Port folio analysis

Port folio simply means a group of securities held together for investment purpose. It is usual that of the investors tends to invest in a group of securities rather than single security. Individual securities have risk return characteristics of thereon. Usually the investors have an awaration of risk. It is hoped that if money is invested in several securities simultaneously. The loss in one will be compensated by the gain in others. Therefore creation of portfolio is important. This creation of portfolio is termed as diversification. The efficiency of portfolio can be evaluated only in terms of expected return and risk. Thus determining the expected risk and return of different portfolio is called portfolio analysis.
Portfolio selection
The objective of every rational investor is to maximize his return and minimize risk. Diversification is a method adopted for reducing risk. It essentially resulted in the construction of portfolio. The proper goal of portfolio construction would be to generate a portfolio that provides the highest return and lowest risk. The investor should maximize return at a given level of risk or minimize risk at a given level of return. Such a portfolio would be known as optimal portfolio. The process of finding optimal portfolio is described as portfolio selection.

*Markowitz theory

Markowitz was the first who has developed modern portfolio analysis model for portfolio construction. He generated a portfolio within a return-risk context. He considered the variance in the expected returns from investment and their relationship to each other in constructing portfolio.
Modern portfolio theory has brought out by Markowitz. It is the construction of securities to get the most efficient portfolio. A portfolio is efficient when it is expected to yield the highest relation for the level of risk accepted for a alternatively the smallest portfolio risk for a specified level of expected return. Markowitz used mathematical and statistical analysis in order to arrange for the optimum allocation of asset within portfolio.

Assumptions within Markowitz theory

1. Investors base these decision on the expected rate of return of
theirinvestment.
2. The market is efficient all investors would react all securities in the
market.
3. All investors are risk owns.
4. By combining asset the security returns are co-related to each other.
5. Investors combines the investment by getting maximum return with minimum
risk.
6. The investor can reduce his risk if he adds investments in his portfolio.
Markowitz has shown the effect combining the securities with the help of
finding out the different mathematical and statistica tools like standard
dividend., co-efficient of co-relation.

Limitations of Markowitz model

One of the major problems in this model is that a large number of input data required for the calculation. With a given set of securities infinite number of portfolio can be constructed. Because of this difficulty it found little use in practical application of portfolio analysis. Much simplification is needed and this is achieved through index models. There are essentially two types of index models.

1. Single Index Model
2. Multi Index model.

1. Single index model

It is the simplest and most widely used simplification and may be considered as the extreme point of the continuum with Markowitz model. The basic notion underlying the single index model is that all stocks are affetcetd by movements in the stock market. Casual observations in the stock prices reveals that when the market moves up prices of the most shares tempt to increase. When the market goes down response to market changes.


Sharpe Single Index Model

William Sharp tried to simplify the Markowitz method of diversification of portfolio. Sharpe index model simplifies the process of Markowitz model by reducing the data in a sustentative manner. He assumed that security not only have individual relationship but they are related to each other through some indexes represented by business activity. Sharpe has improved the estimate of expected return and variance of index which may be one or more and are related to economic activity. Sharpe index showed that the return of each securities is co-related by some securities.

2. Multi Index model.

The single index model is infact an over simplification. It assumes that stock together only because of a common movement with the market. Many researchers found that there are influences other than market that cause stock to move together. Multi index model attempts to identify and incorporate these non market factors that cause securities to move together also into the model. These extra factors are a set of economic factors that leads to changes in price. A multi index complex and require more data estimate for its application. But single index model and multi index model have helped to make portfolio analysis practical.