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  • 1

    The Process of Portfolio Management

    Presentation by:

    William Wood CFP®

  • 2

    Investments

    Traditional investment processes cover:

    • 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 investor considers prospects for the economy,

    given the stage of the business cycle,

    2) Determines which industries are likely to fare well in

    the forecasted economic conditions,

    3) Chooses particular companies within the favored

    industries

    • EIC (Economy, Industry, Company) analysis

    (a top-down approach)

  • 4

    Portfolio Management

     Literature supports the

    • efficient markets hypothesis

    • 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 will be

    essentially fruitless

    – Free lunches are difficult to find

  • 5

    Portfolio Management (cont’d)

     Market efficiency and portfolio

    management

    • A properly constructed portfolio achieves a

    given level of expected return with the least

    possible risk

  • 6

    Purpose of Portfolio

    Management

     Portfolio management primarily involves

    reducing 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 ten

    years, respectively (high risk)

  • 7

    Low Risk vs. High Risk

    Investments

    $25,937

    $10,000

    $23,642

    $0

    $10,000

    $20,000

    $30,000

    ' '99 '01 '03 '05 '07

    Low Risk

    High Risk

    Both investments have a mean return of 10 percent.

  • 8

    Low Risk vs. High Risk

    Investments (cont’d)

    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 ten years, respectively (high risk)

    • Terminal value is $23,642

     The lower the dispersion in the returns, the greater the accumulated value of equal investments

  • 9

    Managing Your Portfolio

     Begins with a statement of investment

    policy, which outlines:

    • Return requirements: given the funds

    available for investment, what ROI do I need

    to reach my goal.

    • Risk tolerance: how much risk am I

    comfortable with.

    • Portfolio constraints: when do I need the

    money.

  • 10

    Six Steps of Portfolio

    Management

    1) Learn the basic principles of finance

    2) Set portfolio objectives

    3) Formulate an investment strategy

    4) Have a game plan for portfolio revision

    5) Evaluate the performance

    6) Protect the portfolio when appropriate

  • 11

    Step One

    Background, Basic Principles, and

    Investment Policy

    A investor cannot effectively manage a

    portfolio without a solid grounding in the

    basic principles of finance

    Egos sometimes get involved

    • Take time to review “simple” material

    • Fluff and bluster have no place in the formation

    of investment policy or strategy

  • 12

    Step One

    Background, Basic Principles, and

    Investment Policy (cont’d)

    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

  • 13

    Step One

    Background, Basic Principles, and

    Investment Policy (cont’d)

     The two key concepts in finance are:

    1) A dollar today is worth more than a dollar

    tomorrow…inflation erodes the purching

    power of a dollar!

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

     These two ideas form the basis for all

    aspects of portfolio management

  • 14

    Step Two

    Set Portfolio Objectives

     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

  • 15

    Step Two (con’t)

    Investment Policy

     Investment policy

    • The separation of investment policy from

    investment management is a fundamental

    tenet of money management

  • 16

    Step Three

    Portfolio Construction

     Formulate an investment strategy based

    on the investment policy statement

    • Investors must understand the basic elements

    of capital market theory

    – Informed diversification

    – Naïve diversification

    – Beta

  • 17

    Step Three

    Portfolio Construction (cont’d)

     Informed Diversification

     Security screening

    • A screen is a logical protocol to reduce the security

    universe to a workable number for closer

    investigation

  • 18

    Step Four

    Portfolio Management

     Subsequent to portfolio construction:

    • Economic conditions change

    • Market conditions change

    • Portfolios need maintenance

  • 19

    Step Four

    Portfolio Management (cont’d)

     Passive management has the following

    characteristics:

    • Follow a predetermined investment strategy

    that is invariant to market conditions

    • Do nothing

    • Let the chips fall where they may

    • Buy and Hold

  • Portfolio Management (cont’d)

    Passive Management

    Less knowledge required

    Reduced psychological anxiety in

    management

    • When to buy and sell??

    The argument for index investing with

    mutual funds?

    20

  • 21

    Step Four

    Portfolio Management (cont’d)

     Active management:

    • Requires the periodic changing of the

    portfolio components as the investor’s

    outlook for the market changes; business

    cycles evolve; Black Swan events change the

    playing field.

  • Active Management Through

    Rebalancing the Portfolio

    Rebalancing a portfolio is the process of

    periodically adjusting it to maintain the

    original conditions

  • Rebalancing Within the

    Equity Portfolio

    Constant Mix

    Constant Proportion Portfolio Insurance

    Constant Beta Portfolio

  • Constant Mix Strategy

    The constant mix strategy:

    • Is one in which the investor makes adjustments to maintain the relative weighting of the asset classes within the portfolio as their prices change

    • Requires the purchase of securities that have performed poorly and the sale of securities that have performed the best

  • Constant Mix Strategy (cont’d)

    Example (cont’d)

    What dollar amount of stock should the portfolio

    manager buy to rebalance this portfolio? What dollar

    amount of bonds should he sell?

    Date Portfolio Value Actual Allocation Stock Bonds

    1 Jan $2,000,000 60%/40% $1,200,000 $800,000

    1 Apr $2,500,000 56%/44% $1,400,000 $1,100,000

  • Constant Proportion

    Portfolio Insurance

    A constant proportion portfolio

    insurance (CPPI) strategy requires the

    investor to invest a percentage of the

    portfolio in stocks

  • Constant Proportion

    Portfolio Insurance (cont’d)

    Example

    A portfolio has a market value of $2 million. The

    investment policy statement specifies a floor value of $1.7

    million and a multiplier of 2.

    What is the dollar amount that should be invested in

    stocks according to the CPPI strategy?

  • Constant Proportion

    Portfolio Insurance (cont’d)

    Example (cont’d)

    Solution: $600,000 should be invested in stock:

    $ in stocks = 2.0 × ($2,000,000 – $1,700,000)

    = $600,000

    If the portfolio value is $2.2 million one quarter later, with $650,000 in stock, what is the desired equity position under the CPPI strategy? What is the ending a

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