Page 263 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes 10.1 Inputs to Portfolio Analysis

Portfolio analysis builds on the estimates of future return and risk of holding various
combinations of assets. As we know, individual assets have risk return characteristics of their
own. Portfolios, on the other hand, may or may not take on the aggregate characteristics of their
individual parts. In this section, we will reflect on the assessment of return-risk attributes of
individual assets and portfolios.

Return and Risk Characteristics of Individual Assets

For individual assets, the returns are measured in an intuitively logical way over the
predetermined investment horizon (or holding period). For instance, the returns from investment
in equity shares are measured over a single holding period (t) as follows:
Total Returns = [Dividends + (Market Prices – Market Prices – 1)]/[Market Prices – 1]
Within a multi-period framework, one may even apply a discounting model to estimate returns.
What an investment analyst essentially endeavours to obtain is the forecasts of return.
It is axiomatic that return predictions are seldom accurate. So, investment analyst also aims at
measuring ‘upside’ potential and ‘downside’ danger – that is, the potential that actual returns
may exceed the estimate and the danger that the returns may be less than that. In investment
parlance, this is known as measuring ‘investment risk’.
Usually, an analyst obtains, for a given period of time in the future, a series of possible rates of
return with some probability of occurrence for each return estimate. Based on the distribution of
these return estimates, he computes two summary statistics, namely ‘expected (or mean) rate of
return’ and the ‘variance (or equivalent i.e., its square root, (or the standard deviation) of return
distribution’. The latter, which measures the breadth of the distribution of expected returns
from an investment, is considered a measure of the investment risk.

A question with variance as a measure of risk is: why count ‘happy’ surprises (those above the
expected return) at all in a measure of risk? Why not just consider the deviations below the
expected return (i.e. the downside danger)? Measures that do so have much to recommend them.
But if a distribution is symmetric, such as the normal distribution, the result will be the same.
Because the left side of a symmetric distribution is a mirror image of the right side. Although
distributions of forecasted returns are often non-normal, analysts generally assume normality
to simplify their analysis.

Expected Return and Risk of a Portfolio

The return on a portfolio of assets is simply a weighted average of the return on the individual
assets. The weight applied to each return is the fraction of the portfolio invested in that asset.
Thus,
n
r = x r
p i i
i 1
Where
r = Expected return of the portfolio;
p
x = Proportion of the portfolio’s initial fund invested in asset i;
i
r = Expected return of asset i; and
i
n = Number of assets in the portfolio;

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