Chapter-2

Portfolio Analysis and Selection

MEANING OF PORTFOLIO ANALYSIS:

In terms of securities, a portfolio analysis is one in which the investment portfolio is checked, in
order to optimize the allocation of holdings. Portfolio Analysis is the process of reviewing or
assessing the elements of the entire portfolio of securities or products in a business. The review is
done for careful analysis of risk and return. Portfolio Analysis conducted at regular intervals helps the
investor to make changes in the portfolio allocation and change them according to the changing
market and different circumstances. The analysis also helps in proper resource/asset
allocation to different elements in the portfolio.

DEFINITION OF PORTFOLIO ANALYSIS:

A process used to assess the suitability of a portfolio of securities or businesses relative to its
expected investment return and its correlation to the risk tolerance of an investor seeking the optimal
trade-off between risk and return.

An analysis conducted at regular intervals enables investors to make the necessary adjustments in the
portfolio's allocation of different investment classes according to changing market conditions or
changes in his own circumstances.

COMPONENTS OF PORTFOLIO ANALYSIS:

Following are the component of portfolio analysis:
1) Return: A good rate of return on an investment is the first and the foremost condition for
effective investment. The rate of return is the ratio of the sum of annual income and price
appreciation for the purchasing price of the asset or investment. The rate of return on various
investment avenues would vary widely.
2) Risk: The rate of return from different investment options varies a lot. More the risk and more the
profits. It is a general phenomenon that more return is expected out of a high-risk investment.
Risk means the uncertainty of returns. It can be calculated with the help of variance, standard
deviation and beta.
3) Liquidity: Liquidity means marketability of an investment. For example, equity shares of a big
company can be easily liquidated in the stock markets. On the other hand, money invested in an
asset (machinery) cannot be liquidated as easily as the equity share. An investment is considered
highly marketable or liquid it can be easily transacted with low transaction cost and low-price
variation. A finance manager looks for more liquid investments when the funds are available for
the short period. Liquidity is always given a preference because it helps the managers remain
flexible.
4) Tax Benefits: It is true for some investments and not for all. Most of the countries have tax
incentives for particular investments except tax-free countries. So, for investments which have tax
benefits, it is an important consideration because taxes form a major part of their expenses.

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5) Convenience: Convenience means ease of investment. When an investment can be made and
looked after easily, we consider it as convenient investing. For example, it is easy to invest in
equity shares compared to real estate because real estate involves a lot of documentation and legal
requirements.
6) Safety: While no investment option is completely safe, there are products that are preferred by
investors who are risk averse. Some individuals invest with an objective of keeping their money
safe, irrespective of the rate of return they receive on their capital. Such near-safe products
include fixed deposits, savings accounts, government bonds, etc.
7) Growth: While safety is an important objective for many investors, a majority of them invest to
receive capital gains, which means that they want the invested amount to grow. There are several
options in the market that offer this benefit. These include stocks, mutual funds, gold, property,
commodities, etc. It is important to note that capital gains attract taxes, the percentage of which
varies according to the number of years of investment.
8) Marketability: Marketability refers to buying and selling of securities in market. Marketability
means transferability or salability of an asset. Securities are listed in a stock market which are
more easily marketable than which are not listed. Public Limited Companies shares are more
easily transferable than those of private limited companies.
9) Purchasing Power Stability: It refers to the buying capacity of investment in the market.
Purchasing power stability has become one of the import traits of investment. Investment always
involves the commitment of current funds with the objective of receiving greater amounts of
future funds.
10) Liquidity: Liquidity refers to an investment ready to convert into cash position. In other words, it
is available immediately in cash from. Liquidity means that investment is easily realisable,
saleable or marketable. When the liquidity is high, then the return may be low for example, UTI
units. An investor generally prefers liquidity for his investments, safety of funds through a
minimum risk and maximization of return from an investment.

RISK RETURN TRADE OFF:

Meaning:
Higher risk is associated with greater probability of higher return and lower risk with a greater
probability of smaller return. This trade off which an investor faces between risk and return while
considering investment decisions is called the risk return trade off.
The risk-return trade off also exists at the portfolio level. For example, a portfolio composed of all
equities presents both higher risk and the potential for higher returns. Within an all-equity portfolio,
risk and reward can be increased by concentrations in specific sectors or single positions that
represent a large percentage of holdings. Conversely, a portfolio holding short-term
Treasury's presents low risk levels combined with limited returns.

Importance of Risk Return Trade off in designing a portfolio:

The risk-return trade off determines how aggressive an investor wants to be with the assets included
in the portfolio. An investor should be aware of his personal risk tolerance when constructing a
portfolio. Generally, less risk in a portfolio decreases the likelihood for high returns. A portfolio with
greater risk allows for higher returns - but with a larger possibility of loss as well.
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The risk-return trade-off is an important element of modern portfolio theory (MPT). MPT uses
statistical risk measures in portfolio construction to find an optimum mix of assets. According to this
theory, it is possible to construct an efficient frontier of assets maximizing the possibility for returns
while minimizing the overall risk for a portfolio. The efficient frontier is a curved graphical
representation of a combination of assets in a portfolio. A mix of lower-risk assets has a lower
likelihood for large returns; higher-risk assets can maximize returns. MPT relies on diversification of
assets to determine the efficient frontier for a group of assets.

Different investors may have different levels of risk tolerance. Risk tolerance is the degree of
variance in returns an investor is willing to allow in a portfolio. One aspect of portfolio construction
is the time horizon for a portfolio. For example, a younger investor may be willing to take on greater
risk than an investor who is closer to retirement. The younger investor has more time to build a
portfolio before retirement and is therefore able to be more aggressive in seeking higher returns.

MEANING OF PORTFOLIO SELECTION:

The objective of every rational investor is to maximise his returns and minimise the risk.
Diversification is the method adopted for reducing risk. It essentially results in the construction of
portfolios. The proper goal of portfolio construction would be to generate a portfolio that provides the
highest return and the lowest risk. Such a portfolio would be known as the optimal portfolio. The
process of finding the optimal portfolio is described as portfolio selection.
Portfolio selection involves collection of risky assets combined with different weights to provide an
acceptable trade-off between return and risk to an investor.

FEASIBLE SET OF PORTFOLIOS:

Meaning:
With a limited number of securities an investor can create a very large number of portfolios by
combining these securities in different proportions. These constitute the feasible set of portfolios
in which the investor can possibly invest. This is also known as the portfolio opportunity set.
Each portfolio in the opportunity set is characterised by an expected return and a measure of risk, viz,
variance or standard deviation of returns. Not every portfolio in the portfolio opportunity set is of
interest to an investor. In the opportunity set some portfolios will obviously be dominated by others.
A portfolio will dominate another if it has either a lower standard deviation and the same expected
return as the other, or a higher expected return and the same standard deviation as the other.
Portfolios that are dominated by other portfolios are known as inefficient portfolios. An investor
would not be interested in all the portfolios in the opportunity set. He would be interested only in the
efficient portfolios.

Definition:
Feasible set of portfolios is defined as A Possible set of investments chosen from the available
alternatives within the limits of the investor's capital resources, risk tolerance, and investment
objectives. Each feasible portfolio has its own risk and reward profile, and is not necessarily an
efficient portfolio. An investor can choose between multiple feasible portfolios.
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MARKOWITZ MODEL:
Harry Markowitz put forward this model in 1952. It assists in selection of the most efficient by
analysing various possible portfolios of the given securities. By choosing securities that do not 'move'
exactly together, the HM model shows investors how to reduce their risk. The HM model is also
called mean-variance model due to the fact that it is based on expected returns (mean) and the
standard deviation (variance) of the various portfolios. Harry Markowitz made the following
assumptions while developing the HM model:
(1) Risk of a portfolio is based on the variability of returns from the said portfolio.
(2) An investor is risk averse.
(3) An investor prefers to increase consumption.
(4) The investor's utility function is concave and increasing, due to his risk aversion and consumption
preference.
(5) Analysis is based on a single period model of investment.
(6) An investor either maximizes his portfolio return for a given level of risk or maximizes his return
for the minimum risk.
(7) An investor is rational in nature.

SINGLE INDEX MODEL:

The basic notion underlying the single index model is that all stocks are affected by movements in the
stock market. Casual observation of share prices reveals that when the market moves up, prices of
most shares tend to increase. When the market goes down, the prices of most shares tend to decline.
This suggests that one reason why security returns might be correlated and there is co-movement
between securities, is because of a common response to market changes. This c0-movement of stocks
with a market index may be studied with the help of a simple linear regression analysis, taking the
returns on an individual security as the dependent variable (Ri) and the returns on the market index
(Rm) as the independent variable.

The return of an individual security is assumed to depend on the return on the market index. The
return of an individual security may be expressed at:
Ri = ai + Bi Rm + ei

Where:
𝝰 = Alpha parameter = Indicates what the return of the security would be when
the market return is zero.
B = Beta parameter = Measures how sensitive a stock's return is to the return on the
market index.
Rm = Rate of return on the market index.
ei = is the expected return resulting from influences not identified by the model.

William Sharpe, who tried to simplify the data inputs and data tabulation required for the Markowitz
model of portfolio analysis, suggested that a satisfactory simplification would be

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achieved by abandoning the covariance of each security with each other security and substituting in
its place the relationship of each security with a market index as measured by the single index model.
This is known as the Sharpe Index Model.

1) Measuring security return and risk under single index model:

Using the single index model, expected return of an individual security may be expressed as:
Ri = ai + 𝛃i Ṝm

The return of the security is a combination of two Components:

1) A specific return component represented by the alpha of the security; and
2) A market related return component represented by the term 𝛃i Ṝm.

● The risk of a security becomes the sum of a market related component and a component
that is specific to the security.
Total risk = Market related risk + Specific risk
● The market related component of risk is referred to as systematic risk as it affects all
securities. The specific risk component is the unique risk or unsystematic risk which can
be reduced through diversification. It is also called diversifiable risk.

a) Measuring portfolio return and risk under single index model: Portfolio analysis and
selection require as inputs the expected portfolio return and risk for all possible portfolios that can
be constructed with a given set of securities. The return and risk of portfolios can be calculated
using the single index model.
The expected return of a portfolio may be taken as portfolio alpha plus portfolio beta times
expected market return. Thus,
Rp = ap + 𝛃p Ṝm

MULTI INDEX MODEL:

The single index model is in fact oversimplification. It assumes that stocks move together only
because of a common co-movement with the market. Many researchers have found that
there are influences other than the market that cause socks to move together. Multi-index models
attempt to identify and incorporate these non-market or extra-market factors that cause securities to
move together also into the model. These extra market factors are a set of economic factors that
account for common movement in stock prices beyond that accounted for by the market index itself.
Fundamental economic variables such as inflation, real economic growth, interest rates, exchange
rates etc. would have a significant impact in determining security returns and hence, their
co-movement.

A multi-index model augments the single index model by incorporating these extra market factors as
additional independent variables. For example, a multi-index model incorporating the market effect
and three extra-market effects takes the following form.
Ṝi = ai + 𝛃m Rm + 𝛃1 R1 + 𝛃2 R2 + 𝛃3 R3 + ei

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The model says that the return of an individual security is a function of four factors-the general
market factor Rm and three extra-market factors Ri, R2 and R3. The beta coefficients attached to the
four factors have the same meaning as in the single index model. They measure the sensitivity of the
stock return to these factors. The alpha parameter a and the residual term e also have the same
meaning as in the single index model.

Calculation of return and risk of individual securities as well as portfolio return and variance follows
the same pattern as in the Single index model. These values can then be used as inputs for portfolio
analysis and selection.
A multi-index model is an alternative to the single index model. However, it is more complex and
requires more data estimates for its application. Both the single index model and the multi-index
model have helped to make portfolio analysis more practical.

CALCULATION OF EXPECTED RETURN AND RISK:

Q.1) Following returns in of Sun Ltd. and Moon Ltd. in the various economic conditions.
Return
Economic Growth Probability
Sun Ltd. Bun Ltd.
High Growth 0.30 15% 10%
Low Growth 0.40 13% 11%
Stagnation 0.20 09% 12%
Recession 0.10 06% 14%
a) Calculate the expected rate of return and standard deviation of return of Sun Ltd. and Bun Ltd.
b) If you could invest in either stock, but not in both, which stock would you prefer?

Q.2) Mr. Ram wants to invest in company A or company B. The return on stock of company A and
B and probabilities are given below:
Company A Company B
Return (%) Probability Return (%) Probability
06 0.10 04 0.10
07 0.25 06 0.20
08 0.30 08 0.40
09 0.25 10 0.20
10 0.10 12 0.10
Calculate expected return and standard deviation and advise Mr. Ram, for his investment.

Q.3) Given below are the likely returns in case of share Star Ltd. under various economic
conditions:
Economic Growth Probability Return
High Growth 0.25 7%
Low Growth 0.25 10
Stagnation 0.30 14%
Recession 0.20 12%
Calculate expected return and standard deviation.

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Q.5) The rate of return of stock A and stock B under different status of economy are given below:
Particular Boom Normal Recession
Probability 0.30 0.20 0.20
Return Stock A (%) 30% 50% 70%
Return Stock B (%) 70% 50% 30%
a) Calculate expected return and standard deviation of return on both the stock
b) If you could invest in either stock A or stock B, but not in both, which stock would you
prefer?

Q.6) Mr. Akash, a fund manager, produced the following returns for the last five years. Rate of
return are also given for comparison:
Year 2003-04 2004-05 2005-06 2006-07 2007-08
Mr. Akash Return 6% 48% -15% 7% 11%
Sensex Return 12% 40% -6% 20% 3%
Calculate the average return and standard deviation of Mr. Akash's Mutual Fund. Did he do
better or worse than Sensex by these measures?

Q.7) Following is information about shares of ABC Ltd. and XYZ Ltd. under different economic
conditions. At present both shares are traded at Rs. 100.
Expected Price Per Share
Economic Condition Probability
ABC Ltd. XYZ Ltd.
High Growth 0.30 Rs. 140 Rs. 150
Low Growth 0.40 Rs. 110 Rs. 100
Stagnation 0.20 Rs. 120 Rs. 120
Recession 0.10 Rs. 100 Rs. 80
Which company has more risk to invest?

Q.8) Mr. Sonu has two investment options i.e., security M and security N worth price Rs. 200 and
Rs. 250 respectively.
Security M Security N
Probability Expected Price Probability Expected Price
0.30 220 0.50 280
0.50 250 0.40 290
0.20 260 0.10 260
Calculate expected return and standard deviation.

Q.9) Rate of Return on stock X and Y are as below:

Nature Boom Normal Recurring
Probability of occurrences 0.35 0.5 0.15
Return on Stock X 20 30 40
Return on Stock Y 40 30 20
Calculate expected Return and standard deviation.

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CALCULATION OF COVARIANCE:
Practical Problem on Co-variance:

Q.9) From the following information calculate co-variance of a security with market.
Year Return on Security Return on Market Portfolio
1 10% 12%
2 12% 11%
3 15% 14%
4 10% 12%
5 08% 11%

Q.10) Calculate co-variance in case of share of Sonu Ltd., whose return and market portfolio return
on given below:
Year Return on Security Return on Market Portfolio
1 20% 14%
2 24% 18%
3 10% 9%
4 15% 14%
5 -10% -8%
6 12% 10%
7 18% 16%
8 28% 30%
9 33% 35%
10 40% 42%

Q.11) From the following details calculate co-variance.

Year Return on Security Return on Market Portfolio
1 10% 12%
2 12% 10%
3 13% 10%
4 10% 12%
5 8% 15%
6 11% 14%
7 16% 20%
8 12% 15%
9 18% 20%
10 20% 22%

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Q.12) Calculate Co-variance of A Ltd. and B. Ltd., from the following information.
Return on Market
Year Return on Security A Return on Security B
Portfolio
1 20% 19% 20%
2 18% 16% 17%
3 16% 12% 14%
4 21% 19% 20%
5 24% 23% 24%
6 28% 25% 27%
7 22% 20% 21%
8 20% 19% 20%

Q.13) From the following you are expected to calculate.

(I) Expected return of security.
(II) Measure of total risk (Standard Deviation).
(III) Co-efficient of co-variance.
Year Return on A Ltd. Return on B Ltd. Market Return
1 08% 07% 08%
2 09% 11% 11%
3 10% 09% 10%
4 11% 13% 13%
5 12% 15% 12%

CALCULATION OF BETA:
Q.14) From the following calculate Beta of a security:
Year Return on Security Return on Market Portfolio
1 10% 12%
2 12% 11%
3 15% 14%
4 10% 12%
5 08% 11%

Q.15) From the following detail, calculate Beta of a security:

Year Return on Security Return on Market Portfolio
1 11% 12%
2 14% 10%
3 18% 10%
4 10% 15%
5 8% 12%
6 11% 14%
7 18% 15%
8 12% 20%
9 20% 22%
10 10% 10%

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Q.16) From the following detail calculate Beta of a security:
Year Return on Security Return on Market Portfolio
1 10% 12%
2 12% 10%
3 13% 10%
4 10% 12%
5 8% 15%
6 11% 14%
7 16% 20%
8 12% 15%
9 18% 20%
10 20% 22%

Q.17) You are required to calculate Beta factor for Diamond Ltd.:
Year Return on Security Diamond Ltd. Market Return
1 13% 15%
2 14% 16%
3 15% 17%
4 13% 14%
5 12% 12%

Q.18) Calculate Beta of each of the following two companies with the help of given
information.
Year Return on Security A Ltd. Return on Security B Ltd. Market Return
1 25% 30% 26%
2 -15% -18% -30%
3 30% 35% 34%
4 35% 33% 32%
5 15% 23% 15%

Q.19) Compute the Beta factor and expected return for Rajesh Ltd and Rajan Ltd. Return on
government securities is 8%. Return in earlier years are as follows:
Year Rajesh Ltd. Return Rajan Ltd. Return Market Return
1 20% 18% 18%
2 20% 20% 14%
3 16% 16% 13%
4 24% 18% 15%

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Q.20) You are required to calculate Beta factors and expected return for X Ltd and Y Ltd using
CAPM. Risk free rate of return is 7%:
Year X Ltd. Return Y Ltd. Return Market Return
1 13% 13% 15%
2 14% 14% 16%
3 13% 10% 15%
4 12% 11% 14%

Q.21) Compute Beta of A Ltd and B Ltd from the following information:
Year A Ltd. Return B Ltd. Return Market Return
1 20% 19% 20%
2 18% 16% 17%
3 16% 12% 14%
4 21% 19% 20%
5 24% 23% 24%
6 28% 25% 27%
7 22% 20% 21%
8 20% 19% 20%

Q.22) From the following information you are expected to calculate. Assume risk free rate of
return as 6%.
(a) Expected return of security (using CAPM):
(b) Measure of total risk.
(c) Measure of systematic risk.
Year X Ltd. Return Y Ltd. Return Market Return
1 8% 7% 8%
2 9% 11% 11%
3 10% 9% 10%
4 11% 13% 13%
5 12% 15% 02%

Q.23) From the following information you are required to calculate: Risk free rate of return = 10%.
(a) Measure of systematic risk.
(b) Expected return using measure of systematic risk.
Year Toy Ltd. Return Boy Ltd. Return Market Return
1 10% 13% 11%
2 12% 15% 13%
3 14% 17% 15%
4 14% 12% 12%
5 18% 14% 11%
6 11% 12% 10%
7 12% 15% 12%

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CALCULATION OF TOTAL RETURN / HOLDING PERIOD RETURN:
In finance, holding period return (APR) is the total return on an asset or portfolio over a period during
which it was held. It is one of the simplest and most important measures of investment performance.

Q.24) Mr. Kushal purchased 100 shares of Anand Ltd. for Rs. 3,500 per share on 1st April 2014. He
sold all the shares on 13th March 2017 for Rs. 5,000 per share. During this tenure, he received
normal dividend of Rs. 350 per share per year. Calculate the holding period return.

Q.25) Ms. Snehal purchased 1000 shares of ABC Ltd. Rs. 100 each on 1st January 2009. She paid a
brokerage of Rs. 500. During the year 2010 she received bonus shares of ABC Ltd. in the
ratio of 3:5. She also received dividends from the company as follows:
October 2009 = Rs. 500
October 2010 = Rs. 750
She sold all holdings on 1st January 2011@ Rs. 135 each. She had to pay a brokerage of Rs.
875. Calculate the holding period returns.

Q.26) Mrs. Pooja purchased 300 shares of XYZ Ltd. Rs. 70 each on 9th February 2009. She paid
brokerage of Rs. 500. She received dividend from the company as follows:
June 2009 = Rs. 300
June 2010 = Rs. 400
She sold all holdings in February 2011 for Rs. 27,000. What is her holding period return?

Q.27) Mr. Anil purchased 2500 shares of J K Ltd. ® Rs. 20 each (Face value Rs. 5 per share) and
paid brokerage 2% on 1st January 2009. The company paid a dividend 50% each year, he sold
all the shares at Rs. 25 each on 31st December 2010 and paid brokerage of Rs. 1,200.
Calculate HPR and AR.

Q.28) Mr. Ajay purchased 200 shares of Vijay Ltd. 5 years ago at Rs. 600 each. He paid brokerage
2% at that time the company paid the following dividend.
Year 1 2 3 4 5
Dividend Per Share 3 3 4 4 5
Dividend Amount Rs. 600 600 800 800 1000
The current price of the share is R. 700. Calculate the holding period return and annualized
return if he sells the share now.

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Q.30) In January 2010, Mr. Vinod purchased the following five company's shares and paid
brokerage of Rs. 5,000 on Purchase of shares. During the year 2010, Mr. Vinod received
Dividend and Bonus shares. In January 2011, Mr. Vinod sold all his holdings at Market Price
and Paid Brokerage Rs. 6,500 on sale of shares. Calculate holding period return (HPR).
Compan Number of Purchase Price Dividen Market Price
Bonus
y Shares Purchased Per Share Rs. d Rs. Per Share Rs.
A Ltd. 100 200 500 - 300
B Ltd. 100 220 700 - 350
C Ltd. 100 150 900 1:02 280
D Ltd. 100 170 400 - 330
E Ltd. 100 130 500 - 300

Q.31) In January 2011, Mr. Mehta purchased the following 5 scripts, the detail of the scripts were as
follows:
Number of Purchase Price Dividend Market Price
Company Bonus
Shares Purchased Per Share Rs. Rs. Per Share Rs.
A Ltd. 100 230 400 - 250
B Ltd. 150 200 300 1:03 270
C Ltd. 200 125 250 - 160
D Ltd. 150 220 500 - 246
E Ltd. 200 300 200 1:04 250
Mr. Mehta paid brokerage of Rs. 5,320 on purchase of shares.
Mr. Mehta sold all his securities in January 2012 by paying brokerage of Rs. 6,790. Calculate
the holding period return on the investment of Mr. Mehta.

Q.32) Calculate the holding period return from the following:

Particulars P Ltd. Q Ltd.
Price as on 31/03/16 100 225
Price as on 31/03/17 150 280
Dividend 20 30

Q.33) Dr. Ketan purchase 400 shares of Shah Ltd. Rs. 61 each on 15th October 2014. He paid
brokerage of Rs. 600. The company paid the following dividends:
Year Dividend Rs.
June 2015 800
June 2016 1000
June 2017 1200
He sold all his holding for Rs. 34,500 on 15th October, 2017. Calculate, HPR and AR.

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Q.34) (May, 2017)
Mr. Ram wants to invest in company A or B. The return on stock A and B and probabilities
are given below:
Company A Company B
Return Probability Return Probability
6% 0.10 13% 0.10
7% 0.25 15% 0.20
8% 0.30 17% 0.40
9% 0.25 12% 0.20
10% 0.10 14% 0.10
Calculate standard deviation of both companies and advise Mr. Ram.

Theory Questions:
(1) What do you understand about the term Portfolio Analysis? Explain its Components.
(2) Discuss Risk- Return Trade off.
(3) What do you understand about the term Portfolio Selection? Discuss Feasible Set of
Portfolios.
(4) Define what is meant by an efficient set of portfolios. Explain with a suitable diagram.
(5) How to Selection of Optimal Portfolio
(6) Explain how the effective frontier is determined using the Markowitz Approach.

Short Notes Questions:

(a) Limitations of Markowitz Model.
(b) Risk under Single Index Model and Multi Index Model.
(c) Markowitz Model. (May 19)
(d) Risk-Return Tradeoff. (Oct. 19)

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