features of good Portfolio Managers are their ability
to perceive the market n-ends correctly and make correct
expectations and estimates regarding risk, returns, ability to
make proper diversification, to reduce the company related risk
and use proper Beta estimates for selection of securities to
reduce the systematic risk. In such case, it is possible for an
expert Portfolio Manager to show superior performance over
the market. This performance also depends on the timing of
investments and superior investment analysis and security
selection. He has to have the acumen to select the under valued
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11.621.3
shares under each risk class, for which a high degree of equity
SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT
research is needed.
The two major factors which influence his performance are the
return achieved and the level of risk that the portfolio is
exposed to. The Manager has to make proper diversification
into different industries, asset classes and instruments so as to
reduce the unsystematic risk to the minimum for a given level
of return. The market related risk has to be managed by a
proper selection of Beta for the securities.
Criteria for Evaluation of Portfolio
Portfolio managers and investors who manage their own
portfolios continu-ously monitor and review the performance
of the portfolio. The evaluation of each portfolio, followed by
revision and reconstruction are all steps in the portfolio
Management.
Managers and Analysts ‘wish to know how they performed in
their investment strategies in terms of return per unit of risk ,
both in absolute terms and relative terms relative to overall
market performance. They have to assess the extent to which
the objectives aimed at are being achieved say in terms of
income, capital appreciation.
In this context, evaluation has to take into account whether the
portfolio secured above average returns, average or below
average, as compared to the market return. The ability to
diversify with a view to reduce and even eliminate all unsystem-
atic risk and expertise in managing the systematic risk related to
the market by use of appropriate risk measures, namely, Betas.
Selection of proper securities is thus the first requirement.
Superior timing and superior stock selection may result in above
average return. Diversification in terms of Markowitz model or
Sharpe’s Single Index Model will reduce the market related risk
and maximise the returns for a given level of risk. Market
returns being related positively to risk, evaluation has to take
into account:
1. Rate of returns, or excess return over risk free rate.
2. Level of Risk both Systematic (Beta) and Unsystematic and
residual risks through proper diversification.
Under the Traditional theory, the evaluation is only in terms of
the rate of return, particularly in comparison with other assets
of the same risk class. The theory of Markowitz and Modern
Portfolio Theory have opened up the avenue for selecting and
evaluating the portfolios on the basis of risk adjusted return.
Modern portfolio theory has postulated that the portfolio
selection and evaluation should be on the basis of both Risk
and Return-and the objective should be to optimise the return
for a given level of risk or t6 minimise the risk for a given level
of return. Due to uneven fluctuations of return and high
degree of variability of returns, risk adjusted returns become
the basis for evaluation. This is possible due to later develop-
ments involving the quantification of risk by the statistical
measures of S.D., variance and covariance pf returns of
securities in a portfolio.
There was no composite index, which measures both return
and risk under the Traditional Theory. In Modern Portfolio
Theory it became necessary to develop some composite
measures of both return and risk in portfolio performance, as
the objective now is maximisation of return and minimisation
of risk. Because of the trade-off between them, simple
171
 maximisation of returns or single goal of minimisation or risk
SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT
will be defeating the objectives of Modern Portfolio Manage-
ment.
It was in this context that later researches have tried to evolve a
composite index to measure risk based returns taking into
account the different components of risk, viz., systematic,
unsystematic and residual risk. The credit for evolving these
criteria goes to Sharpe, Treynor and Jensen.
Where ST is Sharpe index when, Rt is average return on
portfolio, Rf is risk free return, O is the total risk of the
portfolio.
It measures total! risk by standard deviation. Reward is in the
numerator as risk premium. Total risk is in the denominator as
standard deviation of its return. We get a measure of
portfolio’s total risk and variability of returns in relation to the
risk premium which is the product of the portfolio Manager’s
expertise.
The method adopted by Sharpe is to rank all portfolios on the
basis of evaluation measure ST. If one portfolio has more ST
than another, the first one is better performer as per the
Sharpe’s measure. Take the following example:
Portfolio Management Construction Revison and
evaluation
Treynor’s Measure
In treynor’s measure the risk measure of standard devation
namely, total risk of the portfolio is replaced by market risk,
measured by beta, which is not diversification the equation can
be set our as
Tn = Treynor’s measure of evaluation
Rn = Return on the portfolio, Rf =Risk free rate,Bn is beta of
the portfolio as measure of systematic risk
Treynor based his formula on the concept of characteristic line.
this line is the least squires regression line relating the return to
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172
the risk and Beta is the slope of the line. the regression line
takes the form of
Rp =a+bx+e
Rp = is the return of portfoilo
a is the intercept reflecting the risk free return.
B is the slope of the line and is the market return and e is the
error term.
Thus concept can be graphically represented as follows.
Based on this characteristic line Treynor formula is
Take a Problem as an example
Portfolio Return Bn Rf
A 20 0.5 10
B 24 1.0 10
Portfolio A performs better than portfolio B as Tn A> TnB.
The numerator in Treynor’s formula is the reward measured by
beta coefficient.
The difference between Sharpe measure and Treynor measure is
the following
Sharpe neither takes the total risk of portfolio in to account
while Trey nor considers only systematic risk as relevant to
perfomance. Total risk consists of both systematic and unsys-
tematic risk, while the later is amenable to reduction by
management of proper diversification the former cannot be
elimated but borne by the investor The higher this market risk
one takes the higher is the return If diversification is perfect and
unsystematic risk is nil or negligible then the only elements of
risk in both the portfolio measurement is the systematic
varience. The ranking of portfolios on the basis of both the
measure therefore should give identical results But it is possible
that these two measure in practice give varying results due to
difference in the investment strategies and diversification
techniques.
Problems
Example on Evaluation of portfolio performance
The Measure of sharpen performance evaluation may be
collected from the following data.
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Three Portfolios of the securities

SECURITY ANALYSIS AND POR TFOLIO MANAGEMENT

A comparison of the two measure namely, Treynor’s and
Sharpe performance Evaluation is made in the above example.
Conclusion
By Treynor’s measure the portfolios Ais better as it has a higher
rank of 3.00 than that of B(0.1) by Sharpe index measure also
the same conclusion is arrived namely portfolio A is better than
B as the former got a rank higher than the latter
Jenson/s Measure
Jensen measure of the performance of portfolio is different
from that of Sharpe and Trey nor in that he latter provides a
measure of ranking the relative performance of various
portfolios on a risk adjusted basis while the former gives a
measure of absolute performance on a risk adjusted basis This
stranded based on CAPM measure the portfolio Manger
predictive ability to achieve higher return then expected for the
given riskiness.
Jensen’s Model
RJt- Rft = αj +βj (R mt -Rft)
Rjt =Avarge return on portfoilo Jfor period
Rft = Risk free rate of return for period
αj = Intercept of the graph measuring the forecasting ability of
the Manager
B = Systematic risk measure
Rmt =Average return on the market portfolio for period t.
it is possible that αj =0,. Which is natural performance on the
same as that of market.
α>o, it is superior performance over the market
αj < o it is inferior performance
The Jenson approach can be illustrated by an example.

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