The role of portfolio management
Elements of portfolio management
Return
The portfolio should yield steady returns that at least match the opportunity cost of the funds invested
The better the growth prospects of the company, the better the expected returns
Risk reduction
Minimisation of risks is the most important objective of portfolio management
A good portfolio tries to minimise the overall risk to an acceptable level in relation to the levels of return obtained
Liquidity and marketability
It is desirable to invest in assets which can be marketed without difficulty
A good portfolio ensures that there are enough funds available at short notice
Tax shelter
The portfolio should be developed considering the impact from taxes
A good portfolio enables companies to enjoy a favourable tax shelter from income tax, CGT and gift tax
Appeciation in the value of capital
A balanced portfolio must consist of certain investment that appreciate in value protecting investor from any erosion in purchasing power due to inflation
Portfolio management strategy
Asset allocation
Asset allocation is an investment strategy that aims to balance risk and reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment horizon
Investments are made in suitable mix of assets according to the risk appetite or risk preferences of investors
Risk seeking investors can opt for more volatile assets with higher returns while risk averse investors look for safer investments
Diversifiction
Spreading the risk across multiple investments within asset class is known as diversification
Effective diversification includes investments across different asset classes, securities, sectors and geography
Rebalancing
Rebalancing is the continuous process of comparing portfolio weightings with planned asset allocation
Portfolio risk and return
A company can measure the average return for the portfolio by calculating the correlation among the individual investments
Crorrelation is a statistical tool that measures the degree to which two securities move in relation to each other
Correlation is computed by using the correlation coefficient which has a value that ranges between minus 1 and plus 1
The correlation coefficient is a statistical measure of the strength of the relationship between the relative movements of two variables
The values range between minus one and 1
3 possible results of a correlational study
Positive
When their prices move in the same direction or offer same kind of return
Usually investments in the same industries or with the same set of products that substitute each other
Negative correlation (-1)
When prices move in opposite directions
Usually the investments are industries which are dependent on each other for raw materials or services
Zero correlation
Where underlying investments have no relationship that indicates any kind of correlation
Usually investments in different asset classes or different geographic locations have 0 correlation
Each investment performance holds the price and risk without any dependancy on the performance of other investments
The efficient frontier
Modern portfolio theory tool that shows investors the best possible return they can expect from their portfolio for a defined level of risk
The efficient frontier aims for optimum correlation between risk and return
The portfolio manager shuts for the investment opprotuntieis which offer optimum correlation o maximise return for the portolio
Application and limitations of portfolio theory
Limitations
Single period framework
Probabilities are only estimates
Based on several assumptions
Investors are risk averse and behave rationally
The risk of bankruptcy, legal and administrative constraints are ignored
Portfolio theory assumes that the correlation between assets is constant - this may not be applicable in the real world as every viable is constantly changing
Correlation analysis requires computation of the coefficient, it is very complex
Des not assume any tax payouts or legal and administrative costs
Ignores timeframes of investments
The portfolio model is still not widespread as portfolio managers are sceptical about the accuracy of forecast data