Portfolio Analysis - Traditional and Modern, Difference between Tradinal and Modern Portfolio Analysis

Portfolio Analysis - Tradintional and Modern
Unit 2 SAPM Notes 
Portfolio analysis and Management

Portfolio Management and Security Analysis

Portfolio management: Portfolio management is a dynamic concept and requires continuous and systematic analysis, judgement and operations. It is a process involving many activities of investment in assets and securities. Firstly, it involves construction of a portfolio based upon the data base of the client/investor, his objectives, constraint preferences for risk and return etc. On the basis of above mentioned facts, selection of assets and securities is made. Secondly, it involves monitoring/reviewing of the portfolio from time to time in light of changing market conditions. Accordingly changes are effected in the portfolio. Thirdly, it involves evaluation of the portfolio in terms of targets set for risk and return and making adjustments accordingly.

Basically, portfolio management involves a proper decision making as to what to purchase and what to sell. It requires detailed risk and return analysis and proper money management in terms of investments in a basket of assets, the basic objective being reduction of risk and maximization or return.

Security Analysis: Security analysis involves an examination of expected return and accompanying risks. Securities that have return and risk characteristics of their own, in combination make up a portfolio. The entire process of estimating return and risk for individual securities is known as ‘securities analysis’. Portfolio analysis begins when security analysis ends. Investments are made based on security analysis and decisions involved are what securities to be bought or sold and the extent or proportion of funds to be invested in each. Understanding and measuring risk and return is, therefore, fundamental to the investment process.

PORTFOLIO ANALYSIS

Security analysis deals with the analysis of securities within the framework of return and risk. Portfolio analysis begins where the security analysis ends. The concept of portfolio analysis has very important relevance for investors, because portfolios which are combinations of securities may or may not take on the aggregate characteristics of their individual parts.

Portfolio analysis deals with the determination of future risk and return in holding various combinations of individual securities. The portfolio expected return is the weighted average of the expected returns, from each of the individual securities, with weights representing the proportionate share of the security in the total investment. The portfolio expected variance, in contrast, can be something less than a weighted average of security variances. Therefore, an investor can sometimes reduce risk by adding another security with greater individual risk compared to any other individual security in the portfolio.

TRADITIONAL and MODERN PORTFOLIO ANALYSIS

Traditional portfolio analysis: Traditional portfolio analysis has been of a very subjective nature for each individual. The investors made the analysis of individual securities through the evaluation of risk and return conditions in each security. The normal method of finding the return on an individual security was by finding out the amounts of dividends that have been given by the company, the price earning ratios, the common holding period and by an estimation of the market value of the shares. The traditional theory assumes that selection of securities should be based on lowest risk as measured by its standard deviation from the mean of expect returns. The greater the variability of returns the greater is the risk. Thus, the investor chooses assets with the lowest variability of returns.

Moreover, Traditional Theory believes that the market is inefficient and the fundamental analyst can take advantage of the situation. By analyzing internal financial statements of the company, he can make superior profits through higher returns. The technical analysts believed in the market behaviour and past trends to forecast the future of the securities. These analysis were mainly under the risk and return criteria of single security analysis.

Modern Portfolio analysis and Markowitz Model: As against the Traditional theory the modern Portfolio Theory emphasizes the need for maximization of returns through a combination of securities whose total variability is lower. It is not necessary that success can be achieved by trying to get all securities of minimum risk.

The theory states that by combining a security of low risk with another security of high risk, success can be achieved by an investor in making a choice of investments. This theory, thus, takes into consideration the variability of each security and covariance for their returns reflected through their interrelationships. Thus, as per the Modern Theory expected returns, the variance of these returns and covariance of the returns of the securities within the portfolio are to be considered for the choice of a portfolio. A portfolio is said to be efficient, if it is expected to yield the highest return possible for the lower risk or a given level of risk. The modern Portfolio Theory emphasizes the need for maximization of returns, through a combination of securities, whose total variability is lower. The risk of each security is different from that of others and by a proper combination of securities, called diversification; one can arrive at a combination, where the risk of one is off set partly or fully by that of the other. Combination of securities can be made in many ways. Markowitz developed the theory of diversification through scientific reasoning and method.

MARKOWITZ MODEL

Dr. Harry M. Markowitz was the person who developed the first modern portfolio analysis model. Markowitz used mathematical programming and statistical analysis in order to arrange for the optimum allocation of assets within portfolio. He infused a high degree of sophistication into portfolio construction by developing a mean-variance model for the selection of portfolio. Markowitz approach determines for the investors the efficient set of portfolio through three importance variables - Return, standard deviation and coefficient of correlation.

Markowitz model is called the “Full Covariance Model”. Through this method the investor can find out the efficient set of portfolio by finding out the trade off between risk and return, between the limits of zero and infinity. Markowitz theory is based on several assumptions these are:

ASSUMPTIONS OF MARKOWITZ’S MODEL

a)       The markets are efficient and absorb all the information quickly and perfectly. So an investor can earn superior returns either by technical analysis or fundamental analysis. All the investors are in equal category in this regard.

b)      Investors are risk averse. Before making any investments, all of them, have a common goal-avoidance of risk. But practically this assumption does hold good. In a country like India, majority of investors invests money on the basis of market news without doing any technical and fundamental analysis.

c)       Investors are rational. They would like to earn the maximum rate of return with a given level of income or money.

d)      Investors base their decisions solely on expected return and variance (or standard deviation) of returns only.

e)      For a given risk level, investors prefer high returns to lower returns. Similarly, for a given level of expected return, they prefer less risk to more risk.

f)        The investor can reduce the risk if he adds investments to his portfolio.

g)       Investors consider each investment alternative as being represented by a probability distribution of expected returns over some holding period.

h)      A portfolio of assets under the above assumptions is considered to be efficient if no other portfolio of assets offers higher expected return with the same (or lower) risk or lower risk with the same (or higher) expected return.

PARAMETERS OF MARKOWITZ DIVERSIFICATION

Based on thorough and scientific research, Markowitz has set down his own guidelines for diversification:

a)       The investments have different types of risk characteristics. Some are systematic or market related risks and the others are unsystematic or company related risks.

b)      His diversification involves a proper number of securities not too less nor too many.

c)       The securities have no correlation or negative correlation.

d)      Last is the proper choice of the companies, securities or assets whose returns are not related and whose risks are mutually off setting to reduce the overall risk.

Markowitz lays down three parameters for building up the efficient set of portfolio:

a)       Expected returns.

b)      Standard deviation from mean to measure variability of returns.

c)       Covariance or variance of one asset return to other asset returns.

To generalize, higher the expected return, lower will be the standard deviation or variance and lower is the correlation. In such a case, better will be the security for investor choice. If the covariance of the securities’ returns is negative or negligible, the total risk of the portfolio of all securities may be lower as compared to the risk of the individual securities in isolation.

By developing his model, Markowitz first did away with the investment behaviour rule that the investor should maximize expected return. This rule implied that the non-diversified single security portfolio with the highest expected return is the most desirable portfolio. Only by buying that single security can expected return be maximized. The single security portfolio can be much preferred if the higher return turns out to be the actual return. However, in real world, there are conditions of so much uncertainty that most risk averse investors, joint with Markowitz in adopting diversification of securities.

From the above discussion, the following difference between Traditional Portfolio Theory and Modern Portfolio Theory has been obtained:

Traditional Portfolio Theory	Modern Portfolio Theory
1. It deals with the evaluation of return and risk conditions in each security. 2. It is based on measurement of standard deviation of particular scrip. 3. It assumes that market is inefficient.   4. It gives more importance to standard deviation.	1.       It deals with the maximization of returns through a combination of different types of financial assets. 2.       It is based on mainly diversification process. 3.       It assumes that market is perfect and all information is known to public. 4.       It gives more importance to Beta.