Portfolio Construction

Topics: Modern portfolio theory, Capital asset pricing model, Investment Pages: 12 (3758 words) Published: March 17, 2013


Table of Contents

Executive Summary3
The traditional Approach4
The Modern Approach4
Need for Study5
Literature Review6
Research Methodology8
Analysis and Interpretation10

Executive Summary
An equity portfolio consists of two or more securities. Individual securities have risk and return characteristics of their own. The portfolio which consists of these securities may or may not have the collective properties of the individual securities. By constructing a portfolio we are trying to reduce the risk and increase the return, than investing in a single stock. Risk is the variability of return. More dispersion or variability about a security’s expected return means the security was riskier than one with less dispersion. The risk of a portfolio can be reduced by having securities in which the risk of one security can be cancelled by the other. If we consider a portfolio of two securities, the important point is finding two securities in which every time one security performs poorly, the other security performs well. This will provide reasonable return to its investor, even if some of the stocks in the portfolio perform poorly. In this project we are taking Large Capital Securities and Mid Capital Securities to construct an equity portfolio with the help of Sharpe’s model of portfolio construction. From our analysis it is found that among the top companies in both the segment (Large Cap and Mid Cap), the portfolio consists of only one Large Cap security.

Portfolio construction is art of investing in a variety of funds or investment options that work together to cater the requirements of the investor. Portfolio constructions are of two types, they are Traditional Approach and Modern Approach. The traditional Approach

The traditional approach is based on Current Income and Capital Appreciation. Traditional approach starts with the analysis of constraints andetermine the objectives of investment, after which, the type of portfolio is selected. The portfolio can comprise of Bonds and Stock or only Bonds or only Common Stocks. After selecting the type of portfolio the risk and return of the selected type is assessed. The last step of Traditional approach is diversification. The Modern Approach

The Modern Approach constructs a portfolio to maximize the return from a portfolio at the given level of risk. This theory was put forward by Harry Markowitz in his article "Portfolio Selection," published in 1952 by the Journal of Finance. There are many models for Modern Approach. The first one was Markowitz Model, and then came Sharpe Model. In an ideal case we need a portfolio with securities or stocks with perfect negative correlation. Another method is Capital Asset Pricing Model. It is a relationship explaining how assets should be priced in the capital market. Markowitz is considered to be the father is modern approach. In Markowitz Model we consider only the Unsystematic Risk for the construction of the portfolio. In this model we have to calculate the co variation between each and every stock in the portfolio. If there are “n” numbers of stock in the portfolio, then it will become a hectic task to calculate the co variation between the “n” numbers of stocks, which comes around (n²-n)/2 calculations. William Sharpe is one who tried to simplify the Markowitz model for portfolio construction. According to him, instead of finding the relationship between each and every securities in the portfolio, it’s apt to find the relationship between the individual security and a common index, that common index is the market index. That is, to abandon the covariance of each security with each other security and to substitute information on the relationship of each security to the market. This approach significantly reduced...
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