The Process of Portfolio

Management

1
 Outline
 Introduction
 Part one: Background, Basic Principles, and
Investment Policy
 Part two: Portfolio construction
 Part three: Portfolio management
 Part four: Portfolio protection and
contemporary issues
2
 Investments
 Traditional investments covers:
• Security analysis
– Involves estimating the merits of individual
investments
• Portfolio management
– Deals with the construction and maintenance of a
collection of investments

3
 Security Analysis
 A three-step process
1) The analyst considers prospects for the
economy, given the state of the business cycle
2) The analyst determines which industries are
likely to fare well in the forecasted economic
conditions
3) The analyst chooses particular companies
within the favored industries
• EIC analysis (a top-down approach)
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 Portfolio Management
 Literature supports the efficient markets
paradigm
• On a well-developed securities exchange,
asset prices accurately reflect the tradeoff
between relative risk and potential returns of
a security
– Efforts to identify undervalued securities are
fruitless
– Free lunches are difficult to find
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 Portfolio Management
 Market efficiency and portfolio
management
• A properly constructed portfolio achieves a
given level of expected return with the least
possible risk
– Portfolio managers have a duty to create the best
possible collection of investments for each
customer’s unique needs and circumstances

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 Purpose of Portfolio
Management
 Portfolio management primarily involves
reducing risk rather than increasing return
• Consider two Rs10,000 investments:
1) Earns 10% per year for each of ten years (low
risk)
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%,
-12%, and 10% in the ten years, respectively (high
risk)

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 Low Risk vs. High Risk
Investments
$30,000
$25,937

$23,642
$20,000
Low
Risk
High
$10,000
$10,000 Risk

$0
'92 '94 '96 '98 '00 '02
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 Low Risk vs. High Risk
Investments
1) Earns 10% per year for each of ten years (low
risk)
• Terminal value is Rs25,937
2) Earns 9%, -11%, 10%, 8%, 12%, 46%, 8%, 20%,
-12%, and 10% in the ten years, respectively
(high risk)
• Terminal value is Rs23,642

 The lower the dispersion of returns, the greater

the terminal value of equal investments
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 The Portfolio Manager’s Job
 Begins with a statement of investment
policy, which outlines:
• Return requirements

• Investor’s risk tolerance

• Constraints under which the portfolio must

operate
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 The Steps of Portfolio
Management
1) Set portfolio objectives
2) Formulate an investment strategy
3) Have a game plan for portfolio revision
4) Evaluate performance
5) Protect the portfolio when appropriate

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 Background, Basic Principles, and
Investment Policy
 There is a distinction between “good
companies” and “good investments”
• The stock of a well-managed company may be
too expensive
• The stock of a poorly-run company can be a
great investment if it is cheap enough

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 Investment Policy
 Guide the investor towards the investment
process
– Investor aware about the investment and market?
– Legal restrictions in investment?
– What will happen in adverse financial condition
 Judging the performance of Portfolio
manager
 Benchmark Portfolio
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 Investment Policy
 Investment objective
 Risk tolerance
 Investment constraints

– Age
– Source of Income
– Risk appetite
– The assets you wish to acquire in future
– The time period for your investment
– Expenditure

Rule 1: Never Lose Money

Rule 2: Never forger rule 1
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THE FUNDAMENTAL CORNER STONES OF
SUCCESSFUL INVESTING

 SAVE REGULARLY, INVEST

REGULARLY
 START EARLY
 USE TAX SHELTERS
 INVESTMENT RETURNS SHOULD
EXCEED THE INFLATION.
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PYRAMID OF INVESTMENT
AVENUES

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 Background, Basic Principles, and
Investment Policy
 The two key concepts in finance are:
1) A dollar today is worth more than a dollar
tomorrow
2) A safe dollar is worth more than a risky dollar

 These two ideas form the basis for all

aspects of financial management
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 Background, Basic Principles, and
Investment Policy
 Other important concepts
• The economic concept of utility

• Return maximization

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 Background, Basic Principles, and
Investment Policy
 Setting objectives
• It is difficult to accomplish your objectives
until you know what they are

• Terms like growth or income may mean

different things to different people

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 Portfolio Construction
 Formulate an investment strategy based
on the investment policy statement
• Portfolio managers must understand the basic
elements of capital market theory
– Informed diversification
– Beta

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 Portfolio Construction
 International investment
• Emerging markets carry special risk

• Emerging markets may not be informationally

efficient

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 Portfolio Construction
 Pension funds
• Significant holdings in gold and timberland
(real assets)

• In many respects, timberland is an ideal

investment for long-term investors with no
liquidity problems

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 Portfolio Management
 Subsequent to portfolio construction:
• Conditions change

• Portfolios need maintenance

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 Portfolio Management
 Passive management has the following
characteristics:
• Follow a predetermined investment strategy
that is invariant to market conditions or

• Do nothing

• Let the chips fall where they may

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 Portfolio Management
 Active management:
• Requires the periodic changing of the
portfolio components as the manager’s
outlook for the market changes

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 Portfolio Management
 Performance evaluation
• Did the portfolio manager do what he or she
was hired to do?
– Someone needs to verify that the firm followed
directions
• Interpreting the numbers
– How much did the portfolio earn?
– How much risk did the portfolio bear?
– Must consider return in conjunction with risk
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 Evaluation

 Timing the market

 Selection of superior stocks
 Constant review
 Long term investment philosophy

• Difficult in beating the market with market

timing
• Better to hold market portfolio: Index (page 11)
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 Portfolio Management
 Performance evaluation More complicated when
there are cash deposits and/or withdrawals
• More complicated when the manager uses options to
enhance the portfolio yield

 Fiduciary duties
• Responsibilities for looking after someone else’s
money and having some discretion in its investment

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 Portfolio Protection and
Contemporary Issues
 Portfolio protection
• Called portfolio insurance

• A managerial tool to reduce the likelihood

that a portfolio will fall in value below a
predetermined level

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 Portfolio Protection and
Contemporary Issues
 Futures
• Related to options
• Use of derivative assets to:
– Generate additional income
– Manage risk

 Interest rate risk

• Duration
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 Efficient Portfolio and Efficient
Frontier
 The curve enveloping all portfolios that lie
between the portfolio that has the highest
variance and the portfolio that offers the
highest return is the efficient frontier

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Opportunity ñ Equity Style

Individual Asset Classes

35

30

25

20

15

10

Traditional Assets
Hedge Funds
0
0 5 10 15 20 25 30

Risk

32
Secondary Asset Mix Decisions ñ Value, Growth, Small Cap

Efficient Frontier
Equity - Value, Growth, Small/Fixed Income

14.0

12.0

10.0

8.0

6.0

4.0
Equity/FI
2.0
Equity(Value, Grow th, Small)/FI

0.0
0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 22.0 24.0

Risk

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