Module: 2 - Portfolio Investment & Management - Skill Development Risk/Return Analysis
Selecting a Well-Suited Portfolio Mix Applying Stock Valuation Techniques & Yield
Estimates - The Ability to Forecast Future Returns in Securities Investment
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Diversification of securities is the catchword in PMS. Diversification is needed to minimise risk in a portfolio. But how to effect such diversification ands make intelligent choice from amongst the multitude of securities quoted in the market? But what securities to choose and how to decide their individual lots? What securities to avoid? The answer implies the possession of the skill to evaluate different types of securities to arrive at their intrinsic value as against the quoted market value and to further calculate the estimated future yield. This necessitates a thorough knowledge of the various types of securities that are available in the market to meet the needs of investor. Merits and demerits of each type are to be assessed in terms of the risk associated with each other. The place they have in the investor's portfolio is then decided based on the anticipated reward they are expected to offer. Also needed is an understanding of the methodology of bond valuation, preference share valuation, and various models on equity valuation & analysis that help to calculate the respective yield on these securities. The various techniques used in this process are discussed in more detail in the Annexure: 3

The threat is the risk element. SEBI has defined inherent risks, which emerge as unexpected occurrences in the securities market as under:

Risks that an Investor Might Encounter While Investing in the Securities Market

• "Your expectations of income and/or growth may not materialise.

• Realisation of values of the investment of an equity holder is in the share market only. Thus this investment may not be easily liquid.

• Disinvestment may result in capital losses also.

• Running into problems with the trading and transfer of the securities."

In many cases what was forecast as a distinct possibility gets nullified by a sudden unexpected change. What are the skills that the portfolio manager is to be equipped with in order to meet these challenges effectively?

Drawing together portfolio investment is successful only when the investor has a proper understanding & capacity to correctly assess both Risk and Return so that he is able to deal successfully in the market. It is the skill to equate between risk and reward. It is therefore discussed in depth.

Risk in holding securities is, as seen earlier, generally associated with the possibility that realized returns will be less than the returns that were expected. The source of such disappointment is the failure of dividends (interest) and /or the security's price to materialize as expected.

Forces that contribute to variation in return- price or dividend (interest) - constitute elements of risk. Some influences are external to the firm, cannot be controlled, and affect large number of securities. Other influences are internal to the firm and are controllable. Risks that are external and broad in their effect are called sources of systematic risk. Conversely, controllable, internal factors somewhat peculiar to industries and/or firms are referred to as sources of unsystematic risk.

Systematic risk refers to that portion of total variability in return caused by the factors affecting the prices of all securities. Economic, political and sociological changes are sources of systematic risk. Their effect is to cause prices of nearly all individual common stocks and/or all individual bonds to move together in the same manner.

Unsystematic risk is the portion of total risk that is unique to a firm or industry. Factors such as management capability, consumer preferences, and labor strikes cause systematic variability of returns in a firm. Unsystematic factors are largely independent of factors affecting securities markets in general.

The various types of systematic risks are as follows:

• Market Risk - it is caused by investor reaction to tangible as well as intangible events. It is the variability in returns on most common stocks that is due to basic sweeping changes in investor expectations.

• Interest-Rate Risk - it refers to the uncertainty of future market values and of the size of future income, caused by fluctuations in the general level of interest rates.

• Purchasing Power Risk - it is the uncertainty of the purchasing power of the amounts to be received. It refers to the impact of inflation or deflation on an investment.

The various types of unsystematic risk are as follows

• Business Risk - it is a function of the operating conditions faced by a firm and the variability these conditions inject into operating income and expected dividends.

• Financial Risk - it is associated with the way in a company finances its activities. It is an avoidable risk to the extent that managements have the freedom to decide to borrow or not borrow funds. A firm with no debt financing has no financial risk.

The various sources of risk in holding common stocks must be quantified so that the analyst can examine risk in relationship to measures of return employed. A reasonable surrogate of risk is the variability of return. This proxy measure in statistics is commonly the variance or standard deviation of the returns on a stock around the expected return. In reality, the variation in return below what is expected is the best measure of risk.

People have many motives for investing. Some people invest in order to gain a sense of power or prestige. Often the control of corporate empires is a driving motive. For most investors, however, their interest in investments is largely pecuniary - to earn a return on their money. However, selecting stocks exclusively on the basis of maximization of return is not enough. The fact that most investors do not place available funds into the one, two, or even three stocks promising the greatest returns suggests that other factors must be considered besides return in the selection process. Investors not only like return, they dislike risk. Their holding of an assortment of securities attests to that fact. To say that investors like return and dislike risk is however, simplistic. To facilitate our job of analyzing securities and portfolios within a return-risk context, we must begin with a clear understanding of what risk and return are, what creates them, and how they should be measured.

The ultimate decisions to be made in investments are:

1. What securities should be held?

2. How many rupees / dollars should be allocated to each?

These decisions are normally made in two steps.

• First, estimates are prepared of the return and risk associated with available securities over a forward holding period. This step is known as security analysis.

• Second, return-risk estimates must be compared in order to decide how to allocate available funds among these securities on a continuing basis. This step comprises portfolio analysis, selection and management. In effect, security analysis provides the necessary inputs for analyzing and selecting portfolios.

Security analysis is built around the idea that investors are concerned with two principal properties inherent in securities; the return that can be expected from holding a security, and the risk that surges suddenly to reduce the actual return, when received be less than the return that was expected. The primary purpose of this part is to focus upon return and risk and how they are measured.

Security Returns: Investors want to maximize expected returns subject to their tolerance for risk. Return is the motivating force and the principal reward in the investment process and it is the key method available to investors in comparing alternative investment. Measuring historical returns allows investors to assess how well they have done, and it plays a part in the estimation of future, unknown returns.

We need to distinguish between two terms used in investments. They are realized return is after the fact return- return that was earned (or could have been earned). Realized return is history. Expected return is the return from an asset that investors anticipate they will earn over some future period. It is a predicted return. It may or may not occur. Investors should be willing to purchase a particular asset if the expected return is adequate, but they must understand that their expectation may not materialize.

The objective of fundamental security analysis is to appraise the 'intrinsic value' of a security. The intrinsic value is the true economic worth of a financial asset. The fundamentalists maintain that at any point of time every share has an intrinsic value which should in principle be equal to the present value of the future stream of income from that share discounted at an appropriate risk related rate of interest. The actual price of the security therefore is considered to be a function of a set of anticipated capitalization rate. The job of the fundamental security analyst is to sort out the temporary disequilibrium from the true shifts in the national economy and the accounting gimmicks from true changes in the firm's income in order to arrive at an unbiased estimate of the intrinsic value.

The portfolio analysis begins where the security analysis ends and this fact has important consequences for investors. Portfolios, which are combinations of securities, may or may not take on the aggregate characteristics of their individual parts. Portfolio analysis considers the determination of future risk and return in holding various blends of individual securities. Portfolio expected return is a weighted average of the expected return of individual securities but portfolio variance, in sharp contrast, can be something less than a weighted average of security variances. As a result an investor can sometimes reduce portfolio risk by adding another security with greater individual risk than any other security in the portfolio. This seemingly curious result occurs because risk depends greatly on the covariance among returns of individual securities.

A portfolio is a collection of securities. Since it is rarely desirable to invest the entire funds of an individual or an institution in a single security, it is essential that every security be viewed in a portfolio context. Thus, it seems logical that the expected return of a portfolio should depend on the expected return of each of the security contained in the portfolio. It also seems logical that the amounts invested in each security should be important.

Traditional security analysis recognizes the key importance of risk and return to the investor. However, direct recognition of risk and return in portfolio analysis seems very much a "seat-of-the-pants" process in the traditional approaches, which rely heavily upon intuition and insight. The results of these rather subjective approaches to portfolio analysis have, no doubt, been highly successful in many instances. The problem is that the methods employed do not readily lend themselves to analysis by others.

Most traditional methods recognize return as some dividend receipt and price appreciation over a forward period. But the return for individual securities is not always over the same common holding period, nor are the rates of return necessarily time-adjusted. An analyst may well estimate future earnings and a P/E to derive future price. He will surely estimate the dividend. But he may not discount the values to determine the acceptability of the return in relation to the investor's requirements.

In any case, given an estimate of return, the analyst is likely to think of and express risk as the probable downside price expectation (either by itself or relative to upside appreciation possibilities). Each security ends up with some rough measure of likely return and potential downside risk for the future.

Portfolios or combinations of securities are thought of as helping to spread risk over many securities. This is good. However, the interrelationship between securities may be specified only broadly or nebulously. Auto stocks are, for example, recognized as risk-interrelated with iron & steel stocks; utility stocks display defensive price movement relative to the market and cyclical stocks like steel; and so on. This is not to say that traditional portfolio analysis is unsuccessful. It is to say that much of it might be more objectively specified in explicit terms.

Risk was defined as the standard deviation around the expected return. In effect we equated a security's risk with the variability of its return. More dispersion or variability about a security's expected return meant the security was riskier than one with less dispersion.

The simple fact that securities carry differing degrees of expected risk leads most investors to the notion of holding more than one security at a time, in an attempt to spread risks by not putting all their eggs into one basket. Diversification of one's holdings is intended to reduce risk in an economy in which every asset's returns are subject to some degree of uncertainty. Even the value of cash suffers from the inroads of inflation. Most investors hope that if they hold several assets, even if one goes bad, the others will provide some protection from an extreme loss.