Portfolio is a combination of securities such as stocks, bonds and money market instruments. The process of blending together the broad asset classes so as to obtain optimal return with minimum risk is called portfolio constructions. Diversification of investments helps to spread risk over many assets. A diversification of securities gives the assurance of obtaining the anticipated return on a portfolio. In a diversified portfolio, some securities may not perform as expected, but others may exceed the expectation and making the actual return of the portfolio reasonably close to the anticipated one. Keeping a Portfolio of single security many to a greater likelihood of the actual return somewhat different from that of the expected return. Hence, it is a common practice to diversify securities in the portfolio.
Approaches in portfolio construction
Commonly, there are two approaches in the construction of the portfolio of securities that is traditional approaches and markowitz efficient Frontier approach. In the traditional approach, investors need in terms of income and capital appreciation are evaluated and appropriate securities are selected to meet the needs of the investor. The common practice in the traditional approach is to evaluate the entire financial plan of the individual. In the modern approach, portfolios are constructed to maximize the expected return for a given level of risk. Use portfolio construction in terms of the expected return and the risk associated with obtaining the expected return.
1. Traditional approach
The traditional approach basically deals with two major decisions. They are:
a) Determining the objectives of the portfolio.
b) Selection of securities to be included in the portfolio.
Normally, this is carried out in 4 to 6 steps. Before formulating the objectives, the constraints of Investor should be analysed. Within a given framework of constraints, objectives are formulated. Then based on the objectives, securities are selected. After that, the risk and return of the securities should be studied. The investor has to assess the major business categories that he or she is trying to minimise. Compromise on risk and non risk factor has to be carried out. Finally relative portfolio weights are assigned to securities like bonds stocks and debentures and then diversification is carried out.
Modern approach
The traditional approach is a comprehensive financial plan for the individual. It takes into account the individual needs such as housing, life insurance and pension plans. But these types of financial planning approaches are not done in the Markowitz approach. Markowitz gives more attention to the process of selecting the portfolio. Is Planning can be applied more in the selection of common stocks portfolio than the bond portfolio. The stocks are not selected on the basis of need for income for appreciation. Bara selection is based on the risk and return analysis. Return includes the market return and dividend. Then Western meets return and it may be either in the form of market return or dividend. There are seem to be indifferent towards the form of return.
From the list of stocks quoted at the Bombay Stock exchange or it any other regional Stock exchange, the investor selections of me some group of shares say of 10 or 15 stocks. For these stocks, expected return and risk would be calculated. The investor is to happy objective of maximizing the expected return and minimizing the risk. Further, it is assumed that investors would take an risk in a situation when adequately rewarded for it. This implies that individuals would prefer the portfolio of highest expected return for a given level of risk.
In the modern approach, the final step is asset allocation process that is to choose the portfolio that meets the requirements of the investor. The risk taker that is who are willing to accept a higher probability of risk for getting me expected return would choose high-risk portfolio. Investor with you lower tolerance for risk would choose low level risk portfolio. The risk neutral investor book shows the medium level risk portfolio.
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