Portfolio management strategies

Corporate Commando
Chapter :7
Portfolio Management
Strategies
 Value and Growth
 Asset Allocation Strategies
Chapter:1
Investment Settings
 Measures of Return and
Risk
 Determinants of Required
Rate of Return
 Relationship Between Risk
and Return

Chapter :7
Portfolio Management Strategies
 Value vs. Growth Investing
 Integrated Allocation

Chapter:1
Investment Settings
 Measures of Return and Risk
 Determinants of Required Rate of Return
 Relationship Between Risk and Return

Chapter :7
Portfolio Management Strategies
Topic : Value vs. Growth Investing

Value vs. Growth Investing
It is now common for money management firms to define themselves as
“value stock managers” or “growth stock managers” when selling their
services to clients.
A growth investor focuses on the current and future economic “story” of a
company, with less regard to share valuation.
The value investor focuses on share price in anticipation of a market
correction and, possibly, improving company fundamentals.
The distinction between value and growth investing can be best appreciated
by considering the thought process of a representative manager for each
style.1 In previous chapter, we saw that the price/earnings ratio for any
company can be expressed as:
P/E Ratio=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
where the earnings per share (EPS) measure can be based on either current
or forecasted firm performance.

Value vs. Growth Investing
Value and growth managers will focus on different aspects of this equation when evaluating
stocks. Specifically, a growth-oriented investor will:
• Focus on the EPS component of the P/E ratio and its economic determinants;
• Look for companies that he or she expects to exhibit rapid EPS growth in the future; and
• Often implicitly assume that the P/E ratio will remain constant over the near term, meaning that
the stock price will rise as forecasted earnings growth is realized.
On the other hand, a value-oriented investor will:
• Focus on the price component of the P/E ratio as he or she must be convinced that the price
of the stock is “cheap” by some means of comparison;
• Not care a great deal about current earnings or the fundamental drivers of earnings growth;
and
• Often implicitly assume that the P/E ratio is below its natural level and that the market will soon
“correct” this situation by increasing the stock price with little or no change in earnings.

Chapter :7
Topic : Asset Allocation Strategies

Asset Allocation
Asset allocation is a basic decision that every investor
must make is how to distribute his or her investable
funds amongst the various asset classes available in
the marketplace, such as stocks, fixed income, cash
equivalents, real estate , etc.
The strategic allocation is the proportion of wealth the
investor decides to place in each of these asset
classes.

Asset Allocation Strategies
 Integrated asset allocation
The integrated asset allocation strategy separately examines
(1) Capital market conditions and
(2) The investor’s objectives and constraints.
 Strategic asset allocation
Strategic asset allocation is used to determine the long-term
policy asset weights in a portfolio. Typically, long-term average
asset returns, risk, and co-variances are used as estimates of
future capital market results.

Asset Allocation Strategies
 Tactical asset allocation
Unlike an investor’s strategic allocation, which is set with a long-term focus
and modified infrequently, tactical asset allocation frequently adjusts the asset
class mix in the portfolio to take advantage of changing market conditions.
With tactical asset allocation, these adjustments are driven solely by perceived
changes in the relative values of the various asset classes; the investor’s risk
tolerance and investment constraints are assumed to be constant over time
 Insured asset allocation
Insured asset allocation likewise results in continual adjustments in the
portfolio allocation, assuming that expected market returns and risks are
constant over time, while the investor’s objectives and constraints change as
his or her wealth position changes. For example, rising portfolio values
increase the investor’s wealth and consequently his or her ability to handle
risk, which means the investor can increase his or her exposure to risky
assets.

Chapter:1
Investment Settings
Topic : Measures of Return and Risk

Measures of Return and Risk
To properly evaluate any to investment, you must accurately compare their
historical rates of return. A proper measurements of the rates of return is the
purpose of this section.
HPR =
𝐸𝑁𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
=
220
200
=1.10
Here,
HPY = HPR-1
=1.10-1
=10%
Annual HPR= 𝐻𝑃𝑅
1
𝑛
Annual HPY =HPR-1

 In case of declining wealth value the computation as follows :
HPR =
And HPY =HPR - 1
 In case of multiple year loss over 2 years would be computed as follows:
HPR =
And HPY =HPR – 1
 In contrast, consider an investment of $100 held for only6 months that earned a return of
$12.
HPR =
And HPY =HPR – 1

Note that we made some implicit assumptions when converting the
six-month HPY to an annual basis. we assumed that the rate of
return earned during the first half of the year is likewise earned on
the value at the end of the first six months. The 12 percent rate of
return for the initial six months compounds to 25.44 percent for the
full year. Because of the uncertainty of being able to earn the same
return in the future six months, institutions will typically not compound
partial year results. Remember one final point: The ending value of
the investment can be the result of a positive or negative change in
price for the investment alone (for example, a stock going from $20 a
share to $22 a share), income from the investment alone, or a
combination of price change and income. Ending value includes the
value of everything related to the investment.

 Computing mean historical returns.
Single Investment-
For an individual investment there are two summary measures of return
performance.
Arithmetic Mean
Geometric Mean
To find Arithmetic mean,
AM=
𝐻𝑃𝑌
𝑛
And alternative computation,
GM =[𝜋𝐻𝑃𝑅]
1
𝑛−1
Where ,
𝜋 = 𝑇ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑎𝑠 𝑓𝑜𝑙𝑙𝑜𝑤𝑠:
(𝐻𝑃𝑅1) × (𝐻𝑃𝑅2)…………(𝐻𝑃𝑅 𝑛)

Year Beginning
Value
Ending
Value
HPR HPY
1 100 115 1.15 0.15
2 115 138 1.20 0.20
3 138 110 0.80 -0.20
AM =?
GM =?

Investors are typically concerned with long term
performance when comparing alternative investments.
GM is considered a superior measure of the long term
mean rate of return because it indicates the compound
annual rate of return based on the ending value of the
investment versus its beginning value. Although , the
Arithmetic Average provides a good indication of the
expected rate of return for an investment during a future
individual year , it is biased upward if you are attempting
to measure assets long term performance.

Year Beginnin
g Value
Ending
Value
HPR HPY
1 50 100 2.00 1.00
2 100 50 0.50 -0.50
AM =?
GM =?

A portfolio of investments
The mean historical rate of return (HPY) for a portfolio
of investments is measured as the weighted average
of the HPY’s for the individual investment in the
portfolio, or the overall percentage in value of the
original portfolio.
Investment Number
of
Shares
Beginning
Price
Beginning
Market
Value
Ending
Price
Ending
Market
Value
HPR HPY Market
weighted
Weighted
HPY
A 100,000 10 $1,000,00
0
$12 $1,200,00
0
1.20 20% 0.05 0.01
B 200,000 20 4,000,000 21 4,200,000 1.05 5 0.20 0.01
C 500,000 30 15,000,00
0
33 16,500,00
0
1.10 10 0.75 0.075
Total $20,000,0
00
$21,900,0
00
0.095

Expected Rate of Return (ERR)
 The “Expected Return” on a financial investment is
the expected value of it’s return.
 The “Expected Rate of Return” is the expected
return per currency invested.
 Computing Expected Rate of Return (ERR)
ERR = ∑(Probability of Return)×(Possible Return)

Discussion with three situations
 Situation1
An investor is absolutely certain of a return of 5%.So
the probability of receiving the return is 1.
The ERR = (1×0.05)
=0.05 or 5%

 Situation2
An investor expects three types of return in three
economic conditions
Economic Conditions Probability Rate of Return
Strong Economy
Weak Economy
No Major Change in Economy
0.15
0.15
0.70
0.20
-0.20
0.10
–
The ERR = (0.15×0.20)+(0.15× -0.20)+(0.70×0.10)
=0.07

Discussion with three situations
 Situation3
An investor expects 10 possible outcomes ranging
from -40% to 50% , with the same probability of 0.10
for each rate of return.
ERR = (0.10× -0.40)+(0.10× -0.30)+(0.10× -
0.20)+(0.10× -
0.10)+(0.10×0.0)+(0.10×0.10)+(0.10×0.20)+(0.10×0.3
0)+(0.10×0.40)+(0.10×0.50)
=0.05or 5%

Computing The Risk of Expected Rates
of Return
 The Risk of ERR can be determined by – Variance, Standard
deviation and Coefficient of Variation.
Variance = ∑ Probability × (Possible Return-Expected Return)2
Standard Deviation = √[∑ Probability × (Possible Return-
Expected Return)2]
CV = Standard Deviation of Returns / Expected Rate of Return
The larger the variance for an expected rate of return, the greater the
dispersion of expected returns and the greater the uncertainty ,or
risk, of the investment.

Discussion with two situations
 Situation1
An investor is absolutely certain of a return of 5%.So
the probability of receiving the return is 1 and the
expected rate of return is also 5%.
Variance = 1.00(0.05-0.05)2
=1.00(0.00)
=0
Standard Deviation = √0=0
CV = 0/0.05=0

 Situation2
An investor expects three types of return in three
economic conditions –
Economic Conditions Probability Rate of Return Expected rate of return
Strong Economy
Weak Economy
No Major Change in
Economy
0.15
0.15
0.70
0.20
-0.20
0.10
0.07
0.07
0.07

Variance = [0.15(0.20 - 0.07)2]+[0.15(-0.20 – 0.07)2]+[0.70(0.10
– 0.07)2]
= 0.0141
Standard Deviation = √0.0141
= 0.1187 or 11.87%
CV = 0.1187 / 0.07
=1.696
Conclusion – When your investment is in a perfect certainty
than there is no variation, that means no risk.
But in situation 2 , you expect a return 7%,but the standard
deviation of your expectation is 11.87%

Chapter:1
Investment Settings
Topic : Determinants of Required
Rates of Return

Determinants of Required Rates of
Return
 There are three broad determinants of Required
Rates of Return and these are as follows:
 Time Value of Money
 Expected Rate of Inflation for a particular economy
 Involvement of Risk on Investment

Return
Time Value of Money
The present value of money
Future value of money
Expected Rate of Inflation (Decline in Purchasing Power of Money)
Higher the inflation, higher the required rates of return.
Involvement of Risk with Investment
You know, there is nothing where risk is not involved. And it is money we talk
about is more sensitive towards risk. Risk can vary from industry to industry,
company to company, person to person. But the common thing is higher the
risk higher the rates of return person expect from an investment. Although you
may find there is a variation of risk-taking behavior among the individuals
which is influenced by the personal trait of an individual. Risk can be broadly
categorized into two head; one is systematic and other is an unsystematic risk.

Return
Systematic Risk: Directly involved with the system
which arises from the macroeconomic factors and it is
not possible to minimize this type of risk through
diversification of investment.
Unsystematic Risk: Unsystematic is a type of risk
which is possible to minimize through diversification of
investment. With this risk, there is a correlation
between risk and diversification.

Return
Market change because of the following reasons
 A wide range of available investment alternatives
 Return on specific assets change dramatically
 Change in interest rate over the time period
It does not necessarily need to be the same required
rates of return for all the people. The rate will vary
according to the economic factors and the personal risk-
taking behavior of an individual. So it will be better for you
if you identify the influencing factors and then calculate
your required rates of return on investment.

Chapter:1
Investment Settings
Topic : Relationship Between Risk
and Return

Relationship Between Risk and Return
As a general rule, investments with high risk tend to
have high returns and vice versa. Another way to look
at it is that for a given level of return, it is human
nature to prefer less risk to more risk. Therefore, the
higher the risk of an investment, the higher its returns
have to be to attract investors.

The existence of risk does not mean that you should not
invest – only that you should be aware that any
investment has some degree of risk which should be
considered when deciding whether the expected returns
of that investment are worth it. Therefore, when
considering the suitability of any investment, you must
understand both the likely returns and the risks involved.
The appropriate risk-return combination will depend on
your financial objectives. Some people prefer a low-risk,
steady income stream while others don’t mind taking on
more risk for the chance of making higher returns.

 We can understand the expected relationship
between risk and return from the graph below

Relationship Between Risk and
Return
 It shows that investors increase their required rates of
return as perceived risk increases. The line that reflects
the combination of risk and return available on
alternative investments is referred to as the security
market line(SML).The SML reflects the risk return
combinations available for all risky assets in the capital
market at a given time. Investors would select
investments that are consistent with their risk
preferences; some would consider only low risk
investments, whereas others welcome high risk
investments.

Portfolio management strategies

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