Understanding Portfolio Management

PORTFOLIO MANAGEMENT Submitted by : Group 12 Portfolio Management: The main goal of allocating your assets among various asset classes is to maximize return for your chosen level of risk, or stated another way, to minimize risk given a certain expected level of return. Of course to maximize return and minimize risk, you need to know the risk-return characteristics of the various asset classes. The following chart compares the risk and potential return of some of the more popular ones: As you can see, equities have the highest potential return, but also the highest risk. On the other hand, Treasury bills have the lowest risk since they are backed by the government, but they also provide the lowest potential return. The chart also demonstrates that when you choose investments with higher risk, your expected returns also increase proportionately. But this is simply the result of the riskreturn tradeoff. They will often have high volatility and are therefore suited for investors who have a high risk tolerance (can stomach wide fluctuations in value), and who have a longer time horizon. It's because of the risk-return tradeoff - which says you can seek high returns only if you are willing to take losses - that diversification through asset allocation is important. Since different assets have varying risks and experience different market fluctuations, proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities. So, while part of your portfolio may contain more volatile securities - which you've chosen for their potential of higher returns - the other part of your portfolio devoted to other assets remains stable. Because of the protection it offers, asset allocation is the key to maximizing returns while minimizing risk. Decisions regarding which asset type is best suited for your risk appetite As each asset class has varying levels of return for a certain risk, your risk tolerance, investment objectives, time horizon and available capital will provide the basis for the asset composition of your portfolio. To make the asset allocation process easier for clients, many investment companies create a series of model portfolios, each comprising different proportions of asset classes. These portfolios of different proportions satisfy a particular level of investor risk tolerance. In general, these model portfolios range from conservative to very aggressive: Conservative model portfolios generally allocate a large percent of the total portfolio to lower-risk securities such as fixed-income and money market securities. The main goal with a conservative portfolio is to protect the principal value of your portfolio. As such, these models are often referred to as "capital preservation portfolios". Even if you are very conservative and prefer to avoid the stock market entirely, some exposure can help offset inflation. You could invest the equity portion in high-quality blue chip companies, or an index fund, since the goal is not to beat the market. (For further reading, see the tutorial All about Inflation.) A moderately conservative portfolio is ideal for those who wish to preserve a large portion of the portfolio’s total value, but are willing to take on a higher amount of risk to get some inflation protection. A common strategy within this risk level is called "current income". With this strategy, you chose securities that pay a high level of dividends or coupon payments. Moderately aggressive model portfolios are often referred to as "balanced portfolios" since the asset composition is divided almost equally between fixed-income securities and equities in order to provide a balance of growth and income. Since these moderately aggressive portfolios have a higher level of risk than those conservative portfolios mentioned above, select this strategy only if you have a longer time horizon (generally more than five years), and have a medium level of risk tolerance. Aggressive portfolios mainly consist of equities, so these portfolios' value tends to fluctuate widely. If you have an aggressive portfolio, your main goal is to obtain longterm growth of capital. As such the strategy of an aggressive portfolio is often called a "capital growth" strategy. To provide some diversification, investors with aggressive portfolios usually add some fixed-income securities. Very aggressive portfolios consist almost entirely of equities. As such, with a very aggressive portfolio, your main goal is aggressive capital growth over a long time horizon. Hedging for Aggressive portfolios: The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters. Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another. Technically, to hedge you would invest in two securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another. Although some of us may fantasize about a world where profit potentials are limitless but also risk free, hedging can't help us escape that hard reality of the risk-return tradeoff. A reduction in risk will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you will have typically reduced the profit that you could have made, and if the investment loses money, your hedge, if successful, will reduce that loss. Hedging By Investors For the most part, hedging techniques involve using complicated financial instruments known as derivatives, the two most common of which are options and futures. We're not going to get into the nitty-gritty of describing how these instruments work, but for now just keep in mind that with these instruments you can develop trading strategies where a loss in one investment is offset by a gain in a derivative. Let's see how this works with an example. Say you own shares of Indian Tobacco Company (Ticker: ITC). Although you believe in this company for the long run, you are a little worried about some short-term losses in the Tobacco industry. To protect yourself from a fall in ITC you can buy a put option (a derivative) on the company, which gives you the right to sell ITC at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option. The other classic hedging example involves a company that depends on a certain commodity. Let's say Indian Tobacco Company is worried about the volatility in the price of tobacco, the plant used to make cigarettes. The company would be in deep trouble if the price of tobacco were to skyrocket, which would eat into profit margins severely. To protect (hedge) against the uncertainty of tobacco prices, ITC can buy a futures contract that allows the company to buy the tobacco at a certain price. Now ITC can budget without worrying about the fluctuating commodity. If the prices of tobacco skyrockets above that price specified by the futures contract, the hedge will have paid off because ITC will save money by paying the lower price. However, if the price goes down, ITC is still obligated to pay the price in the contract and actually would have been better off not hedging. Keep in mind that because there are so many different types of options and futures contracts an investor can hedge against nearly anything, whether a stock, commodity price, interest rate, or currency. The Downside Every hedge has a cost, so before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn't to make money but to protect from losses. The cost of the hedge - whether it is the cost of an option or lost profits from being on the wrong side of a futures contract - cannot be avoided. This is the price you have to pay to avoid uncertainty. We've been comparing hedging versus insurance, but we should emphasize that insurance is far more precise than hedging. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn't a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice. Investors and Hedging The majority of investors will never trade a derivative contract in their life. In fact most buy-and-hold investors ignore short-term fluctuation altogether. For these investors there is little point in engaging in hedging because they let their investments grow with the overall market. Even if you never hedge for your own portfolio you should understand how it works because many big companies and investment funds will hedge in some form. Oil companies, for example, might hedge against the price of oil while an international mutual fund might hedge against fluctuations in foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these investments. Conclusion Because risk is an essential yet precarious element of investing, you should, regardless of what kind of investor you are, gain a fairly good awareness of how investors and companies work to protect themselves. Whether or not you decide to start practicing these intricate uses of derivatives, learning about how hedging works will help advance your understanding the market, which will always help. Aggressive Portfolio: The aggressive portfolio as suggested by our team of experts is: Security No. of Trades Traded Quantity (Lakh Shares) Turnover (Rs. cr.) Average Daily Turnover(Rs. cr.) Share in Total Turnover Reliance Industries Ltd. Infosys Technologies Ltd. ICICI Bank Ltd. Indiabulls Fin. Ser. Ltd. Reliance Communications Ltd. Siemens Ltd. State Bank Of India Mahindra Gesco Developers Ltd. Ivrcl Infrast & Proj Ltd. Jaiprakash Associates Ltd. 752860 522973 523400 1480471 921896 705044 407629 1034915 1054964 900263 599.22 271.40 523.53 821.63 1,017.78 284.63 290.39 368.21 854.49 493.58 7608.44 5917.11 4511.57 4342.88 4106.81 3496.02 3494.75 3480.48 3164.00 3158.38 345.84 268.96 205.07 197.40 186.67 158.91 158.85 158.20 143.82 143.56 4.01 3.12 2.38 2.29 2.16 1.84 1.84 1.83 1.67 1.66 The following would be the scripts that we have picked up for the investor for hedging purposes as well as some of them would be used for cash deliveries. These companies have posted very good returns over the last quarter and are fundamentally very strong companies. These companies would allow us to achieve the set goals in accordance with the wishes of the investor. Balanced/ Moderate Portfolio: The investor with a moderate risk appetite would be advised to invest into a balanced mutual fund to fulfill his needs and to achieve the return as assessed by us in the beginning. It is very important for the investor to understand the term “Balanced Funds” for clearer picture in terms of asset allocation. Balanced Mutual Fund: A mutual fund that invests its assets into the money market, bonds, preferred stock, and common stock with the intention to provide both growth and income. Also known as an "asset allocation fund". A balanced fund is geared towards investors looking for a mixture of safety, income, and capital appreciation. The amount the mutual fund invests into each asset class usually must remain within a set minimum and maximum A mutual fund that buys a combination of common stock, preferred stock, bonds, and short-term bonds, to provide both income and capital appreciation while avoiding excessive risk. The purpose of balanced funds (also sometimes called hybrid funds) is to provide investors with a single mutual fund that combines both growth and income objectives, by investing in both stocks (for growth) and bonds (for income). Such diversified holdings ensure that these funds will manage downturns in the stock market without too much of a loss; the flip side, of course, is that balanced funds will usually increase less than an all-stock fund during a bull market FUNDS TO INVEST IN     Principal Child Benifit-CBP- 40.3 Principal Child Benifit-fgp- 40.3 JM balanced fung(G)- 37 HDFC Pruudence Fung (G)- 35.1  FT India Balanced Fund(G)- 33.9 If we invest Rs 5 lacs in each fund , we will be able to achieve an average return of 37.32% Low Risk Portfolio: As mentioned above an investor with a low risk profile, would indulge in investments which are of very low risk character. This hampers the return outlook but with a portfolio of around 25 lakhs, the investor has a host of options available to himself. The team decided to buy for the investor a 2BHK in a tier-2 city say Nagpur, which would by market estimates cost the investor Rs. 22lakhs. The remaining 3lakhs would be invested in government securities wherein the returns are not less than 7%, the only drawback of such an investment is the maturity period but with stable and safe returns the investor would be satisfied.