Portfolio Management

Unit – 1Session No.5

Topic: Investment Objectives

Session Plan• Recap the Previous Session• How the return is measured?–What is investor’s expectation on return?–What are the specific return objectives?–What are the different types of return measures?

• How to reduce portfolio risk?• What is VaR?• What is Absolute Risk and Relative Risk?

Give example.• Why risk budgeting is required?

Recap

What is an Return Objective?• The investment policy framework is the return

objective, which must be consistent with the risk objective.–willingness and ability in setting the risk objective– It requires a resolution of return desires versus the risk

objective• Formulating a return objective, the investor must address

the following four questions:–How is return measured?–How much return does the investor say she wants?–How much return does the investor need to achieve, on

average? –What are the specific return objectives?

Return Objectives• How is return measured?• The usual measure is total return, the sum of

the return from price appreciation and the return from investment income.–Holding period returns (or) Average Returns

• Nominal returns must be distinguished from real returns. –Nominal returns are unadjusted for inflation. – Real returns are adjusted for inflation and

sometimes simply called inflation-adjusted returns.

How is return measured?

How is return measured?

How is return measured?• An investor purchased Rs.1,000 of a mutual

fund's shares. The fund had the following total returns over a 3- year period :

• Year 1 - 5%, • Year 2 – (-)8%, • Year 3 - 12%. • Calculate the value at the end of the 3 -year

period, the holding period return, the mean annual return, and the geometric mean annual return.

How is return measured?• Real return is nominal return adjusted for

inflation• Example: An investor who earns a nominal

return of 7% over a year when inflation is 2%.• The investor’s approximate real return is

simply 7 -2 = 5%.• The investor’s exact real return is slightly

lower,• 1.07/1.02 – 1 = 4.9%

What is an Return?• How much return does the investor say he wants?• This amount is the stated return desire. • These wants or desires may be realistic or unrealistic.• An investor may have higher-than-average return

desires to meet high consumption.–The adviser or portfolio manager must continually

evaluate the desire for high returns and,–The investor’s ability to assume risk and the

reasonableness of the stated return desire, especially relative to capital market conditions

What is an Return?• How much return does the investor need

to achieve, on average?• This amount is known as required return

or return requirement.– investors requirements typically achievable, at

least on average.• Example– the return that a retired investor must earn on

his investment portfolio to cover his annual living expenses.

What is an Return?• What are the specific return objectives?• The return objective incorporates – the required return, – the stated return desire, and – the risk objective into a measurable annual total

return specification.• An investor’s return objective should be

consistent with that investor’s risk objective.• A relative return objective is stated as a return

relative to the portfolio benchmark’s total return

What is an Return?

Summarizing• What is absolute return?• How much return does the investor need to

achieve, on average?• Distinguish return requirement and risk tolerance

for different types of investors. • What are the specific return objectives?