The Process Ch01

8/8/2019 The Process Ch01

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Chapter 1

The Process of Portfolio Management

Portfolio Construction, Management, & Protection , 4e, Robert A. StrongCopyright 2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.


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Th e life of every man is a diary in w h ich h emeans to write one story, and writes

anot h er; and h is h umblest h our is w h en h ecompares t h e volume as it is wit h wh at h e

vowed to make it.

J.M. Barrie


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Ou tlineI ntroductionPart One: Background, Basic Principles,and I nvestment PolicyPart Two: Portfolio ConstructionPart Three: Portfolio ManagementPart Four: Portfolio Protection andContemporary I ssues


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Introd uc tionI nvestmentsSecurity AnalysisPortfolio ManagementPurpose of Portfolio ManagementLow Risk vs. High Risk I nvestmentsThe Portfolio Managers JobSix Steps of Portfolio Management


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InvestmentsTraditional investments covers:

Security analysis I nvolves estimating the merits of individual

investments

Portfolio management Deals with the construction and maintenance of a

collection of investments


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Secu rity AnalysisA three-step process

1) The analyst considers prospects for the economy,

given the stage of the business cycle2) The analyst determines which industries are likely to

fare well in the forecasted economic conditions3 ) The analyst chooses particular companies within the

favored industriesEI C analysis (a top-down approach)


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Portfolio M anagementLiterature supports the efficient markets

paradigmOn a well-developed securities exchange,asset prices accurately reflect the tradeoff

between relative risk and potential returns of asecurity

Efforts to identify undervalued undervaluedsecurities are fruitless

Free lunches are difficult to find


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Portfolio M anagement ( c ontd)Market efficiency and portfoliomanagement

A properly constructed portfolio achieves agiven level of expected return with the least

possible risk Portfolio managers have a duty to create the best

possible collection of investments for eachcustomers unique needs and circumstances


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P u rpose of PortfolioM anagement

Portfolio management primarily involvesreducing risk rather than increasing return

Consider two $10,000 investments:1) Earns 10 percent per year for each of ten years

(low risk )2) Earns 9 percent, 11 percent, 10 percent, 8

percent, 12 percent, 46 percent, 8 percent, 20 percent, 12 percent, and 10 percent in the tenyears, respectively ( high risk )


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L ow Risk vs . High Risk

Investments$25,937

$10,000

$23,642

$0

$10,000

$20,000

$30,000

'95 '97 '99 '01 '03 '05

owRisk HighRisk

Both investments have a mean return of 10 percent.


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L ow Risk vs . High Risk

Investments ( c ontd)1) Earns 10 percent per year for each of ten years

(low risk )

Terminal value is $25

,937

2) Earns 9 percent, 11 percent, 10 percent, 8 percent, 12 percent, 46 percent, 8 percent, 20 percent, 12 percent, and 10 percent in the tenyears, respectively ( high risk )

Terminal value is $2 3 ,642Th e lower t h e dispersion in t h e returns, t h e

greater t h e accumulated value of equal investments


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T he Portfolio M anagers J obBegins with a statement of investment

policy , which outlines:Return requirements

I nvestors risk tolerance

Constraints under which the portfolio mustoperate


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Six Steps of PortfolioM anagement

1) Learn the basic principles of finance2) Set portfolio objectives3 ) Formulate an investment strategy4) Have a game plan for portfolio revision5 ) Evaluate the performance6) Protect the portfolio when appropriate


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Six Steps of PortfolioM anagement ( c ontd)

Learn the BasicPrinciples of Finance

(Chapters 1 2)

Set Portfolio Objectives(Chapters 3 4)

Formulate anInvestment Strategy

(Chapters5

12)

Have a Game Plan for Portfolio Revision(Chapters 1 3 16)

Protect thePortfolio When

Appropriate(Chapters 1 9 23 )

Evaluate thePerformance

(Chapters 1 7 - 18 )


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O verview of the T extP AR T ONE: Background, Basic

Principles, andI nvestment Policy

P AR T TW O: Portfolio ConstructionP AR T T HR EE: Portfolio ManagementP AR T F OU R : Portfolio Protection and

Contemporary I ssues


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P AR T ONE

Ba c kgro u nd, Basi c P rin c iples, andInvestment P oli c y

A person cannot be an effective portfoliomanager without a solid gro u nding in thebasi c prin c iples of finan c eEgos sometimes get involved

Take time to review simple materialFluff and bluster have no place in the formationof investment policy or strategy


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P AR T ONE

Ba c kgro u nd, Basi c P rin c iples, andInvestment P oli c y ( c ontd)

There is a distinction between goodcompanies and good investments

The stock of a well-managed company may betoo expensive

The stock of a poorly-run company can be agreat investment if it is cheap enough


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P AR T ONE


The two key concepts in finance are:1) A dollar today is worth more than a dollar

tomorrow2) A safe dollar is worth more than a risky dollar

These two ideas form the basis for allaspects of financial management


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P AR T ONE


Other important conceptsThe economic concept of utility

Return maximization (given a level of risk)


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P AR T ONE


Setting objectivesI t is difficult to accomplish your objectivesuntil you know what they are

Terms like growt h or income may meandifferent things to different people


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P AR T ONE


I nvestment policyThe separation of investment policy frominvestment management is a fundamentaltenet of institutional money management

A board of directors or investment policycommittee establis h es policy An investment manager implements the plan


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P AR T TW O

Portfolio Constr uc tionF ormulate an investment strategy based

on the investment policy statementPortfolio managers must understand the basicelements of capital market theory

I nformed diversification

Nave diversification Beta


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P AR T TW O

Portfolio Constr uc tion ( c ontd)I nternational investment

Emerging markets carry special risk

Emerging markets may not be informationallyefficient


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P AR T TW O

Portfolio Constr uc tion ( c ontd)Stock categories and security analysis

Preferred stock Blue chips, defensive stocks, cyclical stocks

Security screeningA screen is a logical protocol to reduce thesecurity universe to a workable number for closer investigation


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P AR T TW O

Portfolio Constr uc tion ( c ontd)Debt securities

Pricing

Duration Enables the portfolio manager to alter the risk of

the fixed-income portfolio component

Bond diversification


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P AR T TW O

Portfolio Constr uc tion ( c ontd)Pension funds

Significant holdings in gold and timberland(real assets )

I n many respects, timberland is an idealinvestment for long-term investors with noliquidity problems


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PAR T T HR EE

Portfolio M anagementSubsequent to portfolio construction:

Conditions change

Portfolios need maintenance


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PAR T T HR EE

Portfolio M anagement ( c ontd)Passive management has the following

characteristics:Follow a predetermined investment strategythat is invariant to market conditions or

Do nothing

Let the chips fall where they may


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PAR T T HR EE

Portfolio M anagement ( c ontd)Active management:

Requires the periodic changing of the portfolio components as the managersoutlook for the market changes


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PAR T T HR EE

Portfolio M anagement ( c ontd)Options and option pricing

Black-Scholes Option Pricing model

Option overwriting A popular activity designed to increase the yield

on a portfolio and to improve performance in a flatmarket

Use of stock options under various portfolioscenarios


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PAR T T HR EE

Portfolio M anagement ( c ontd)Performance evaluation

Did the portfolio manager do what he or shewas hired to do?

Someone needs to verify that the firm followeddirections

I nterpreting the numbers How much did the portfolio earn? How much risk did the portfolio bear? Must consider risk in conjunction with return


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PAR T T HR EE

Portfolio M anagement ( c ontd)Performance evaluation (contd)

More complicated when there are cash depositsand/or withdrawals from the portfolioMore complicated when the manager uses options toenhance the portfolio yield

F iduciary dutiesResponsibilities for looking after someone elsesmoney and having some discretion in its investment


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P AR T F OU R

Portfolio P rote c tion andContemporary Issu es

Portfolio protection

Called portfolio insurance prior to 1 987

A managerial tool to reduce the likelihoodthat a portfolio will fall in value below a

predetermined minimum level


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P AR T F OU R

Portfolio P rote c tion andContemporary Issu es ( c ontd)

Futures

Related to optionsUse of derivative assets to: Generate additional income Manage risk

I nterest rate risk Duration


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P AR T F OU R

Portfolio P rote c tion andContemporary Issu es ( c ontd)

Contemporary issues

Derivative securitiesProgram tradingStock lending

Security analyst independenceCFA program

The Process Ch01

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