Using the same annual returns of 15%, 10%, 12% and 3% as above, we compute the geometric mean as follows: $$\text{Geometric mean} = [(1+15\%) × (1+10\%) × (1+12\%) × (1+3\%)]^{1/4} – 1 = 9.9\%$$. If we have a large enough portfolio it is possible to eliminate the unsystematic risk We examine the cash flows from the perspective of the investor where amounts invested in the portfolio are seen as cash outflows and amounts withdrawn from the portfolio by the investor are cash inflows. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute. It is important to be able to compute and compare different measures of return to properly evaluate portfolio performance. x̅ is the mean or the weighted average return. Return and standard deviation and variance of portfolios can also be com­pared in the same manner. 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. The expected return depends on the probability of the returns and their weighted contribution to the risk of the portfolio. The total risk of a portfolio (as measured by the standard deviation of returns) consists of two types of risk: unsystematic risk and systematic risk. 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. Headline stock market indices typically report on price appreciation only and do not include the dividend income unless the index specifies it is a “total return” series. 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%. 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. An aggressive portfolio takes on great risks in search of great returns. Share Your PDF File 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. Active Portfolio Management: This type of portfolio management aims to make better returns in contrast to what the market hypothesizes. Investment Analysis & Portfolio Management (FIN630) VU general types: those that are pervasive in nature, such as market risk or interest rate risk, and As returns and prices of all securities do not move exactly together, variability in one security will be offset by the reverse variability in some other security. Thus (.04)2 = .0016 and this multiplied by the probability of it 0.25 gives .0004 and so on. A geometric return provides a more accurate representation of the portfolio value growth than an arithmetic return. This means itâs generating the highest possible return at your established risk tolerance . Image Credit Onemint 2 most basic types of risk Investment is related to saving but saving does not mean investment. 1. 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. Module â 4 Valuation of securities: Bond- Bond features, Types of Bonds, Determinants of interest rates, Bond Management Strategies, Bond Valuation, Bond Duration. For example, a year relative to a 20-month holding period is a fraction of 12/20. Average investors are risk averse. Employees of both private and public companies often save and invest for retirement... Risk budgeting is focused on implementing the risk tolerance decisions taken at a... 3,000 CFA® Exam Practice Questions offered by AnalystPrep – QBank, Mock Exams, Study Notes, and Video Lessons, 3,000 FRM Practice Questions – QBank, Mock Exams, and Study Notes. It includes more than average values and stresses on taking benefits of stock market inabilities. PORTFOLIO MANAGEMENTWhat is portfolio management? 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 portfolio is a collection of investment instruments like shares, mutual funds, bonds, FDs and other cash equivalents, etc. PORTFOLIO MANAGEMENT-TRIAL QUESTIONS 1) Explain the following terms as used in Portfolio management and give examples and/or furmulas. 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. investments in high quality, blue-chip stocks . If there is no relation between them, the coefficient of correction can be zero. (Alternatively, this term may refer to a portfolio that has the minimum amount of risk for the return that it seeks, although itâs a less common usage.) This Risk is reflected in the variability of the returns from zero to infinity. When we have assets for multiple holding periods, it is necessary to aggregate the returns into one overall return. There are other measures of returns that need to be taken into account when evaluating performance. The summation of all deviations from the mean and then squared will give the variance. Privacy Policy3. Thus, one measure of risk is absolute deviations of returns under column 6. these object types have been created, you can also attach your Account to a Model Portfolio, and then attach your Model Portfolio to a Strategy â all in Portfolio Management. Portfolio Management Involves,-Investing and divesting different, -investment Risk management,- Monitoring and analyzing returns Portfolio management is a process encompassing many activities aimed at optimizing the investment All Rights ReservedCFA Institute does not endorse, promote or warrant the accuracy or quality of AnalystPrep. Beta measures the systematic market related risk, which cannot be eliminated by diversification. 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. First, financial assets may provide some income in the form of dividends or interest payments. This means we look at the return as a composite of the price appreciation and the income stream. Suitable securities are those whose prices are relatively stable but still pay reasonable dividends â¦ The formula for the holding period return computation is as follows: $$\text{Holding Period Return (HPR)} = \frac {P_t – P_{t-1} + D_t} {P_{t-1}}$$, $$P_t$$ is the price of the asset at time t when the asset is sold, $$P_{t-1}$$ is the price of the asset at time t-1 when the asset was bought, $$D_t$$ is the dividend per share paid between t and t-1. Aggressive Portfolio: An aggressive portfolio comprises of high-risk investments like commodities, futures, options and other securities expecting high returns in the short run. A holding period return is a return earned from holding an asset for a specified period of time. In other words, a portfolio is a group of assets. 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 assetâs rate of profit or rate of return (ROI). So the portfolio manager according to the risk-taking capacity and the kind of returns calculated provides a portfolio structured in tandem with that. For example, if a share has returned 15%, 10%, 12% and 3% over the last four years, then the arithmetic mean is as follows: $$\text{Arithmetic mean} = \frac {15\% + 10\% + 12\% + 3\%} {4} = 10\%$$. The square root of variance is standard deviation (sd). 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. 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. The expected return of the portfolio can be computed as: Covariances and correlation of returns Before moving on to the variance of the portfolio, we will have a quick look at the definitions of covariance and correlation. 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 net return is the return post-deduction of fees. If on the other hand, Rho is -1, the direction of the movement will be opposite as between the stock price and market index. β or Beta describes the relationship between the stock’s return and the Market index return. A weekly return of 2%, when annualized, is as follows: $$\text{Annualized return} = (1+2\%)^{52} – 1 = 180\%$$. 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. If α is a positive return, then that scrip will have higher returns. Column 6 is the result of multiplying deviation under column 5 with the probability in column 2 without considering signs. 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. It is a long-term strategy for index investing whose purpose is to generate â¦ Real returns are useful for comparing returns over different time periods as inflation rates vary over time. Financial market assets generate two different streams of return: income through cash dividends or interest payments and capital growth through the price appreciation of the asset. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. A risk averse investor always prefer to â¦ 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. Dow Theory: ADVERTISEMENTS: Charles Dow, the editor of Wall Street Journal, USA, presented this theory through a series of editorials. 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. What are the arithmetic mean and geometric mean, respectively, of an investment which returns 8%, -2% and 6% each year for three years? If the portfolio is efficient, Beta measures the systematic risk effec­tively. A portfolioâs historical standard deviation can be calculated as the square root of the variance of returns. The Company with a higher return of 11.5% has a higher risk than the other company. Return on Portfolio: Each security in a portfolio contributes returns in the proportion of its invest­ment in security. A portfolio contains different securities, by combining their weighted returns we can obtain the expected return of the portfolio. This is the coefficient of variation, namely (SD/X). a) Investment b) Speculation c) Technical analysis d) Fundamental analysis e Active portfolio management strategy is normally dependent on the style of management and analysis that can generate healthy returns and beat the stock market as well. The different types of portfolio investment are as follows: Risk-Free Portfolios â Risk-free portfolios are the ones that have investment securities regarding treasury bonds and such where the risk is almost nil but low returns. On the other hand alpha and Epsilon (α + ∑) measures the unsystematic risk, which can be reduced by efficient diversification. Traditional Approach: 1. Say company A and B have the following characteristics: Which company do you prefer? Risk on a portfolio is different from the risk on individual securities. A monthly return must be compounded 12 times, a weekly return 52 times and a daily return 365 times. It is the percentage change in the price of the stock regressed (or related) to the percentage changes in the market Index. Passive Portfolio Managemeâ¦ Portfolio management helps an individual to decide where and how to invest his hard earned money for guaranteed returns in the future. Dow â¦ A defensive portfolio focuses on consumer staples that are impervious to downturns. Portfolio management involves selecting and managing an investment policy that minimizes risk and maximizes return on investments. If Beta is zero, stock price is unrelated to the Market index. 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.