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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
Ba c kgro u nd, Basi c P rin c iples, andInvestment P oli c y ( c ontd)
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
Ba c kgro u nd, Basi c P rin c iples, andInvestment P oli c y ( c ontd)
Other important conceptsThe economic concept of utility
Return maximization (given a level of risk)
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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)
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
Ba c kgro u nd, Basi c P rin c iples, andInvestment P oli c y ( c ontd)
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