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Security Analysis and Portfolio Management

Notes Investment Decision-making

Investment decision-making can best be viewed as an integrated process to which security
analysis makes its unique contribution. Portfolio management requires the consistent application
of economic, capital market and sector analysis to the definition of objectives and the measurement
of performance. Security analysis serves the investment decision-maker by identifying the
fairly priced or under-priced securities that are most likely to produce the desired results.

Investment policies and asset allocation strategies are developed based on the following
objectives:
1. To earn a sufficient "real" rate of return and maintain the purchasing power of its assets
adjusted for inflation in perpetuity.
2. To control portfolio risk and volatility in order to provide as much year-to-year spending
stability as possible and still meet.

2.1 Risk Defined

Risk can be defined as the probability that the expected return from the security will not
materialize. Every investment involves uncertainties that make future investment returns risk-
prone. Uncertainties could be due to the political, economic and industry factors.

Risk could be systematic in future depending upon its source. Systematic risk is for the market
as a whole, while unsystematic risk is specific to an industry or the company individually. The
first three risk factors discussed below are systematic in nature and the rest are unsystematic.
Political risk could be categorised depending on whether it affects the market as whole, or just
a particular industry.

2.1.1 Systematic versus Non-systematic Risk

Modern investment analysis categorizes the traditional sources of risk causing variability in
returns into two general types: those that are pervasive in nature, such as market risk or interest
rate risk, and those that are specific to a particular security issue, such as business or financial
risk. Therefore, we must consider these two categories of total risk. The following discussion
introduces these terms. Dividing total risk into its two components, a general (market) component
and a specific (issuer) component, we have systematic risk and non-systematic risk, which are
additive:
Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Non-systematic risk

Systematic Risk: An investor can construct a diversified portfolio and eliminate part of the total
risk, the diversifiable or non-market part. What is left is the non-diversifiable portion or the
market risk. Variability in a security's total returns that is directly associated with overall
movements in the general market or economy is called systematic (market) risk.
Virtually all securities have some systematic risk, whether bonds or stocks, because systematic
risk directly encompasses interest rate, market, and inflation risks. The investor cannot escape
this part of the risk because no matter how well he or she diversifies, the risk of the overall
market cannot be avoided. If the stock market declines sharply, most stocks will be adversely
affected; if it rises strongly, as in the last few months of 1982, most stocks will appreciate in
value. These movements occur regardless of what any single investor does. Clearly, market risk
is critical to all investors.

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