Investment Analysis and Portfolio Management

Introduction: The Science of Investing

Investment Analysis and Portfolio Management is a field that deals with the management of an individual's or an institution's investments. The process involves identifying investment objectives, analyzing and valuing different types of securities, and constructing a diversified portfolio that balances risk and return. This course is designed to provide you with a rigorous and practical understanding of the investment process. We will move from analyzing individual assets to understanding how to combine them in a way that maximizes return for a given level of risk, based on the principles of modern portfolio theory.

Module 1: The Investment Environment

This module provides an overview of the investment landscape, including the different types of assets available for investment and the markets where they are traded.

• Investment vs. Speculation: Understanding the key differences between investing (long-term, based on analysis) and speculating (short-term, based on market sentiment).
• Investment Avenues (Asset Classes):
  • Equity Shares: Represent ownership in a company and offer the potential for capital appreciation and dividends.
  • Debt Instruments: Securities like bonds and debentures that pay a fixed interest income.
  • Real Estate: Investment in physical property.
  • Commodities: Investment in raw materials like gold, silver, and oil.
  • Mutual Funds: A professionally managed investment fund that pools money from many investors to purchase a diversified portfolio of securities.
• Financial Markets: The primary market (where new securities are issued) and the secondary market (where existing securities are traded, e.g., stock exchanges).
• Risk and Return: The fundamental trade-off in investing. Higher potential returns are typically associated with higher risk. We will learn how to measure historical risk (using standard deviation) and return.

Module 2: Security Analysis

Security analysis is the process of determining the value of a security. There are two main approaches to security analysis: fundamental analysis and technical analysis.

2.1 Fundamental Analysis

Fundamental analysis involves evaluating a security's intrinsic value by examining related economic, financial, and other qualitative and quantitative factors. The goal is to identify undervalued securities.

• Top-Down Approach: This involves a three-step analysis:
  1. Economic Analysis: Analyzing the overall state of the economy (e.g., GDP growth, inflation, interest rates).
  2. Industry Analysis: Analyzing the specific industry in which the company operates (e.g., using Porter's Five Forces).
  3. Company Analysis: Analyzing the company itself, including its financial statements (ratio analysis), management quality, and competitive position.
• Equity Valuation Models:
  • Dividend Discount Model (DDM): Values a stock by discounting its expected future dividends back to the present.
  • Price/Earnings (P/E) Ratio: A relative valuation metric that compares a company's stock price to its earnings per share.

2.2 Technical Analysis

Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts believe that market trends and patterns can predict future price movements.

• Key Assumptions: (1) The market discounts everything, (2) prices move in trends, and (3) history tends to repeat itself.
• Tools of Technical Analysis:
  • Charts: Line charts, bar charts, and candlestick charts are used to visualize price movements.
  • Trends and Patterns: Identifying chart patterns like head and shoulders, triangles, and flags.
  • Technical Indicators: Moving averages, Relative Strength Index (RSI), and MACD are used to generate buy and sell signals.
• Efficient Market Hypothesis (EMH): A theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. We will discuss the three forms of EMH: weak, semi-strong, and strong.

Module 3: Modern Portfolio Theory (MPT)

Developed by Harry Markowitz, MPT is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

3.1 Diversification and Portfolio Risk

The core idea of MPT is that holding a combination of assets is less risky than holding any single asset. This is because the returns of different assets do not move perfectly together.

• Systematic Risk (Market Risk): Risk inherent to the entire market, which cannot be eliminated through diversification (e.g., risk of a recession).
• Unsystematic Risk (Specific Risk): Risk specific to an individual company or industry, which can be reduced through diversification.
• The Power of Diversification: By combining assets with low correlation, a portfolio's overall risk (standard deviation) can be reduced without sacrificing expected return.

3.2 The Markowitz Model

This model provides a mathematical framework for creating an "efficient frontier" of optimal portfolios. The efficient frontier is a set of portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.

Module 4: Portfolio Management and Asset Pricing

This module builds on MPT to introduce key asset pricing models and discuss the practical aspects of managing a portfolio.

4.1 The Capital Asset Pricing Model (CAPM)

CAPM is a model that describes the relationship between systematic risk and expected return for assets, particularly stocks. It is widely used for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.

• The CAPM Formula: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate).
• Beta: A measure of a stock's volatility in relation to the overall market. A beta of 1 means the stock moves with the market. A beta > 1 indicates the stock is more volatile than the market, and a beta < 1 means it is less volatile.

4.2 Portfolio Management Strategies

• Active Portfolio Management: Involves active stock picking and market timing in an attempt to outperform the market.
• Passive Portfolio Management: Involves creating a portfolio that mimics a market index (e.g., an index fund). This strategy is consistent with the Efficient Market Hypothesis.

4.3 Portfolio Performance Evaluation

How do we know if a portfolio manager is doing a good job? We use risk-adjusted performance measures to evaluate portfolio returns.

• Sharpe Ratio: Measures the excess return (return above the risk-free rate) per unit of total risk (standard deviation).
• Treynor Ratio: Measures the excess return per unit of systematic risk (beta).
• Jensen's Alpha: Measures the portfolio's return in excess of what would be predicted by the CAPM. A positive alpha indicates superior performance.