Investment Process Explained: Five Steps, Markowitz Model & Modern Portfolio Theory

Investment

Investment is the employment of funds on assets in aim of earning income or application of capital. Investment has two attributes 

• Time & 
• Risk

Present consumption is sacrifice to get in return in future. the sacrifice that has to be born in certain but the return in the future may be uncertain the attributes of investments indicate the risks factors the risks is undertaken with the view to in clue gets some return from investment. For example – for Layman investment means monetary commitment of investments a person commitment purchases a flat for his personal use this can’t be considered as actual investment as it is involving sacrifice but not yield ratio return. Tee financial investment is allocation of money to the assets that are same gain over same period of time. It’s and the exchange of money such as stock and bond they are expected to yield return and experience capital growth.

Five steps of investment process these are 

1. Investment Policy – first steps are which investment policy should be adopted weather the capital required for investment is borrowed from outside or own investment. If borrowed from outside then which type of lending we adopt equity or debts or combination of both.
• Investible funds – The investible funds are invested on safe ventures and also gave us optimum returns on the investment.
• Objective – The firms aim should be optimum use of capital funds so that getting maximum use of it.
• Knowledge – The investor invests that sector which have complete knowledge.
2. Analysis - Second step would be analysis of the investment. Evaluating investment opportunities through systematic analysis of the
• Market
• Industry
• Company
3. Valuation –
• Intrinsic value
• Future value
4. Portfolio construction
• Diversification
• Selection & allocation
5. Portfolio Evaluation
• Appraisal
• Revision

Markowitz Model 

Most people agree that holding two stocks is less risky than one stock but building of optimum portfolio is very difficult the Markowitz provide to it the help of the risk and return relationship.

Assumption

1. An individual investor estimates the risk on the basis of variability of risk the Variance of return.
2. Investor decision is sole based on the expected of return Variance of return only.

Concept

In developing his model Markowitz had givens single stock portfolio and introduce diversification a single security would be preferable if investor is perfectly certain the expectation of highest return would turn out to be real in the world of uncertainty most avers investor would like to join Markowitz rather keeping in single stock because diversification reduce risk.

Modern Portfolio Theory 

Modern portfolio theory of investment with attempt to maximize portfolio expected return for given amount of portfolio risk, or equivalently minimize risk for a given level of expected return by carefully choosing the proportion of various assets. Modern portfolio theory is a mathematical formulation concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual assets. That this is possible can be seen intuitively because different types of assets often change in value in opposite way. For example – to the extent price in the stock market more differently from price in the bond market a collection of both types of assets can in theory face lower overall risk than either individually, but diversification lowers risk even if assets return is not negatively correlated – indeed, even if they are positively correlated.

Portfolio theory deals with the value & risk of portfolio rather than individual securities it often called Modern portfolio theory or Markowitz portfolio theory.

The key result in portfolio theory is that the volatilities of the securities it contains the standard deviation of the expected return or a portfolio = √ (ΣW_a²σ_a² + ΣΣW_aW_bCov_ab)

Where:

• W_a is the size of the portfolio in security a,
• σ_a is the standard deviation of the expected return of the security a, and
• Cov_ab is the covariance of the expected returns of the securities a and b

Assuming that the covariance is less than one (invariably true), this will be less than the weight age average of the standard deviation of the expected return of the securities this is why diversification reduces risk the other important results in modern portfolio theory are those dealing with the construction of efficient portfolio. 

Modern portfolio theory is not universally accepted, despite being the standard text book description of portfolio risk & return. Markowitz himself thought normally distributed variance an inadequate measure of risk. Models have been developed that are asymmetric and fat tailed distribution (post modern portfolio theory). There is also more radical objection including an alternative behavioural portfolio theory. Any theory or strategies that suggest it is possible to outperform the market without taking extra risk contradicts Markowitz portfolio theory as does the evidence for the value effect or the existence of persistent arbitrage opportunities.

Note that: The last of there is necessarily a failure of market efficiency the two often confused at least in the contest of their failure.

Markowitz’s Selection of efficient portfolio  

Theory of selected portfolio or theory of a selection of efficient portfolio an investor must a s select the portfolio which will be best to suit which all are those which is available to him. The selection of most efficient portfolio can be discovered basically in the light theory Markowitz model as follows.

H.M. Model 

The model is developed by Harry Markowitz in 1952 it analysis the various possible portfolio of given number of securities and helps the selection of the best or the most efficient portfolio. The HM model shows as to how an investor reduce his risk mean the standard deviation (σ) of the portfolio return by choosing those which don’t more exactly together as the HM model is based on the expected return (Variance) of the different portfolio it is also called as mean Variance model.

Assumption 

1. In an investor basically risk averse and risk of the portfolio is estimated on the basis of variability of return their form.
2. The decision of the investor regarding to selection of the portfolio on the basis of return and risk of the portfolio.
3. An investor attempt to get maximum returns from the investment with minimum risk for given label of risk he attempted to earn the higher return.

Optimum Portfolio 

The theory of portfolio management describes the resulting risk and return of a combination of individual assets. A primary objective of the theory is to identify assets combination that are efficient here, efficiency means the highest expected rate of return on an investment for a specific level of risk. Portfolio theory integrates the process of efficient portfolio formation to the pricing of the individual assets can be eliminated or diversified away, by holding a proper combination of assets.

Risk & Return for individual securities 

if investor is restricted to holding single security, and since they prefer less risk to more risk, so they will prefer B to D and A to C. thus no rational, risk averse will hold C or D. the investor must decide whether the additional risk it also exhibits. If these are the only four alternatives, then A & B are efficient portfolio since they exhibit the high return for a given risk level. Rational investor however may disagree which of the two portfolios to select. For example – if the expected return on were 12 % and the expected return and B were 20%, then a portfolio with an equal proportion of each would be expected to 16% if proportion of B was increased, the expected return would be rise, conversely, it would decline if the proportion of A was enhanced determining the risk inherent in these two securities. Portfolio is somewhat more complex. There are a risk component contribution f A and B. statistically, this third component is referred to as covariance or correlation. This co movement term can be strong or weak. It can also positive, indicating that the return from A & B tend to move in the same direction. Although the co movement component makes risk analysis of portfolio more complicated, it also represents the source of risk diversification and provide superior investment alternative for many investors than can be allowed by holding A or B in isolation.

Construction of optimum portfolio

1. The key to construction an optimal portfolio is asset allocation three type of assets
• Share – High risk & high return
• Bond – less volatile than stock but offer lower return.
• Cash & cash equivalents – NSD, Deposit, Treasury bill
2. Choosing your assets allocation on might be the most important investment decision you will ever make the bad news is, no universal mix of stocks, bonds and cash is right for everyone. The good news is you can tailor your portfolio to your specific circumstance & needs let start with the business.
3. What is asset allocation – asset allocation is the apportioning of investment dollar among assets categories such as stock, bonds and cash equivalent, some inventors also hold secondary assets classes such as real estate, precious metals and collectibles your allocation is the percentage (%) in which you divide your total portfolio into each category.
4. Why is an asset allocation important – Studies shows that decisions about assets allocation can have a far greater impact on investment results than specific bond or mutual fund choices the idea is that because the returns of different assets classes are not perfectly correlated – that is they don’t move up and down at the same time? The overall risk of a portfolio is reduced by diversification, simply put you, and don’t keep all your eggs in one basket. Diversification, incidentally, is important within assets classes as well as among them.
5. Why change my assets allocation an overtime – It has to do with risk & reward. The 30-year-old investor might have a longer investment time horizon in which to ride out the ups and down of the stock market and therefore invest more in stocks. The 50-year-old, with a shorter time horizon, might seek to decrease portfolio volatility and therefore tilt towards bonds, which generally are considered safer. A final word,  it’s important to rebalance one’s portfolio every year to ensure your asset allocation remain on track.

Risk 

risk in investment means that the future return form that investment is unpredictable the concept of risk may be defined as the possibilities that the actual return may not be same as expected. In other words, the actual result or outcome may vary from the estimate so, the risk may be also be considered as a chance of variation or chance of loss. Risk consists of two components –

1. Systematic risk – It affects the entire market the systematic risk is caused by factors external to the particular company and uncontrollable by the company. The economic conditions, political situation and the sociological changes affect the security market. The systematic risk further sub divided into three part –
• Market risk – Jack Clark Francis define market risk as that portion of total variability of return caused by the alternating force of bull & bear market. In bull market, the index moves from a low level to the peak & bear market is just a reverse to the bull market.
• Interest rate risk – It is the variation in the single period rate of return caused by the fluctuation in the market interest rate. It mostly affects the price of bonds, debenture & stock. It generally caused by the changes in the government monetary policy and the charge in the interest rate of treasury bills and government bonds.
• Purchase power risk – it is the probable loss in the purchasing power of the return to be received it is cause due to inflation may be demand pull or cost push inflation.
2. Unsystematic risk – It is unique and peculiar to a firm or an industry. Its factors are specific unique and related to the particular industry or company this is cause due to inefficient technological change in the production process, availability of raw materials, change in the customer preference and labor problems. It is classified into two categories.
• Business risk – business risk is that portion of the systematic risk caused by the operating environment of the business it a rise from the inability of affirm to maintain its competitive edge and the growth or stability of the earning it can be divided into external business risk & internal business risk.
• Internal business risk – fluctuation in the sales, research & development, personnel management, fixed cost, single product.
• External business risk – social & regulatory factors, political risk, business cycle.
• Financial risk – It is associated with the capital structure of the company. Capital structure of the company consists of equity fund and borrowed fund.

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Sandeep Ghatuary

Finance & Accounting blogger simplifying complex topics.

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