Portfolio can be defined as a collection of assets in which an investor invests to gain profit.
So it can range from one assets to multiple assets. And portfolio management is an art of
managing these diversified assets. An investor can choose to diversify investments based
on their risk appetite. I.e they can choose to invest in less risky assets or high risky assets,
or build a combination of investment in these two risk ranges. Applying the technique of
investing in a combination of assets reduces risk as well as optimizes return. Thus, it helps
to keep investment safe. This is the gist of portfolio management practice.
Portfolio management can also be said as an art of investing in several assets so that the
risk is minimized or the return is maximized. There are two ways of portfolio management:
Active and Passive. Active management is the process of actively managing investments
by frequently checking the trends and investing according to it. They also involve
investments in IPO. Passive management, on the other hand, focuses on long-term growth
by investing in index funds or exchange-traded funds (ETFs) that mirror the market’s
performance.
As said earlier, the key concept of portfolio management is diversification. In this technique
assets are diversified among several investments so that the risk of investing in only one
asset is reduced. This risk reduction protects the property of a company and makes sure
that the company become sustainable. We can also make the risk of investing theoretically
zero. This means, there will be virtually no risk in the investment. Thus, an investor is
considered safe if they invest according to rules of portfolio management.
Investment returns and risk
While managing a portfolio, the return on investment and the risk associated with it is
considered. Investment is decided only if the expected return on a fixed level of risk is high
enough to meet expectations. Not only expectations, it should give higher return than the
market is providing. This is because market investment choices such as Banks give good
return and are considered less risky. Thus, there should be tradeoff between investment
return and risk. The more risk an investor takes, the more return he/she should get. This
is a general principle of investment theory and portfolio management is also guided by
this theory. As a result, some investors take higher risk and expect higher return and
others take lower risk and are ok with lower return.
To choose which investment to consider, one can use the Markowitz model of portfolio
management or CAPM model. In the Markowitz model all the risk and return of all of the
possible combinations of investments are calculated. By doing this it is understood which
combinations give the highest return with the same level of risk or which combinations give
higher return on the higher level of risk. It is suggested to choose the assets in the efficient
frontier shown by this model. An efficient frontier is the area on Markowitz model where the
highest return giving combination of assets in comparison to risk lies.
Another model to consider in portfolio management is the CAPM model. In this model, the
required rate of return is calculated by a formula. If the expected return is higher than the
required rate of return, then an investor decides to invest, otherwise not. The formula is based
on risk free rate, the market rate of return and stock beta, where stock beta is the relation
between share market index and the share’s movement. If the beta is higher, the required rate
of return is higher and vice versa.
There is a technical way to find out the rate of return which we can expect from our investment.
It’s called Security Market Line. It indicates the required rate of return for our investment. Its
formula is based on the risk free rate of return, expected market return and the beta coefficient
of the portfolio.
Its formula is:
E(Ri)=Rf+βi(E(Rm)−Rf)
Where:
E(Ri)) = Expected return on security i
Rf = Risk-free rate of return
βi = Beta of security i
E(Rm) = Expected return of the market portfolio
E(Rm)−Rf = Market risk premium
We can easily find the required rate of return using this formula.
Let
Let’s take an example. Suppose the risk free return (The return on treasury bills) is 3%.
The market return is expected to be 10% and the portfolio beta is o.7, then the required
rate of return
is:
3%+(10%-3%)*0.72
=8.04%
It shows that the required return on invested portfolio is 8.04%. Thus if the return is lower
than this, then the stocks is overvalued and if the return is higher than this then the stocks
is undervalued. If overvalued, one should understand that the price of stocks should be
lower and take decision accordingly. But if the stock is undervalued, one should understand
that the price of stock should be higher.
