Security Analysis and Portfolio Management
Security Analysis and Portfolio Management tests how securities are valued, how risk is measured and how portfolio performance is judged against risk taken.
Core rules
- Fundamental analysis proceeds economy → industry → company, valuing shares through the dividend discount model (P0 = D1/(Ke − g)), P/E multiples and book value. Technical analysis uses price and volume patterns and assumes trends persist.
- Total risk = systematic + unsystematic risk; diversification eliminates only the unsystematic part.
- CAPM: E(R) = Rf + β(Rm − Rf). Portfolio beta is the market-value-weighted average of constituent betas.
- Sharpe ratio = (Rp − Rf)/σp; Treynor ratio = (Rp − Rf)/βp; Jensen's alpha = Rp − [Rf + β(Rm − Rf)].
Worked example
Rf = 6%, Rm = 12%, β = 1.4. Required return = 6 + 1.4 × (12 − 6) = 14.4%. If the analyst expects 16%, the stock plots above the security market line: alpha = 16 − 14.4 = +1.6%, so it is underpriced and a buy candidate. If the expectation were 13%, alpha would be negative and the stock overpriced.
Traps
Feeding standard deviation into CAPM - beta is the priced risk measure; averaging expected returns instead of weighting by market value for portfolio beta; confusing Sharpe (total risk) with Treynor (systematic risk); mixing required return with historical realised return; forgetting that alpha is measured after adjusting for beta, not for total volatility.