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Security Analysis and Portfolio Management

Notes Securities come in a bewildering variety of forms – there are more types of securities than there
are breeds of cats and dogs, for instance. They range from relatively straightforward to incredibly
complex. A straight bond promises to repay a loan over a fixed amount of interest over time and
the principal at maturity. A share of stock, on the other hand, represents a fraction of ownership
in a corporation, and a claim to future dividends. Today, much of the innovation in finance is in
the development of sophisticated securities: structured notes, reverse floaters, IO’s and PO’s –
these are today’s specialized breeds. Sources of information about securities are numerous on
the worldwide web. For a start, begin with the Ohio State Financial Data Finder. All securities,
from the simplest to the most complex, share some basic similarities that allow us to evaluate
their usefulness from the investor’s perspective. All of them are economic claims against future
benefits. No one borrows money that they intend to repay immediately; the dimension of time
is always present in financial instruments. Thus, a bond represents claims to a future stream of
pre-specified coupon payments, while a stock represents claims to uncertain future dividends
and division of the corporate assets. In addition, all financial securities can be characterized by
two important features: risk and return. These two key measures will be the focus of this unit.

12.1 Markowitz Risk-return Optimisation

Dr. Harry Markowitz is credited with developing the first modern portfolio analysis model
since the basic elements of modern portfolio theory emanate from a series of propositions
concerning rational investor behaviour set forth by Markowitz, then of the Rand Corporation,
in 1952, and later in a more complete monograph sponsored by the Cowles Foundation. It was
this work that has attracted everyone’s perspective regarding portfolio management. Markowitz
used mathematical programming and statistical analysis in order to arrange for the optimum
allocation of assets within portfolio. To reach this objective, Markowitz generated portfolios
within a reward-risk context. In other words, he considered the variance in the expected returns
from investments and their relationship to each other in constructing portfolios. In so directing
the focus, Markowitz, and others following the same reasoning, recognized the function of
portfolio management as one of composition, and not individual security selection – as it is
more commonly practiced. Decisions as to individual security additions to and deletions from
an existing portfolio are then predicated on the effect such a manoeuvre has on the delicate
diversification balance. In essence, Markowtiz’s model is a theoretical framework for the analysis
of risk return choices. Decisions are based on the concept of efficient portfolios.
A portfolio is efficient when it is expected to yield the highest return for the level of risk
accepted or, alternatively, the smallest portfolio risk for a specified level of expected return. To
build an efficient portfolio an expected return level is chosen, and assets are substituted until the
portfolio combination with the smallest variance at return level is found. As this process is
repeated for other expected returns, a set of efficient portfolios is generated.

Assumptions

The Markowitz model is based on several assumptions regarding investor behaviour.
1. Investors consider each investment alternative as being represented by a probability
distribution of expected returns over some holding period.
2. Investors maximize one period’s expected utility and progress along the utility curve,
which demonstrates diminishing marginal utility of wealth.
3. Individuals estimate risk on the basis of the variability of expected returns.
4. Investors base decisions solely on expected returns and variance (or standard deviation)
of returns only.

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