[FAQs] on Portfolio Management

There are two types of risk – systematic (or non-diversifiable) and unsystematic (or diversifiable) relevant for investment – also, called as general and specific risk.

Types of Systematic Risk

1. Market risk: Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate. Major cause appears to be changing psychology of the investors. The irrationality in the security markets may cause losses unrelated to the basic risks. These losses are the result of changes in the general tenor of the market and are called market risks.
2. Interest Rate Risk: The change in the interest rate has a bearing on the welfare of the investors. As the interest rate goes up, the market price of existing fixed income securities falls and vice versa. This happens because the buyer of a fixed income security would not buy it at its face value if its interest rate is lower than the prevailing interest rate on a similar security.
3. Social or Regulatory Risk: The social or regulatory risk arises, where an otherwise profitable investment is impaired as a result of adverse legislation, harsh regulatory climate, or in extreme instance nationalization by a socialistic government.
4. Purchasing Power Risk: Inflation or rise in prices lead to rise in costs of production, lower margins, wage rises and profit squeezing etc. The return expected by investors will change due to change in real value of returns.

Types of Unsystematic Risk

1. Business Risk: As a holder of corporate securities (equity shares or debentures) one is exposed to the risk of poor business performance. This may be caused by a variety of factors like heightened competition, emergence of new technologies, development of substitute products, shifts in consumer preferences, inadequate supply of essential inputs, changes in government policies etc. But quite often the principal factor may be inept and incompetent management.
2. Financial Risk: This relates to the method of financing, adopted by the company, high leverage leading to larger debt servicing problem or short term liquidity problems due to bad debts, delayed receivables and fall in current assets or rise in current liabilities.
3. Default Risk: Default risk refer to the risk accruing from the fact that a borrower may not pay interest and/or principal on time. Except in the case of highly risky debt instrument, investors seem to be more concerned with the perceived risk of default rather than the actual occurrence of default. Even though the actual default may be highly unlikely, they believe that a change in the perceived default risk of a bond would have an immediate impact on its market price.

Capital Asset Pricing Model: The mechanical complexity of the Markowitz’s Portfolio model kept both practitioners and academics away from adopting the concept for practical use. Its intuitive logic, however, spurred the creativity of a number of researchers who began examining the stock market implications that would arise if all investors used this model. As a result what is referred to as the Capital Asset Pricing Model (CAPM), was developed.

The capital Asset pricing model was developed by Sharpe, Mossin and Lintner in 1960. The model explains the relationship between the expected return, non- diversifiable risk and the valuation of securities. It considers the required rate of return of a security on the basis of its contribution to total risk. It is based on the premise that the diversifiable risk of a security is eliminated when more and more securities are added to the portfolio. However, the systematic risk cannot be diversified and is or related with that of the market portfolio. As per CAPM,

Expected return on security = R_f + Beta (R_m – R_f).

Assumptions of CAPM

1. The investor’s objective is to maximize the utility of terminal wealth.
2. Investors make choices on the basis of risk and return.
3. Investors have identical time horizon.
4. Investors have homogenous expectations of risk and return.
5. Information is simultaneously and freely available to all investors.
6. There are no taxes, transaction costs, restrictions on short sales or other market imperfections.
7. Total asset quality is fixed and all assets are marketable and divisible.

The Efficient Market Hypothesis (EMH) is concerned with speed with which information affects the prices of securities. As per the study carried out by the technical analysts, it was observed that information is slowly incorporated in the price and it provides an opportunity to earn excess profit. However, once the information is incorporated then investor can not earn this excess profit.

Level of Market Efficiency: If price reflects all information, it is the highest order of market efficiency. According to FAMA, there exist three levels of market efficiency:-

1. Weak form efficiency – Price reflect all information found in the record of past prices and volumes.
2. Semi-strong efficiency – price reflect not only all information found in the record of past prices and volumes but also all other publicly available information.
3. Strong form efficiency – price reflect all available information public as well as private.

Some of the major challenges to efficient market theory are:

1. Information Inadequacy: Information is neither freely available nor rapidly transmitted to all participants in the stock market. There is a calculated attempt by many companies to circulate misinformation.
2. Limited information processing capabilities: Human information processing capabilities are sharply limited. According to Herbert Simon every human organism lives in an environment which generates millions of new bits of information every second but the bottle necks of the perceptual apparatus does not admit more than thousand bits per second and possibly much less.
   David Dreman maintained that under conditions of anxiety and uncertainty, with a vast interacting information grid, the market can become a giant.
3. Irrational Behaviour: It is generally believed that investors’ rationality will ensure a close correspondence between market prices and intrinsic values. But in practice this is not true. J. M. Keynes argued that all sorts of consideration enter into the market valuation which is in no way relevant to the prospective yield. This was confirmed by L.C. Gupta who found that the market evaluation processes work haphazardly almost like a blind man firing a gun. The market seems to function largely on hit or miss tactics, rather than on the basis of informed beliefs about the long term prospects of individual enterprise.
4. Monopolistic Influence: A market is regarded as highly competitive. No single buyer or seller is supposed to have undue influence over prices but in practice, powerful institutions and big operators wield great influence over the market. The monopolistic power enjoyed by them diminishes the competitiveness of the market.

There are three policies of portfolio rebalancing- Buy and hold policy, Constant mix policy, and Constant Proportion Portfolio Insurance (CPPI) policy.