Approaches in portfolio construction
Commonly, there are two approaches in the construction of the portfolio of securities that is traditional approaches and markowitz efficient Frontier approach. In the traditional approach, investors need in terms of income and capital appreciation are 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 modern approach, portfolios are constructed to maximize the expected return for a given level of risk. Use portfolio construction in terms of the expected return and the risk associated with obtaining the expected return.
1. Traditional approach
The traditional approach basically deals with two major decisions. They are:
a) Determining the objectives of the portfolio.
b) Selection of securities to be included in the portfolio.
Normally, this is carried out in 4 to 6 steps. Before formulating the objectives, the constraints of Investor should be analysed. Within a given framework 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 business categories that he or she is trying to minimise. Compromise on risk and non risk factor has to be carried out. Finally relative portfolio weights are assigned to securities like bonds stocks and debentures and then diversification is carried out.
Analysis of Constraints: The constants normally discussed are: income needs, liquidity, time horizon, safety tax considerations and the temperament.
Income needs: the information depend on the need for income in constant rupees and current rupees. The need for income in current rupees arises from the investors 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.
a) need for current income: The investor should establish the income which the portfolio should generate. The current income made depends upon the entire current financial plan of the investor. The expenditure required to maintain a certain level of standard of living and all the other income generating sources should be determined. Once this information is arrived at, it is possible to decide how much income must be provided for the portfolio of securities.
b) 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 recognised 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 too early 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 a 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 horison is the investment planning period of the individuals. This varies from individual to individual. Individuals risk and return preferences are often described in terms of his "life cycle". The stages of the life cycle determined the nature of investment. The first stage of 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 maybe the house he owns. His priority to what 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 horizontal of life expectancy which possibilities of growth in income, he can invest in high waist and growth oriented investments.
The Other stage of the time horizen if the mid career individual. At this stage, his assets are larger than his liabilities. Potential pension benefits are available to him. But this time establishes his Investment program. The time horizont before him is not as long as the earliest age 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 one 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 programs are completed by him. He shift his investment to low return and low risk category investments, because safety of the principal is given priority. Mostly he likes to have a 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 considered the tax concessions they could get from their investments. For all practical purpose, they would like to reduce the taxes. For income tax purpose, interest and dividends are taxed under which 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 done 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 that is 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 NSE can avoid taxation. Discount stream 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 objective. Some investors are risk lovers or takers who would like to take up higher even for low return. While some investors are risk averse, who may not be willing to undertake higher level of given 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 rupees ₹100-₹200and returns may fluctuate between ₹00-₹100 in a year. 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 objective: Portfolios have the common objective of Financing present and future expenditure from a large pool of assets. The return that the investor requires the degree of risk is willing to take depend upon the constraints. Objectives of portfolio range from income to capital appreciation. The common objective are stated below:
a) current income
b) growth in income
c) capital appreciation
d) 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 objective simultaneously. The investor aims at capital appreciation, he should include risky securities where there is an equal likelihood of using 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 selection of portfolio under different objective are dealt subsequently.
Objectives and asset mix: if the main objective is getting adequate amount of current income, 60% of the investment is made on debts and 40% on equities. The proportions of investment 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, defence 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 investor opts for long term debt. The maturity period may be a constraint.
Growth of income and assessments: here the investor requires a certain percentage of growth in the ankle receive from his investment. The investors portfolio consists of 60-100 % equities and 0 to 40% 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 means that the value of the additional investment increases over the years. Investment in real estates like land and house may provide a faster rate of capital appreciation but they lack liquidity. In the capital market, Diwali of the shershah 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. Market capitalisation also has increased. Next to real assets, stock market provide best opportunity for capital appreciation. If the investor's objective is capital appreciation, 90-100% office portfolio mein consists of equity 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 investors portfolio may consist more of debt instruments and within the debt portfolio more would be on short term dates.
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 raised and his ability to take specific risks. The risks are namely interest rate risk, purchasing power risk, financial risk and market risk. The investor analysis the varying degrees of risk and construct 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 minimise.
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 minimised by commitments to top-quality bonds, but the securities of a poor resistance to inflation. Stocks provide better inflation protection than bonds but are more vulnerable to financial risks. Good quality convertibles mein balance the financial risk and purchasing power risk. According to the investors 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, she 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 criteria then industries, which resists 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 perception 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 locks 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. Is 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 for appreciation. Bara selection is based on the risk and return analysis. Return includes the market return and dividend. Then Western meets return and it may be either in the form of market return or dividend. There are seem to be indifferent towards the form of return.
From the list of stocks quoted at the Bombay Stock exchange or it any other regional Stock exchange, the investor selections of me some group of shares say of 10 or 15 stocks. For these stocks, expected return and risk would be calculated. The investor is Asin to happy objective of maximizing the expected return and minimising the risk. Further, it is assumed that investors would take an 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 requirements of the investor. The risk taker that is who are willing to accept a higher probability of risk for getting me expected return would choose high-risk portfolio. Investor with you lower tolerance for risk would choose low level risk portfolio. The risk neutral investor book shows the medium level risk portfolio.
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