Determination of 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 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.