Reduction of Risk through Portfolio Management

(A Study on Portfolio Evaluation of selected companies)

*M.Madhavi **R.Radhika

ABSTRACT
The current financial crisis is creating a panic among the investors due to the turbulences of
the stock markets. Investors are the basis for fund rising for a number of companies as the
investors contribute their funds to the organizations through public issues. It is the
responsibility of the organizations to safeguard the interests of the investors through better
management of funds. But at the same time, it is necessary that the investors have some
knowledge of the organizations into which their funds are invested and the risks and the returns
associated with their investments. Portfolio management provides an opportunity to the
investors to reduce the risks and maximize the returns through proper planning, as it considers
more than one investment for the total funds available with the investors .Keeping in view the
importance of the portfolio management, the authors in this paper have proposed to evaluate
the risks and returns associated with some select organizations and how the investments in
these companies can be converted into a good choice of portfolio.

INTRODUCTION

Financial planning is a holistic approach to plan for the financial future of an individual. Financial
planning provides a direction and meaning for the investment decisions. The expression “don’t put all
your eggs in one basket” is apt for investing and diversification is the best way to design a portfolio. An
ideally diversified portfolio contains different asset classes, with different market timings. Investors’
choice always will be the combination of assets with minimum risk and maximum return. Portfolio
management provides the investors with the knowledge of the risk and return analysis of securities chosen
for investments.

RISK

A rational investor analyses the risks associated with the investment before investing his or her wealth in
various forms of investments. Risk is the probability of occurrence of loss. It consists of two components,
the systematic risk and the unsystematic risk. Systematic risk is the measurable par of the total risk and
used in the evaluation of portfolios. Unsystematic risk is not measurable and so it is not considered for
the portfolio evaluation.
The systematic risk affects the entire market. This indicates the movement of the entire market and
updates in periodic intervals are generally given by the media. This risk is not entirely avoidable by the
investor, but is manageable. The systematic risk is measured by the computation of Standard deviation
and variance.
*Head, Dept. of Mgt., Aurora’s PG College, Hyd. She can be reached @madhaviprani12@gmail.com.
** Asst. Professor, Dept of Mgt. Aurora’s PG College, Hyd. She can be reached @radhika.ramanchi@gmail.com.

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PORTFOLIO MANAGEMENT
Portfolio can be defined as combination of securities that have Return and Risk characteristics of
their own. Portfolio is the collection of financial or real assets such as shares, debentures, bonds,
treasury bills etc. These holdings are the result of individual preferences, decisions of the holders
regarding the return and risk aspects, and other considerations.
Portfolio management is the combination of activities which start with the construction of a
portfolio, evaluation of the performance of the portfolio, and the revision of the portfolio if
necessary. Portfolio management services help investors to make a wise choice between
alternative investments without a post trading shares. This service renders optimum return to the
investors by proper selection and continuous shifting of portfolio from one scheme to another
scheme or from, one plan to other plan within the same scheme.

INVESTMENT VALUATION
Investment value, in general is taken to be the present worth to the owners of future benefits
from investments. The investor has to bear in mind the value of these investments. An
appropriate set of weights have to be applied with the use of forecasted benefits to estimate the
value of the investment assets such as stocks, debentures, and bonds and other assets.
Comparison of the value with the current market price of the assets allows a determination of the
relative attractiveness of the asset. Each asset must be value on its individual merit.

Investors are not unique and the selection of investments is not similar. Different types of
investors opt for different sets of investments depending on their requirements and the returns
associated with the investments. Moreover the skills of choosing the investments by each
investor will be different. Based on the skill sets and choices of the investments the investors are
categorized into the following types.

TYPE ‘A’ INVESTOR (No Market Timing and No Stock Picking Skills)
If the investor does not believe that he has any special skills in picking undervalued stocks or in
predicting the movements of the market, then the portfolio design problem becomes relatively
simple. The investor simply chooses a diversified portfolio of equity stocks and debt instruments
and then adjust its risk i.e. beta to the desired level. He can achieve the same effects by
increasing or decreasing the allocation of equity in the overall portfolio.

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TYPE ‘B’ INVESTOR (Only Stock- Picking Skills)
An investor who has some knowledge of the stock markets and wishes to exploit his stock
picking skills should start with a base portfolio similar to that of the type A investor. He should
then adjust the weights of the stock’s, which are in his opinion less-priced. Specifically, he
should overweight the stocks which are overvalued and underweight those which are under
valued.

TYPE ‘C’ INVESTORS (Only Market-Timing Skills)

The type C investor holds a well-diversified portfolio but switches actively between defensive
and offensive portfolios to take advantage of the market timing. If he expects the market
to rise, he pushes his portfolio beta above his target level by any of the techniques based
on market timing. The converse should be done if the investor is bearish about market.
In either case, the portfolio would remain diversified all through. The portfolio of this
investor is diversified, but it’s managed and not constant.

TYPE ‘D’ INVESTOR (Both Stock Picks And Market-Timing Skills)

This type of investor would use the techniques used by both the type B and type C investors.
These investors would have the most active and aggressive portfolio management strategies.
Using their superior ability to predict booms and bust in the market as a whole and their skills in
identifying undervalued scrips these can manage a well diversified and balanced port folio.

TECHNIQUES FOR ANALYSIS

There are different models of portfolio analysis. Among them, the most popular method and the
modern method is the Harry Markowitz model of portfolio analysis and valuation. Markowitz
theories emphasize the importance of the calculation of risk by measuring the standard
deviation, correlation between the select securities and finally diversification of portfolio based
on the risk and return aspects.
Standard Deviation:
It is a measure of the dispersion of a set of data from its mean. The more spread apart the data,
the higher the deviation. Standard deviation is calculated as the square root of variance. For the

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calculation of standard deviation, average return is calculated for a set of data, by adding
observations and dividing the sum with the number of observations.
Std. Deviation (σ ) = √ Σ(X-Average X ) 2/ N
Correlation Coefficient:
Correlation measures the relationship between two variables. If there is a positive correlation
between the variables that indicates that both the variables are moving in the same direction. If
there is a negative correlation between the variables that indicated that they are moving in
different directions. For the portfolio to be efficient, the assets should be negatively correlated.
Correlation Coefficient is measured by the following formula
( )(
r= ∑ A − A . B − B )
(
∑ A− A ) 2. ∑( B − B )2
Where A,B are returns on securities A&B
A , B are average returns on securities A&B
∑ =Sum
Portfolio Risk:
Portfolio risk is calculated with the help of standard deviations of the independent assets and
their correlation coefficient. It is measured by the following formula
P=√A2.WA2+B2.WB2+2WA.WB.(rAB.)A.B
Where p is the risk of the portfolio,
WA,WB are the weights of the assets in the portfolio,
A,B are the standard deviations of the two assets taken for the combination in the portfolio,
r is the correlation coefficient of the two assets A,B
METHODOLOGY
This study is based on the data of returns of the stocks of the selected organizations for the
period April, 2007- March, 2008. Some 11 organizations are selected for the study which are
having good returns during the period of study and which are well known to the investors. These
organizations are selected from different sectors like IT, Infrastructure, Petroleum, Banking to
avoid risk of one particular sector influencing the portfolio risk. Based on the computation of
returns and standard deviations these are formulated into combinations. Then these combinations
are analyzed by measuring the port folio risk.

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From the data, average returns of these organizations are computed and standard deviations are
plotted with the help of the formulae mentioned above, which are shown in the following table.
Table: 2 Average Return & Std. Deviation

S.No Company Name Average Return Std. Deviation

1 AMBUJA CEMENTS 12.9720 16.8064

2 INFOSYS 5.0811 5.6801

3 BAJAJ AUTO 1.3468 7.4759

4 ACC CEMENTS 2.784 8.8855

5 ZEE TELEFILMS 0.1568 6.9104

6 HDFC 2.8143 7.483

7 BPCL -1.4734 15.4259

8 HEROHONDA 0.8815 9.8618

9 TISCO 0.6238 16.8069

10 SATYAM 2.4742 6.7543

11 WIPRO -2.5818 21.035

The table shows that Ambuja cements is having highest return with high standard deviation and
BPCL is having least return i.e. negative return with somewhat high standard deviation. HDFC
shows moderate standard deviation with relatively low return. Infosys shows moderate returns
with low risk. Tisco in high risk zone with less returns and zee telefilms is showing less return
with less risk.
Based on the calculations of average returns and standard deviations correlation coefficients are
measured for the defined sets of organizations. The following table shows them.
Table: 3 Correlation Coefficients
Correlation
S.No Combinations
coefficients
AMBUJA CEMENTS & BAJAJ
1 0.1185
AUTO
2 INFOSYS & ACC -0.2213

3 ZEETELEFILM &HDFC -0.0441

4 WIPRO & BPCL -0.283

5 HEROHONDA & SATYAM 0.1272

6 BAJAJ Auto & TISCO -0.1988

7 AMBUJA CEMENTS& INFOSYS -0.2067

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From the calculations of returns and risk, correlation coefficients for the defined sets are
calculated. The combinations are designed so the the portfolio risk is reduced when compared to
the individual risk.
The following seven combinations are constructed for the analysis of portfolio risk.

1. AMBUJA CEMENTS & BAJAJ AUTO

2. INFOSYS & ACC

3. ZEETELEFILM &HDFC
4. WIPRO & BPCL

5. HEROHONDA & SATYAM

6. BAJAJ Auto & TISCO

7. AMBUJA CEMENTS& INFOSYS

Based on the returns and standard deviation calculations the proportions are decided for the
combinations. The proportions are denoted by weights i.e. W. The total weight of the portfolio
should be equivalent to one or 100%.
The first combination i.e., Ambja Cements and Bajaj Auto.Ltd. is taken for the study and detailed
procedure of allocation of weights and measurement of portfolio risk are explained below.
The following table shows the allocation of weights to Abmjua Cements and Bajaj Auto Ltd.
Table:4 WEIGHTS
WB = Weight of Bajaj Auto Ltd.
WA Weight of Ambuja Cements
WB = B(B - rAB A) / A2 + B2 rAB A.B
7.4759 [7.4759 - (-0.1185) (16.8064) / 7.47592+16.80642.(-0.1185)
WB = 16.8064.7.4759
WB = 70.7781 / 318.1216
W
B= 0.2225

WA = 1 – WB
WA = 1- 0.2225
WA = 0.7775

Where WA= Weight of Ambuja Cements and WB is weight of Bajaj Auto Ltd.

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A and B are standard deviations of Ambuja Cements and Bajaj Auto ltd.
rAB is the correlation coefficient of the two.
After assigning weights to each of the securities in the portfolio, the portfolio risk is measured
using the following procedure

Table:5 PORTFOLIO RISK

AMBUJA CEMENTS & BAJAJ AUTO
P= 1/A2WA2 + B2 WB2 + 2rAB AB WA WB

A = 16.8064 B =7.476 rab=0.1185

WA= 0.2225 WB=0.7775
1/(16.8064)2 (0.2225)2 + (7.4759)2 + (0.7775)2+ 2(-0.11185) (16.8064) (7.4759)
P= (0.2225) (0.7775)

1
P= (13.9833) + (33.7853)-( 5.1513)
1
P= 42.6173
P= 6.53%

Where p is the port folio risk, WA, WB are the proportions of the securities in the portfolio, A,B
are standard deviations of the selected securities, rAB is the correlation coefficient of securities
A,B. Here the port folio risk is 6.53%
AMBUJACEMENTS&BAJAJAUTO:
In this combination, the investors can invest their funds in accordance with the calculated
proportion of investment i.e. 0.2225 for Ambuja and the remaining 0.7775 in Bajaj. The
difference in weights exists because the risk of Ambuja, which is 16.8064%, is higher than that
of Bajaj whose risk is 7.4759%. So if an investor has to invest funds in this protfolio it is
suggested that the investor should invest a larger portion of funds in Bajaj and divert the
remaining funds to Ambuja. In comparison, the portfolio risk, which is 6.53% is less than the
individual risks of both the assets in the portfolio.

Similarly the weight allocation and measurement of portfolio risk of Infosys and ACC are
presented below.

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 Table:6 WEIGHTS
WA = Weight of INFOSYS Ltd.
WB = Weight of ACC
WB = B(B - rAB A ) / A2 + B2 2r AB AB
WA = 1 – WB
WB = 8.8855 [8.8855 - (-0.2213) (5.6801)]/(5.6801)2 + (8.8855)2 2(-0.2213) (5.6801) (8.8855)
WB = 8.8855 (10.1425)/
(32.2635) + (78.9521) + (22.3383)
WA = 90.1212/133.5539
WA = 0.6748
WB = 1 - WA
WB = 1 - 0.6748
WB = 0.3252

Table:7 PORTFOLIO RISK

INFOSYS & ACC LTD
2 2 2 2
P= 1/ A WA + B WB +2.rAB.A.B.WA.WB.

=5.6801, B =8.8855, r AB=-0.2213

A

WA=0.6748, WB=.03252
=1/(5.6801)2 (0.6748)2 + (8.8855)2 + (0.3252)2+ 2(-0.2213) (5.6801) (8.8855) (0.6748) (0.3252)
P

P =(14.6914) + (8.3496)- (4.9020)

P =√18.139
P =4.26%

INFOSYSLTD&ACC:
The proportion of the investment in this combination is 0.6748 for INFOSYS and 0.3252 for
ACC. The investor can invest a large share of funds in INFOSYS and a lesser part in ACC. This
is because the risk of INFOSYS which is 5.6801% is less than the risk of ACC, which is
8.8855% and investors generally tend to invest in lesser riskier securities. Also the portfolio
standard deviation is less than the individual risks of both the companies.

Like wise portfolio risk for all the combinations is calculated by assigning weights to different
securities.

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ZEE&HDFC:
The standard deviation/risk of ZEE TELEFILMS is 6.9014% and the risk of HDFC is 7.4830%.
This means that the risk of ZEE is less when compared to the risk of HDFC. It therefore
suggests that investors can invest a greater percentage of their funds in ZEE and the remaining
funds in HDFC. The calculated weight also suggests the same. It shows that an investor can
invest up to 0.5380% in Zee and a ratio of 0.4620% in HDFC. If we combine both the securities
the portfolio standard deviation stands at 45.
WIPRO & BPCL:
In this combination of portfolio, the risk of BPCL is less when compared to the risk of
Wipro i.e 15.4259 < 21.0350. Also the calculated proportion of investment is 0.3817 for Wipro
and 0.6183 for BPCL. So it is suggested that investor a larger share of funds in BPCL which is
less risky and the remaining funds be diverted to Wipro. The calculated portfolio risk, which is
1.5873%, is less when compared to the individual standard deviations of the companies in the
portfolio.
HERO HONDA MOTORS & SATYAM LTD:
In this set the investor can invest unto 0.3385% in HERO HONDA and 0.6615 in
SATYAM. The lesser proportion of investment is because of the higher risk involved in this
security when compared to SATYAM i.e. the risk of HERO HONDA which is 9.8616% is greater
than that of SATYAM which is 6.7543%. Where as the portfolio risk is 5.2261% which is less
than the individual risks of both companies in the portfolio.
BAJAJ AUTO LTD & TISCO LTD:
In this portfolio the risk of BAJAJ is less when compared to the risk of TISCO (7.4759
<16.8069). The proportion of investment arrived at is 0.7917 at is 0.7917 For BAJAJ and 0.2083
for TISCO. The calculated portfolio risk is 6.2489%, which is much lesser when compared to
the individual standard deviation of both the companies involved in the portfolio.

The following table gives a comprehensive view of the calculations of portfolio risk.

TABLE :8 PORTFOLIO RISK OF COMBINATIONS

Portfolio Portfolio Risk (%)

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 AMBUJA Cements & INFOSYS 4.9629

AMBUJA Cements & BAJAJ Auto 6.5282

INFOSYS & ACC 4.259

ZEETELEFILMS& HDFC 4.969

WIPRO & BPCL 10.5873

HEROHONDA& SATYAM 5.2261

BAJAJ Auto & TISCO 6.2489

INFOSYS & HEROHONDA 4.885

FINDING AND CONCLUSIONS

The analytical part of the study for the 12months period reveals the following.
1. As far as the average returns of the selected companies are concerned AMBUJA cements is
performing well whereas WIPRO’S average return for the period of the study is very poor.
2. As far the risk of the selected companies is concerned WIPRO’S risk is very high whereas its
return is very low, so it is concluded that WIPRO scrip’s are highly risky scrip’s. AMBUJA
cements stands at second place in terms of risk but it is yielding some return, this means that
higher the risk higher will be the return. Another risky security in the selected scrip’s is
BPCL. Rests of the scrip’s in the study are moderately risky.
3. As far the correlation coefficient is concerned the study selects only negatively correlated
scrips as suggested by Markowitz model. The best correlation coefficient is existing between
WIPRO& BPCL but the portfolio risk with this combination is very high when compared to
other portfolio combinations hence the investors who are slightly risk averse can invest in
WIPRO and BPCL’S portfolio combination.
4. Another set of portfolio that is negatively correlated is of INFOSYS & ACC this combination
portfolio risk is less when compared to the risk of the other portfolios. So the investors who
are conscious of the risk can invest their funds in this combination. Rest of the port folio
combinations fall under the moderate risk category.

CONCLUSION

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 Most people agree that holding two stocks is less risky than holding one stock. Further
inverting in one sector also proves to be risky. For a given level of risk an investor always
prefers high return. Put simply, all investors want maximized returns with minimum risk, which
can be made easy through portfolio management. It is like planning for a road trip, the decision
should always be taken by the traveler himself. Selecting the destination will solve half of the
problem. So, goal setting is the corner stone of financial planning exercise, which decides the
needs and wants to be pursued by the investor.
In India, most of the people believe that financial planning is nothing but tax planning. But
tax planning is just a part of financial planning. Financial planning can be made easy if the
investor go for portfolios rather than investing in a single option. The present stock market
conditions offer a good value buying opportunity for the investors. The culture of investing in
developmental activities should be encouraged and portfolio managers have to extend a helping
hand to the investors.

References
Sudip Bandopadhyay
“Markets wait for end to Fall sell off” Economic times 14-9-2008.
Anish M.Wig “Why should you statt financial Planning for 2009 Now”/ Economic Times 19-9-
2008.
Jayanth Manglik “Why portfolio diversification is a time tested virtue” Economic Times 7-12-
2008.
Managing Turbulence Financial Express 21-9-2008.
Punithavathy Pandian “Security Analysis & Portfolio Management Vikas publicationw 2007.
Prasanna Chandra
Investment Analysis and P ortfolio Management Tata Mcgrawel 2005.

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