INVESTMENTS:
Analysis and Management
Learning Objectives
• Discuss why portfolio management should be
considered a process.
• Describe the steps involved in the portfolio
management process.
• Assess related issues such as asset allocation.
Portfolio Management
• Involves decisions that must be made by every
investor whether an active or passive investment
approach is followed
• Relationships between various investment
alternatives must be considered if an investor is
to hold an optimal portfolio
Portfolio Management as a
Process
• Definite structure everyone can follow
• Integrates a set of activities in a logical and
orderly manner
• Continuous and systematic
• Encompasses all portfolio investments
• With a structured process, anyone can execute
decisions for an investor
Portfolio Management as a
Process
• Objectives, constraints, and preferences are
identified
Leads to explicit investment policies
• Strategies developed and implemented
• Market conditions, asset mix, and investor
circumstances are monitored
• Portfolio adjustments are made as necessary
Individual vs.
Institutional Investors
• Institutional investors • Individual investors
Maintain relatively Life stage matters
constant profile over Risk defined as “losing
time money”
Legal and regulatory Characterized by
constraints personalities
Well-defined and Goals important
effective policy is critical Tax management is
important part of
decisions
Institutional Investors
• Primary reason for establishing a long-term
investment policy for institutional investors:
Prevents arbitrary revisions of a soundly
designed investment policy
Helps portfolio manager to plan and execute on a
long-term basis
• Short-term pressures resisted
Formulate Investment Policy
• Investment policy summarizes the objectives,
constraints, and preferences for the investor
• Information needed
Objectives
• Return requirements and risk tolerance
Constraints and Preferences
• Liquidity, time horizon, laws and regulations,
taxes, unique preferences and circumstances
Life Cycle Approach
• Risk/return position at
various life cycle stages
A: Accumulation phase –
early career
B: Consolidation phase –
A
Return mid-to-late career
B C: Spending phase –
spending and gifting
C
Risk
Formulate Investment Policy
• Investment policy should contain a statement
about inflation-adjusted returns
Clearly a problem for investors
Common stocks are not always an inflation hedge
• Unique needs and circumstances
May restrict certain asset classes
Formulate Investment Policy
• Constraints and Preferences
Time horizon
• Objectives may require specific planning horizon
Liquidity needs
• Investors should know future cash needs
Tax considerations
• Ordinary income vs. capital gains
• Retirement programs offer tax sheltering
Legal and Regulatory
Requirements
• Prudent Man Rule
Followed in fiduciary responsibility
Interpretation can change with time and
circumstances
Standard applied to individual investments
rather than the portfolio as a whole
Capital Market Expectations
• Macro factors
Expectations about the capital markets
• Micro factors
Estimates that influence the selection of a
particular asset for a particular portfolio
• Rate of return assumptions
Make them realistic
Study historical returns carefully
Constructing the Portfolio
• Use investment policy and capital market
expectations to choose portfolio of assets
Define securities eligible for inclusion in a
particular portfolio
Use an optimization procedure to select
securities and determine the proper portfolio
weights
• Markowitz provides a formal model
Asset Allocation
• Involves deciding on weights for cash, bonds,
and stocks
Most important decision
• Differences in allocation cause differences in
portfolio performance
• Factors to consider
Return requirements, risk tolerance, time horizon,
age of investor
Asset Allocation
• Strategic asset allocation
Simulation procedures used to determine
likely range of outcomes associated with each
asset mix
• Establishes long-run strategic asset mix
• Tactical asset allocation
Changes in asset mix driven by changes in
expected returns
Market timing approach
Asset Allocation Examples
• The following mix may be appropriate for a
young, knowledgeable investor with a long time
horizon and a high risk tolerance:
5% cash / 15% fixed income / 80% equities
• The following mix may be appropriate for a
retired investor with a short to medium time
horizon, with low risk tolerance, and a need for
current income:
20% cash / 60% fixed income / 20% equities
Monitoring Conditions and
Circumstances
• Investor circumstances can change for several
reasons
Wealth changes
Investment horizon changes
Liquidity requirement changes
Tax circumstance changes
Legal/Regulatory considerations changes
Unique needs and circumstances changes
Portfolio Adjustments
• Portfolio not intended to stay fixed
• Key is to know when to rebalance
• Rebalancing cost involves
Brokerage commissions
Possible impact of trade on market price
Time involved in deciding to trade
• Cost of not rebalancing involves holding
unfavourable positions
Performance Measurement
• Allows measurement of the success of
portfolio management
• Key part of monitoring strategy and
evaluating risks
• Important for:
Those who employ a manager
Those who invest personal funds
• Determine reasons for success or failure
