Definition of Portfolio Construction

Portfolio is a combination of securities such as stocks, bonds and money market instruments. The process of blending together the broad asset classes so as to obtain optimum return with minimum risk is called portfolio construction. Diversification of investments helps to spread risk over many assets. A diversification of securities gives the assurance of obtaining the anticipated return on the portfolio. In a diversified portfolio, some securities may not perform as expected, but others may exceed the expectation and making the actual return of the portfolio reasonably close to the anticipated one. Keeping a portfolio of single security may lead to a greater livelihood of the actual return somewhat different from that of the expected return. Hence, it is a common practice to diversify securities in the portfolio.

Approaches in Portfolio Construction

Commonly, there are t approaches in the construction of the portfolio of securities viz, traditional approach and Markowitz efficient frontier approach. In the traditional approach, investor’s needs in terms of income and capital appreciation re evaluated and appropriate securities are selected to meet the needs of the investor. The common practice in the traditional approach is to evaluate the entire financial plan of the individual. In the modem approach, portfolios are constructed to maximize the expected return for a given level of risk. It views portfolio construction in terms of the expected return and the risk associated with obtaining the expected return.

The Traditional Approach

The traditional approach basically deals with two major decisions. They are:

Determining the objectives of the portfolio.

Selection of securities to be included in the portfolio.

Normally, this is carried out in four to six steps. Before formulating the objectives, the constraints of the investor should be analysed. Within the given frame work of constraints, objectives are formulated. Then based on the objectives, securities are selected. After that, the risk and return of the securities should be studied. The investor has to assess the major risk categories that he or she is trying to minimize. Compromise on risk and non-risk factors has to be carried out. Finally relative portfolio weights are assigned to securities like bonds, stocks and debentures and then diversification is carried out. The flow chart 4.5 explains this

Analysis of Constraints

The constraints normally discussed are: income needs, liquidity time harizon, safety, tax considerations and the temperament.

Income Needs

The income needs depend on the need for income in constant rupees and current rupees. The need for income in current rupees arises from the investor’s need to meet all or part of the living expenses. At the same time inflation may erode the purchasing power, the investor may like to offset the effect of the inflation and so, needs income in constant rupees.

Steps In Traditional Approach

Need for current

Income The investor should establish the income which the portfolio should generate. The current income need depends upon the entire current financial plan of the investor. The expenditure required to maintain a certain level of standard of living and the other entire income generating source should be determined. Once this information is arrived at, it is possible to decide how much income must be provided for the port1olio of securities.

Need for Constant Income

Inflation reduces the purchasing power of the money. Hence, the investor estimates the impact of inflation on his estimated stream of income and tries to build a portfolio which could offset the effect of inflation. Funds should be invested in such securities where income from them might increase at a rate that would offset the effect of inflation. The inflation or purchasing power risk must be recognized but this does not pose a serious constraint on portfolio if growth stocks are selected.

Liquidity

Liquidity need of the investment is highly individualistic of the investor. If the investor prefers to have high liquidity then funds should be invested in high quality short term debt maturity issues such as money market funds, commercial papers and shares that are widely traded. Keeping, the funds in shares that are poorly traded or stocks in closely held business and real estate lack liquidity. The investor should plan his cash drain and the need for net cash inflows during the investment period.

Safety of the Principal

Another serious constraint to be considered by the investor is the safety of the principal value at the time of liquidation. Investing in bonds and debentures is safer than investing in the stocks. Even among the stocks, the money should be invested in regularly traded companies of longstanding. Investing money in the unregistered finance companies may not provide adequate safety

Time Horizon

Time horizon is the investment-planning period of the individuals. This varies from individual to individual. Individual’s risk and return preferences are often described in terms of his “life cycle”. The stages of the life cycle determine the nature of investment. The first stage is the early career situation. At the career starting point assets are lesser than their liabilities. More goods are purchased on credit. His house might have been built with the help of housing loan scheme. His major asset may be the house he owns. His priority towards investments may be in the form of savings for liquidity purposes. He takes life insurance for protecting him from unforeseen events like death and accidents and then he thinks of the investments. The investor is young at this stage and has long horizon of life expectancy with possibilities of growth in income, he can invest in high-risk and growth oriented investments.

The other stage of the time horizon is the mid-career individual. At this stage, his assets are larger than his liabilities. Potential pension benefits are available to him. By this time he establishes his investment program. The time horizon before him is not as long as the earlier stage and he wants to protect his capital investment. He may wish to reduce the overall risk exposure of the portfolio but, he may continue to invest in high risk and high return securities.

The final stage is the late career or the retirement stage. Here, the time horizon of the investment is very much limited. He needs stable income and once he retires, the size of income he needs from investment also increases. In this stage, most of his loans are repaid by him and his assets far exceed the liabilities. His pension and life insurance programmes are completed by him. He shifts his investment to low return and low risk category investments, because safety of the principal is given priority. Mostly he likes to have lower risk with high interest or dividend paying component to be included in his portfolio. Thus, the time horizon puts restrictions on the investment decisions.

Tax Consideration

Investors in the income tax paying group consider the tax concessions they could get from their investments. For all practical purpose, they would like to reduce the taxes. For income tax purpose, interests and dividends are taxed under the head “income from other sources”. The capital appreciation is taxed under the head “capital gains” only when the investor sells the securities and realises the gain. The tax is then at a concessional rate depending on the period for which the asset has been held before being sold. From the tax point of view, the form in which the income is received i. e. interest, dividend, short term capital gains and long term capital gains are important. If the investor cannot avoid taxes, he can delay the taxes. Investing in government bonds and NSC can avoid taxation. This constraint makes the investor to include the items which will reduce the tax.

Temperament

The temperament of the investor himself poses a constraint on framing his investment objectives. Some investors are risk lovers or takers who would like to take up higher risk even for low return while some investors are risk averse, who may not be willing to undertake higher level of risk even for higher level of return. The risk neutral investors match the return and the risk. For example, if a stock is highly volatile in nature then the stock may be selling in a range of ` l00 - 200 and returns may fluctuate. Investors who are risk averse would find it disturbing and do not have the temperament to invest in this stock. Hence, the temperament of the investor plays an important role in setting the objectives.

Determination of Objectives

Portfolios have the common objective of financing present and future expenditures from a large pool of assets. The return that the investor requires and the degree of risk he is willing to take depend upon the constraints. The objectives of portfolio range from income to capital appreciation. The common objectives are stated below

Current income

Growth in income

Capital appreciation

Preservation of capital

The investor in general would like to achieve all the four objectives; nobody would like to lose his investment. But, it is not possible to achieve all the four objectives simultaneously. If the investor aims at capital appreciator, he should include risky securities where there is an equal likelihood of losing the capital. Thus, there is a conflict among the objectives.

Selection of Portfolio

The selection of portfolio depends on the various objectives of the investor. The selections of portfolio under different objectives are dealt subsequently.

Objectives and Asset Mix

If the main objective is getting adequate amount of current income, sixty per cent of the investment is made on debts and 40 per cent on equities. The proportions of investments on debt and equity differ according to the individual’s preferences. Money is invested in short term debt and fixed income securities. Here the growth of income becomes the secondary objective and stability of principal amount may become the third. Even within the debt portfolio, the funds invested in short term bonds depends on the need for stability of principal amount in comparison with the stability of income. If the appreciation of capital is given third priority, instead of short term debt the investor opts for long term debt. The maturity period may not be a constraint.

Growth and Income and Asset Mix

Here the investor requires a certain percentage of growth in the e received from his investment. The investor’s portfolio may consist of 60 to 100 percent equities and 0 to 40 percent debt instrument. The debt portion of the portfolio may consist of concession regarding tax exemption. Appreciation of principal amount is given third priority. For example computer software, hardware and non-conventional energy producing company shares provide good possibility of growth in dividend.

Capital Appreciation and Asset Mix

Capital appreciation and asset mix Capital appreciation means that the value of the original investment increases over the years. Investment in real estate’s like land and house may provide a faster rate of capital appreciation but they lack liquidity. In the capital market, the values of the shares are much higher than their original issue prices. For example Satyam Computers, share value was ` 306 in April 1998 but in October 1999 the value was ` 1658. Likewise, several examples can be cited. The market capitalisation also has increased. Next to real assets, the stock markets provide best opportunity for capital appreciation. If the investor’s objective is capital appreciation, 90 to 100 per cent of his portfolio may consist of equities and 0-10% of debts. The growth of income becomes the secondary objective.

Safety of Principal and Asset Mix

Usually, the risk averse investors are very particular about the stability of principal. According to the life cycle theory, people in the third stage of life also give more importance to the safety of the principal. All the investors have this objective in their mind. No one likes to lose his money invested in different assets. But, the degree may differ. The investor’s portfolio may consist more of debt instruments and within the debt portfolio more would be on short term debts.

Risk and Return Analysis

The traditional approach to portfolio building has some basic assumptions. First, the individual prefers larger to smaller returns from securities. To achieve this goal, the investor has to take more risk. The ability to achieve higher returns is dependent upon his ability to judge risk and his ability to take specific risks. The risks are namely interest rate risk, purchasing power risk, financial risk and market risk. The investor analyses the varying degrees of risk and constructs his portfolio. At first, he establishes the minimum income that he must have to avoid hardships under most adverse economic condition and then he decides risk of loss of income that can be tolerated. The investor makes a series of compromises on risk and non-risk factors like taxation and marketability after he has assessed the major risk categories, which he is trying to minimize.

Diversification

Once the asset mix is determined and the risk and return are analysed, the final step is the diversification of portfolio. Financial risk can be minimized by commitments to top-quality bonds, but these securities offer poor resistance to inflation. Stocks provide better inflation protection than bonds but are more vulnerable to financial risks. Good quality convertibles may balance the financial risk and purchasing power risk. According to the investor’s need for income and risk tolerance level portfolio is diversified. In the bond portfolio, the investor has to strike a balance between the short term and long term bonds. Short term fixed income securities offer more risk to income and long term fixed income securities offer more risk to principal. In the stock portfolio, he has to adopt the following steps which are shown in the following figure:

The investor has to select the industries appropriate to his investment objectives. Each industry corresponds to specific goals of the investor. The sales of some industries like two wheelers and steel tend to move in tandem with the business cycle, the housing industry sales move counter cyclically. If regular income is the criterion then industries, which resist the trade cycle should be selected. Likewise, the investor has to select one or two companies from each industry. The selection of the company depends upon its growth, yield, expected earnings, past earnings, expected price earning ratio, dividend and the amount spent on research and development. Selecting the best company is widely followed by all the investors but this depends upon the investors’ knowledge and perceptions regarding the company. The final step in this process is to determine the number of shares of each stock to be purchased. This involves determining the number of different stocks that is required to give adequate diversification. Depending upon the size of the portfolio, equal amount is allocated to each stock. The investor has to purchase round lots to avoid transaction costs.

Modern Approach

The traditional approach is a comprehensive financial plan for the individual. It takes into account the individual needs such as housing, life insurance and pension plans. But these types of financial planning approaches are not done in the Markowitz approach. Markowitz gives more attention to the process of selecting the portfolio. His planning can be applied more in the selection of common stocks portfolio than the bond portfolio. The stocks are not selected on the basis of need for income or appreciation. But the selection is based on the risk and return analysis. Return includes the market return and dividend. The investor needs return and it may be either in the form of market return or dividend. They are assumed to be indifferent towards the form of return.

From the list of stocks quoted at the Bombay Stock Exchange or at any other regional stock exchange, the investor selects roughly some group of shares say of 10 or 15 stocks. For these stocks’ expected return and risk would be calculated. The investor is assumed to have the objective of maximizing the expected return and minimising the risk. Further, it is assumed that investors would take up risk in a situation when adequately rewarded for it. This implies that individuals would prefer the portfolio of highest expected return for a given level of risk. In the modern approach, the final step is asset allocation process that is to choose the portfolio that meets the requirement of the investor. The risk taker i.e. who are willing to accept a higher probability of risk for getting the expected return would choose high risk portfolio. Investor with lower tolerance for risk would choose low level risk portfolio. The risk neutral investor would choose the medium level risk portfolio.

Managing the Portfolio

After establishing the asset allocation, the investor has to decide how to manage the portfolio over time. He can adopt passive approach or active approach towards the management of the portfolio. In the passive approach the investor would maintain the percentage allocation for asset classes and keep the security holdings within its place over the established holding period. In the active approach the investor continuously assess the risk and return of the securities within the asset classes and changes them. He would be studying the risks (1) market related (2) group related and (3) security specific and changes the components of the portfolio to suit his objectives.

Construction of the Optimal Portfolio

After determining the securities to be selected, the portfolio manager should find out how much should be invested in each security. The percentage of funds to be invested in each security can be estimated as follows:

The first expression indicates the weights on each security and they sum upto one. The second shows the relative investment in each security. The residual variance or the unsystematic risk has a role in determining the amount to be invested in each security.

Taking up the previous example

Thus, the proportions to be invested in different securities are obtained. The largest investment should be made in security 1 and the smallest in security 4.

Optimum Portfolio With Short Sales

The procedure used to calculate the optimal portfolio when short sales are allowed is, more or less similar to the procedure adopted for no short sales, except the cut-off point concept. At first, the stocks have to be ranked by excess return to beta.

Summary

Markowitz developed alogrithms to minimise portfolio risk. Diversification reduces the unsystematic risk component of the portfolio.

The level of risk exposure is measured with the help of the standard deviation of the returns. The expected return is the weighted sum of the expected returns of the portfolio, the weights being the probabilities of their occurence.

If securities with less than perfect positive correlation between their price movements are combined risk can be reduced considerably. The risk would be nil or the standard deviation would be zero if two securities have perfect negative correlation. Risk cannot be reduced if the securities have perfect positive correlation.

Many portfolios may be attainable. But some portfolios are attractive because they give more return for the same level of risk or same return with lesser level of risk. These portfolios form the efficient frontier.

Utility curves of the investor decide the most efficient portfolio.