Risk:

Risk is uncertainty of the income /capital appreciation or loss or both. All investments are risky.
The higher the risk taken, the higher is the return. But proper management of risk involves the
right choice of investments whose risks are compensating. The total risks of two companies may
be different and even lower than the risk of a group of two companies if their companies are
offset by each other.

The two major types of risks are:

 Systematic or market related risk.

 Unsystematic or company related risks.

Systematic risks affected from the entire market are (the problems, raw material availability, tax
policy or government policy, inflation risk, interest risk and financial risk). It is managed by the
use of Beta of different company shares.

The unsystematic risks are mismanagement, increasing inventory, wrong financial policy,
defective marketing etc. this is diversifiable or avoidable because it is possible to eliminate or
diversify away this component of risk to a considerable extent by investing in a large portfolio of
securities. The unsystematic risk stems from inefficiency magnitude of those factors different
form one company to another.

RETURNS ON PORTFOLIO:

Each security in a portfolio contributes return in the proportion of its investments in security.
Thus the portfolio expected return is the weighted average of the expected return, from each of
the securities, with weights representing the proportions share of the security in the total
investment. Why does an investor have so many securities in his portfolio? If the security ABC
gives the maximum return why not he invests in that security all his funds and thus maximize
return? The answer to this questions lie in the investor’s perception of risk attached to
investments, his objectives of income, safety, appreciation, liquidity and hedge against loss of
value of money etc. this pattern of investment in different asset categories, types of investment,
etc., would all be described under the caption of diversification, which aims at the reduction or
even elimination of non-systematic risks and achieve the specific objectives of investors

RISK ON PORTFOLIO :

The expected returns from individual securities carry some degree of risk. Risk on the portfolio
is different from the risk on individual securities. The risk is reflected in the variability of the
returns from zero to infinity. Risk of the individual assets or a portfolio is measured by the
variance of its return. The expected return depends on the probability of the returns and their
weighted contribution to the risk of the portfolio. These are two measures of risk in this context
one is the absolute deviation and other standard deviation.

Most investors invest in a portfolio of assets, because as to spread risk by not putting all eggs in
one basket. Hence, what really matters to them is not the risk and return of stocks in isolation,
but the risk and return of the portfolio as a whole. Risk is mainly reduced by Diversification.

RISK RETURN ANALYSIS:

All investment has some risk. Investment in shares of companies has its own risk or uncertainty;
these risks arise out of variability of yields and uncertainty of appreciation or depreciation of
share prices, losses of liquidity etc

The risk over time can be represented by the variance of the returns. While the return over time
is capital appreciation plus payout, divided by the purchase price of the share.
Normally, the higher the risk that the investor takes, the higher is the return. There is, how ever,
a risk less return on capital of about 12% which is the bank, rate charged by the R.B.I or long
term, yielded on government securities at around 13% to 14%. This risk less return refers to lack
of variability of return and no uncertainty in the repayment or capital. But other risks such as loss
of liquidity due to parting with money etc., may however remain, but are rewarded by the total
return on the capital. Risk-return is subject to variation and the objectives of the portfolio
manager are to reduce that variability and thus reduce the risky by choosing an appropriate
portfolio.

Traditional approach advocates that one security holds the better, it is according to the modern
approach diversification should not be quantity that should be related to the quality of scripts
which leads to quality of portfolio.

Experience has shown that beyond the certain securities by adding more securities expensive.

Simple diversification reduces:

An asset’s total risk can be divided into systematic plus unsystematic risk, as shown below:
Systematic risk (undiversifiable risk) + unsystematic risk (diversified risk) =Total risk
=Var (r).

Unsystematic risk is that portion of the risk that is unique to the firm (for example, risk due to
strikes and management errors.) Unsystematic risk can be reduced to zero by simple
diversification.

Simple diversification is the random selection of securities that are to be added to a portfolio. As
the number of randomly selected securities added to a portfolio is increased, the level of
unsystematic risk approaches zero. However market related systematic risk cannot be reduced by
simple diversification. This risk is common to all securities.

CONCEPT OF EFFICIENT PORTFOLIO:

Assume that X is selected it is in –efficient portfolio because

1. If he is prepare to take a risk of STD deviation for the same risk “Y”. gives in the higher rate of
Ry . Therefore “Y” is a dominant portfolio and “X” is a dominated portfolio.

2.if a investor is satisfied with the return of Rx , the same return can be earn by choosing portfolio
“Z” which has a similar risk of std deviation x (As against larger risk std deviation x)

The dominants principle states that among all the investment opportunities available with a given
return, the investment with the least risk is the most desirable one or among the investment in a
given risk class, the one with the highest return with the most desirable one. Risk principle is also
called Efficient set theorem.

In the light of this segment A, B is the relevant portion of the feasible set it is called the Markowitz
efficient frontier. It is so called because all efficient portfolios lie on this frontier.
 An efficient portfolio is one, that gives the highest return for given return or a minimum risk for a
given return, these efficient portfolios are also refer as means variance efficient portfolios. The
shape of the efficient frontier is given by Delta RP /Delta STD deviation p.

1. RISK FREE ASSET:

Investment in risk free asset is often referred to as risk free lending. Since this approach involves
investing for a single holding period, it means that the return of the risk free asset is certain. That
is, if the investor purchases this asset at the beginning of the holding period, then the investor
knows exactly what the value of the asset will be at the end of the holding project. Since there is no
uncertainty about the terminal value of the risk free asset, the standard deviation of the risk free
assets, by definition, zero. In turn, this means that the covariance between the rate of return on the
risk free asset and the rate of return on any risky asset is zero.

2. INVESTMENT IN BOTH THE RISK FREE ASSETS AND A RISKY ASSTS:

The efficient frontier would be altered substantially if a risk frees securities is included among
available investment opportunities. While a risk free security does not exist in the strict sense of the
word, there are securities, which promise return with relative certainty. They are characterized by an
absence of default risk and return rate; full payment of principle is assured with out serious prospect
of capital loss arising from changes in the level of interest rates. A risk free security of this type
includes cash, short-term treasury bills, and time deposits in banks or savings and loan association;
cash would be dominated by the other positive return investments.

Given the opportunity to either borrow or lend at the risk free rate, an investor proceed to identify
the optimal portfolio by plotting his or her indifference curves on graph and nothing where once of
them is tangent to the indifference efficient set.

For example portfolio, has an expected return of 11% and a standard deviation of 12.5%. However,
portfolio is not efficient, since portfolio B has the same expected return but a standard deviation of
only 8%. Portfolio but not efficient, l since portfolio f has a still higher return with the same degree
of risk as e and h. Portfolio A is a single equity portfolio that has the highest return and risk; in no
way can investor improve on its return-to-risk ratio. If investor moves to the right on the curve,
return decreases and risk decreased. Hence investor moves to the left and down. The only way the
investor can obtain a higher return on the efficient frontier is to accept a higher return on the efficient
frontier is to accept a higher amount of risk.

Where investors operate on the capital market line depends on their attitudes towards risk and return.
Investors must determine their own preference for risk and return by way of a difference cure. In
theory, the investor will invest the combination of securities found at the point where the highest
indifference curve just touches the capital market line. Investors might have higher return and lower
risk goals, but they can obtain those combinations only on the capital market line, and will invest at
some point that gives the combination of returns and risk that allows them to maximize net worth
and make a satisfactory investment

To be realistic, assume that the investor’s borrowing rate is above the lending rate. Combination of
lending or borrowing with a portfolio of risky assets lies along a straight lines, with lending and
borrowing the efficient frontier. Noticed that for all investors, expect for those whose risk-return
trade-offs causes they to hold portfolios, the ability to lend and borrow improve their opportunities.
The ability to lend is hardly controversial. The borrowing part may be more controversial.
Borrowing and buying a less risky portfolio can give higher returns and less risk and buying a more
risky portfolio.

Higher expected return at the same risk level by borrowing. Of course, borrowing like short sales,
almost any financial mechanism can be abused. It can be used to take extreme and imprudent risk
position. On the other hand, it can be used to enhance performance. Rejecting borrowing entirely
would throw out positive opportunities. For example, consider an investor wishing to have a high
portfolio with greater expected returns than offered by portfolio B. this investor would have the
same expected return and less risk by buying port folio B and borrowing than by buying portfolio,
which does not involve borrowing.
Returning to the concept of the efficient frontier, it is necessary to deal further into the subject of
prudent investment. In an efficient frontier, an investor should never hold a security or portfolio that
lie below that frontier. Because all single securities expect the risk less asset lie below the frontier,
there is almost never a situation where a single security is efficient. All efficient portfolios are will
diversified.

CAPITAL ASSET PRICING MODEL(CAPM)

The relevant risk for an individual asset is a systematic risk (or market –market risk) because non
market risk can be eliminated by diversification, the relationship between an asset’s return and its
systematic risk can be expressed by the CAPM, which is also called the security market (SML). The
equation for the CAPM is as follows:

E(ri)=R+[E(rm)-R]bi

Where E (ri) is the expected return for an asset,

R is the risk-free rate (usually assumed to be a short-term T-bill rate)
E (rm)equals the expectecmarket return (usually assumed to be the S&P500)
Bi denotes for the asset’s beta.

The CAPM is an equilibrium model for measuring the risk-return tradeoff for all asset s including
both inefficient and efficient portfolios. A graph of the CAPM is given below:
 Figure representing : RISK EXPOSURE OF PORTFOLIO

Assumptions underlying CAPM

The Capital Asset Pricing Model {CAPM} is an equilibrium model. The derivation of the model is
based on several assumptions about investors and the market, whichwe present below for
completeness. Investors are assumed to take in to account only two parameters of return distribution,
namely the mean and the varience , in making a choice of portfolio . in other words, it is assumed
that a secutity can be completely represented in terms of its expected return and varience and those
investors behave as if a security were a commodity with two attributes,namely , expected return
which is a desirable attribute and varience, which is an undesirable attribute. Investors are supposed
to be risk averse and for every additional unit of risk they take, they demand compensation in terms
of expected returns.

Again the capital market is assumed to be efficient. An efficient market implies that all new
information which could possibly affect the share price becomes available to all the investors
quickly and more or less simultaneously. Thus in an efficient market no single investor has an edge
over another it terms of the information possessed by him since all investor are supposedly well
informed and rational,meaning that all of them process the available information more or less alilke.
And finally in an efficient market, all investors are price takers, i.e., no investor are so big as to
affect the price of security significantly by virtue of his trading in that security

The Capital Asset Pricing Model also assumes that the difference between lending and borrowing
rates are negligibly small for investors. Also, the investors are assumed to make a single period
investment decisions. The cost of transactions and information are assumed to be negligibly small.
The model also ignores the existence of taxes, which may influence the investor’s behavior.

The fact that some of the above assumptions are some what restrictive has attracted considerable
criticism of the model. This however need not distract us from main thrust of the model. The Capital
Asset Pricing Model merely implies that in a reasonably well-functioning market where a large
number of knowledgeable financial analysts operate, all securities will yield returns consistence with
their risk, since if this were not is, the knowledgeable analysts will be able to take advantage of the
opportunities for disproportionate returns and there by reduce such opportunities.

Hence, according to CAPM, in an efficient market, returns disproportionate to risk are difficult to
come by. assumptions concerning the investor behavior, market efficiency, lending and borrowing
rates, etc., are to be taken not in their literal sense, but rather as approximate conditions. Factors such
as taxes, transaction cost, etc, can be easily incorporated in to the model for greater rigor.

The security market line (SML) express the basic theme of the CAPM i.e.., expected return of a
security increases linearly with risk, as measured by Beta. It can be drawn as follows.
The SML is upward sloping straight line with an intercept at the risk free return securities and passes
through the market portfolio. The upward slope of the line indicates that greater expected return
accompany higher level of Beta. In equilibrium, each security or portfolio lies on the SML.

In the above figure that the return expected from portfolio or investment is a Combination of risk
free return plus risk premium. An investor will come forward to take risk only if the return on
investment also includes risk premium.

The CAPM has shown the risk and return relationship of a portfolio in the following formula.

E (Ri) =Rr +ßi-(Rm-Rr)

Where

E (Ri) = expected rate of return on any individual security (or portfolio of security)

Rr =Risk free rate of return

Rm =expected rate of return on the market portfolio.

ßi =market sensitivity index of individual security (or portfolio of securities)

B. INVESTMENT DECISION

By a certain sum of funds, the investment decision are basically depends upon the following
factors:-
I. Objectives of investment portfolio: This is a crucial point which a Finance Manager must
consider. There can be many objectives of making an investment. The manager of a provident
fund portfolio has to look for security and may be satisfied with none too high a return, where as
an aggressive investment company is willing to take high risk in order to have high capital
appreciation. How the objectives can affect in investment decision can be seen from the fact that
the Unit Trust of India has two major schemes : Its “capital units” are meant for those who wish
to have a good capital appreciation and a moderate return, where as the ordinary unit are meant
to provide a steady return only. The investment manager under both the scheme will invest the
money of the Trust in different kinds of shares and securities. So it is obvious that the objectives
must be clearly defined before an investment decision is taken.

II. Selection of investment: Having defined the objectives of the investment, the next decision is
to decide the kind of investment to be selected. The decision what to buy has to be seen in the
context of the following:-

a. There is a wide variety of investments available in market i.e. Equity shares, preference share,
debentures, convertible bond, Govt.securities and bond, capital units etc. Out of these what types
of securities to be purchased

b. What should be the proportion of investment in fixed interest dividend securities and variable
dividend bearing securities. The fixed one ensure a definite return and thus a lower risk but the
return is usually not as higher as that from the variable dividend bearing shares.

c. If the investment is decided in shares or debentures, then the industries showed a potential in
growth should be taken in first line. Industry-wise-analysis is important since various industries
are not at the same level from the investment point of view. It is important to recognized that at a
particular point of time, a particular industry may have a better growth potential than other
industries. For example, there was a time when jute industry was in great favour because of its
growth potential and high profitability ,the industry is no longer at this point of time as a growth
oriented industry.

d. Once industries with high growth potential have been identified, the next step is to select the
particular companies, in whose shares or securities investments are to be made.
To identify the industries, which have a high growth potential the following
techniques/approaches may be taken in to consideration:-

a. Statistical analysis of past performance: A statistical analysis of the immediate past

performance of the share price indices of various industries and changes there in related to the
general price index of shares of all industries should be made. The Reserve Bank of India index
numbers of security prices published every month in its bulletin may be taken to represent the
behaviour of share prices of various industries in the last fiew years. The related changes in the
price index of each industry as compare with the changes in the average price index of the shares
of all industries would show those industries which are having a higher growth potential in the
past fiew years. It may be noted that a Industry may not remaining a growth Industry for all the
time. So we have to make an assessment of the various Industries keeping in view the present
potentiality also to finalized the list of Industries in which we will try to spread our investment.

b. Assessing the intrinsic value of an Industry/Company:-

After identifying the Industry, we have to assess the various factors which influence the value of
a particular share. Those factors generally relate to the strengths and weaknesses of the company
under consideration, Characteristics of the industry within which the company fails and the
national and international economic scene. The major objective of the analysis is to determine
the relative quality and the quantity of the security. It is also to be seen that the security is good
at current market prices. This approach is known as intrinsic value approach.
Industry analysis can help to assess the nature of demand of a particular product, Cost structure
of the industry and other economic and Govt. constraints on the same. An appraisal of the
particular industries prospect is essential and the basic profitability of any company is depends
upon the economic prospect of the industry to which it belongs. The following factors are
important in this regards:-

a. Demand and Supply pattern for the industries products and its growth potential: The
management expert identify fives stages in the life of an industry. These are “Introduction,
development, rapid growth, maturity and decline”. If an industry has already reached the
maturity or decline stage, its future demand potential is not likely to be high.
b. Profitability: It is a vital consideration for the investors as profit is the measures of
performance and a source of earning for him. So the cost structure of the industry as related to its
sale price is an important consideration. The other point to be considered is the ratio analysis,
especially return on investment, gross profit and net profit ratio of the existing companies in the
industry.
c. Particular characteristics of the industry: Each industry has its own characteristics, which must
be studied in depth in order to understand their impact on the working of the industry. Because
the industry having a fast changing technology become obsolete at a faster rate. Similarly, many
industries are characterized by high rate of profits and losses in alternate years. Such fluctuations
in earnings must be carefully examine.

d. Labour management relations in the industry: The state of labour-management relationship in

the particular industry also has a great deal of influence on the future profitability of the industry.
So it is vital to see that the industry under analysis has been maintaining a cordial relationship
between labour and management.
e. Company Analysis: To select a company for investment a number of qualitative factors have
to be seen to visualize the performance of the company in future by analyzing its past
performance such as :-
1. Size and ranking: In this regard the net capital employed, the net profits,the return on
investment and the sales volume of the company under consideration may be compared with
similar data of other company in the same industry group to assess the risk associated with the
company.
2. Growth record: Three growth indicators may be looked in to i.e.
Price earnings ratio, Percentage growth rate of earnings per annum and Percentage growth rate of
net block of the company in the past fiew years should be examined.
3. Financial analysis: By the help of Financial analysis we can understand
the financial solvency and liquidity, the efficiency, the profitability and the financial and
operating leverage of the company in which the fund are used.

4. Pattern of existing stock holding: This analysis would show the stake of
Various parties associate with the company. An interesting case in this regard is that of the
Panjab National Bank in which the L.I.C. and other financial institutions had substantial
holdings. When the bank was nationalized, the residual company proposed a scheme whereby
those shareholders, who wish to opt out, could received a certain amount as compensation in
cash. It was only at the instant and bargaining strength of institutional investors that the
compensation offered to the shareholders, who wish to opt out of the company, was raised
considerably.

5. Marketability of the shares: Mere listing of a share on the stock exchange does
not automatically mean that the share can be sold and purchase. There may be inactive shares
with no transaction for long period. So we have to examined the speculative interest of such
scrip, extent of public holding and the particular stock exchange where it is traded.
Fundamental analysis thus is basically an examination of the economics and financial aspects of
a company with the aim of estimating future earnings and dividend prospect. So after having
analysed of all the relevant information we have to decide whether we should buy or sell the
securities.

II. Timing of Purchases:-

The timing of dealings in the securities, specially shares is of crucial

importance, because after correctly identifying the companies one may lose
money if the timing is bad due to wide fluctuation in the price of shares of
that companies.

The decision regarding timing of purchases is particularly difficult because

of certain psychological factors. It is obvious that if a person wishes to
make any gains, he should buy cheap and sell dear, i.e. buy when the share are selling at a low
price and sell when they are at a higher price. But in practical it is a difficult task. When the
prices are rising in the market i.e. there is bull phase, everybody joins in buying without any
delay because every day the prices touch a new high. Later when the bear face starts, prices
tumble down everyday and everybody starts counting the losses. The ordinary investor regretted
such situation by thinking why he did not sell his shares in previous day and ultimately sell at a
lower price. This kind of investment decision is entirely devoid of any sense of timing.

There are various theories and technique to deal with the portfolio management, some of their
concept are discuss shortly hereunder:-

Dow Jones theory: According to this theory of Charles H. Dow , purchase should be made when
bull trend started i.e. when price of the share are on the rise and sells them when they are on the
fall i.e. at the time when bearish trend started.

Randam walk theory: Basically stock prices can never be predicted because they are not a result
of any underlying factors but are mere statistical ups and downs. This hypothesis is known as
Randam walk hypothesis. In the Layman’s language it may be said that prices on the stock
exchange behave exactly the way a drunk would behave while walking in a blind lane, i.e. up
and down, with an unsteady way going in any direction he likes, bending on the side once and on
the other side the second time.

Capital Assets Pricing Model(CAPM): CAPM provides a conceptual framework for evaluating
any investment decision. It is used to estimate the expected return of any portfolio with the
following formula:
E(Rp) = Rf+Bp(E(Rm)-Rf)
Where,
E(Rp) = Expected return of the portfolio
Rf = Risk free rate of return
Bp = Beta portfolio i.e. market sensitivity index
E(Rm)= Expected return on market portfolio
(E(Rm)-Rf)= Market risk premium

The above model of portfolio management can be used effectively to:-

*Estimate the required rate of return to investors on company’s common stock.
**Evalute risky investment projects involving real Assets.
***Explain why the use of borrowed fund increases the risk and increases the rate of return.
****Reduce the risk of the firm by diversifying its project portfolio.
Moving Average: It refers to the mean of the closing price which changes constantly and moves
ahead in time, there by encompasses the most recent days and deletes the old one.